Can government efforts to streamline private equity and venture capital investments erase their weak spots? – BusinessToday

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On February 1, 2022, Finance Minister Nirmala Sitharaman responded to a long-standing request from the venture capital (VC) and private equity (PE) community by announcing that the government would set up an expert panel to examine issues concerning the investor ecosystem. Seven months later, a high-level panel headed by former Sebi chairman Mr. Damodaran was formed and tasked with suggesting measures to scale up private equity and venture capital investment in the country.

India’s PE/VC industry is still in its infancy. According to a report by the Indian Venture and Alternate Capital Association (IVCA)-EY, the industry made investments worth $77 billion in 1,266 deals in 2021. In the first half of 2022, venture capitalists -investment and venture capital recorded investments worth $34 billion in 714 deals. Over 80% of private capital invested in India comes from foreign investors – there is no other significant source of venture capital available for the country’s growing businesses. Foreign investors continue to invest, convinced that India will outperform other markets.

Yet investors and funds are grappling with ambiguity related to the taxation of deferred interest, the treatment of long-term capital gains (LTCG), restrictive foreign pricing rules and the co- investment, the use of convertible instruments, the lack of hedging and leverage options, downside protections, and the lack of a one-stop-shop system to address industry issues.

PE/VC investors believe that the country’s regulations have not kept pace with the complexity of this industry. “We are making regulations unnecessarily complex, which is why 80% of capital still looks like FDI. Reforms need to be [about] rationalization [processes]making unnecessary steps easier and leveling the playing field with foreign VCs,” says Karthik Reddy, chairman of industry body IVCA, and co-founder and managing partner of Blume Ventures.

One of the main demands of investors is to find a solution to the taxation of “carried interest” or “carry”, which is taxed under income tax as well as GST. Carry, in venture capital parlance, is the share of profits that the general partners of a venture capital fund receive as compensation for managing a fund. Bhavin Shah, head of transactions at PwC India, suggests that the committee should consider making the “pass-through” provisions of the Income Tax Act applicable to funds to determine that carried interest retains the same character as the underlying income of the fund, similar to the practices followed by countries such as the United States and the United Kingdom. “Overall, the ‘carried interest’ is taxed as a capital gain (profit sharing) and not as income from services. Think of the manager as an active partner in a partnership business and the investors as passive partners. Except for the payment of appropriate remuneration (management fees in the case of the fund industry), the distribution of profits between partners is not treated as service income,” he explains. .

Reddy says these regulatory complexities put Indian funds at a disadvantage. “Someone sitting in New York can close a deal much more quickly and efficiently, without even traveling to India, on more tax-efficient terms, while hard-raised money from an Indian fund is subject to GST because he’s based here. How can we compete?” Reddy asks.

Another long-standing request is to bring parity in the treatment of LTCGs for listed and unlisted securities. The LTCG tax rate is 10% for listed shares and 20% for unlisted shares. PE/VC is an asset class that invests patient capital, venture capital and stays for the long haul, industry players say, adding that the introduction of parity in the LTCG tax will encourage more investors to enter in industry.

Pranav Parikh, managing partner of PE and VC funds at Edelweiss Financial Services, says foreign pricing rules are still very restrictive in India. “One of the things that restricts foreign entities in this country is that they are considered foreign owned and controlled even though all their capital is in India and it never leaves the country. [country’s] shores,” he says. It also calls for hedging and leverage to be allowed within the structure of the AIF.

Manav Nagaraj, Partner-General Corporate at Shardul Amarchand Mangaldas & Co., adds that the Damodaran-led panel is also expected to address issues related to convertible instruments, downside protection, ease of investment and exit. and ease of fundraising. It should also introduce global best practices, he adds.

Rashi Kapoor Mehta, partner at Universal Legal, also calls for greater clarity on the use of convertible debt structures and SAFE (simple agreement for future equity) ratings by angel platforms. “There are platforms that make investments through SAFE Notes and Mandatory Convertible Debentures (CCDs). What checks and balances… [have] these platforms… [put] in place?” she asks. CCDs are debt securities that must be converted into shares at a later stage.

Mehta adds that even though angel funds have a different set of criteria for investors, they need to be deepened to accommodate participants with smaller tickets. It also expects employee-friendly regulations for ESOPs. The panel, Mehta adds, should clarify the concept of round trip, which refers to funds channeled through foreign companies as investments by resident investors who ultimately return to origin under the guise of foreign investment.

Vijay Lavhale, co-founder of venture debt market 8vdX, agrees. He says High Net Worth Individuals (HNI) are unable to invest in offshore funds that invest in Indian start-ups due to back and forth regulations even though they are allowed to invest in funds offshore venture capital using the Liberalized Funds Transfer System (LRS). “Therefore, only ‘trendy’ angels, who have access [to ventures] can invest in the unicorns of tomorrow, especially those incorporated overseas. Regulations should be relaxed to allow HNIs to invest in offshore venture capital funds that invest in Indian start-ups.

Lavhale points to another problem: foreign providers of subprime loans are incurring additional costs due to tenure conditions in the current structure. “[Such] investors… are treated the same as [those who provide] non-convertible debentures (NCDs) to large corporations,” he says, adding that these have restrictions on minimum tenure, so only 30% of a REIT’s portfolio can be made up of non-convertible debentures. short term with a maturity of less than three years. Since most venture debt investments have an 18-month term, REITs must set up a local fund structure (AIF) increasing legal, compliance and operational costs.

Jidesh Kumar, managing partner of business law firm King Stubb & Kasiva, calls for the creation of a separate regulator for the private market. “There needs to be a separate regulator for AIFs because Sebi, in its current set-up and avatar, does not understand the dynamics of the private market as well as it understands the public market. In the private market, the risk-reward program is [more] aggressive, with a great responsibility on Sebi as a regulator of the public market to safeguard investments due to the diversity of investors in the public market,” he says.

The six-member committee – which includes former full-time Sebi member G. Mahalingam; former CBIC DP member Nagendra Kumar; former Chief Income Tax Commissioner Ashish Verma; Poonam Gupta, Director General of the National Council for Applied Economic Research; and PR Acharya, director of the National Institute of Financial Management Arun Jaitley, like its other members, assesses the recommendations made by the IVCA and other industry bodies. Damodaran declined to participate in the story, saying the committee had just begun its work. According to industry sources, the committee aims to present a number of recommendations to the Ministry of Finance before the start of deliberations on the budget. It is expected that some of his recommendations will be reflected in next year’s budget document.

Globally, institutional capital is driving the alternative investment landscape, while in India, HNIs and family offices are driving its adoption. A favorable regulatory environment can attract much more domestic institutional capital to this asset class and also attract more family offices to set up AIFs, which will bring in more capital under regulation. At a time when investor sentiment towards startup funding is pessimistic, positive regulatory reforms can help lift the morale of the ecosystem.

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