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Blocking The Alternative

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In what should have been a welcome move, market regulator Sebi (Securities and Exchange Board of India) put out a concept note this week detailing a regulatory framework for alternative investment funds. But, if implemented in its current form, it could choke the investment activities of domestic private equity (PE) and venture capital (VC) funds.

‘Domestic' implies funds that are registered with Sebi and fall under the (VC Funds) Regulations 1996 and the (Foreign VC Funds) Regulations 2000. These cover both early stage investors (VC) and later stage investors (PE). Such funds typically raise some portion of their capital from domestic institutional investors and invest in both listed and unlisted companies. The problem is they account for just 10 per cent or less, of total PE and VC funds active in India today. Most foreign VC and PE funds invest through offshore arms using the foreign direct investment route. "An omnibus regulatory framework is a good move but it should cover everybody," says Nitin Deshmukh, CEO of Mumbai-based Kotak Private Equity.

In overall intent, Sebi means well. For the first time, there is a serious exercise to categorise and regulate funds by investment asset type. The move to regulate investments in listed companies is also in line with global practice.

However, the draft framework seeks to curb the flexibility that PE and VC funds enjoy in terms of the kinds of companies they can invest in. For instance, it prohibits PE funds from investing more than half their corpus in a pre-IPO company. It also stipulates that 50 per cent of their corpus should be invested in unlisted companies. Similarly, PIPE (private investment in public equity) funds will be restricted to small listed companies that are not part of any market indices.

Flexibility has been key to the functioning of this industry in India. Investors argue that the ability to mix investments in unlisted companies that are in the early stages of growth with later stage investments, has enabled a sustained investment run so far. "PE investing has to be opportunistic to enable the best possible returns," says the head of a US-based buyouts fund in Mumbai. This has encouraged domestic institutional investors and HNIs (high networth individuals) to invest in PE funds. Earlier PE funds in India were entirely dependent on foreign institutional investors. Sebi itself probably anticipates many of these problems and has therefore kept the draft framework open to public debate till the end of the month.

(This story was published in Businessworld Issue Dated 15-08-2011)