India-China regulation: Punching bag

On April 14, Rahul Gandhi, leader of the Indian National Congress, tweeted concerns that local companies were “attractive targets for takeovers” due to their worsening equity positions caused by the COVID-19 pandemic. He spoke out after the People’s Bank of China increased its stake in Housing Development Finance Corporation, a private lender affiliated with India’s largest private bank. Gandhi’s statement was retweeted nearly 20,000 times.

Three days later, the government announced that investors in local companies hailing from countries that shared a border with India must apply for specific approvals. Naming China directly could have violated WTO principles on non-discrimination, lawyers say.

Standard government approval for investments in sensitive areas like defense can take up to six months. Stakeholders within the Indian VC ecosystem were dismayed not only by the imposition of an onerous bureaucratic process, but also by its potentially broad application. The wording of the legislation suggests transactions involving funds that have Chinese LPs could be caught in the dragnet alongside Chinese corporates pursuing majority or minority stakes in businesses.

“It looks like they’re bringing in a gun to a knife fight,” says Abhishek Krishnan, a Hong Kong-based partner at Goodwin. “A vast majority of funds that are typically thought of as being ‘global’ have some Chinese LPs participating as passive investors.”

Since the rule change, India-based lawyers have warned investors to be careful when inking deals with cash-starved start-ups. Media reports cite unnamed officials claiming investments from Hong Kong funds would be scrutinized but not those from Taiwan. The confusion stems from uncertainty as to how the government defines the “beneficial owners” from bordering countries that it says will be targeted by these enhanced oversight measures. Clients are being advised to wait for the release of formal guidelines.

“Which ministry is going to be relevant for this approval? What information is required? There are a host of as yet unanswered questions, which is why many deals have been put on hold,” says Shagoofa Rashid Khan, a partner at Indian law firm Cyril Amarchand Mangaldas.

It is difficult to detect this trend in the data because of the general debilitating impact of COVID-19 on activity. AVCJ Research has records of 20 announced rounds for Indian start-ups in 2017 that featured Chinese VC firms, Chinese strategic investors, or both. A total of $1.6 billion was committed across these rounds. In each of 2018 and 2019, the figure surpassed $3.4 billion, with 35-40 deals per year. The likes of Shunwei Capital, Qiming Venture Partners, Morningside Ventures, and Hillhouse Capital all feature.

There have been 12 so far this year with $370 million committed. Eight of these deals were announced before April.

Spheres of influence

Apart from Gandhi, many believe the Indian government has also been influenced by similar measures implemented elsewhere. In March, Spain issued a royal decree requiring government approval for foreign direct investments for stakes that exceed 10% in domestic assets within strategic industries. Italy issued a new law four days before Gandhi’s warning that requires a screening process for any investments in strategic entities until the end of the year.   

The original note issued by India’s Department for Promotion of Industry & Internal Trade (DPIIT) forewarning investors explained that the change in rules was to ward off “corporate takeovers.” However, Chinese groups – whether corporates or investment firms – rarely execute them. There have been 11 such takeovers involving Chinese strategic investors in the past five years. Two deals accounted for three-quarters of the $2.6 billion deployed.

The amendment to the Foreign Exchange Management Act – which governs foreign inflows of capital – is far more nebulous than the DPITT suggested. It encompasses minority investments in non-strategic sectors and then there is the lack of clarity over what constitutes a beneficial owner. On one level, the government might want to ensure that Chinese groups do not route investments through offshore vehicles: regulators would look through to the ultimate capital source or decision-making authority.

This leaves VC and PE managers in a difficult position. Most Chinese GPs – generally recognized as Chinese because that is their core market – doing deals in India domicile their funds and locate their management entities in the Cayman Islands. There is often an advisory presence in Hong Kong. Some of these funds have Chinese LPs but they would only directly participate in the investment decisions if co-investing alongside the funds. India’s position on such arrangements is unknown.

The US has already been through a version of this process with the Foreign Investment Risk Review Modernization Act (FIRRMA), which came into force in February. The experience might be instructive.

The legislation was introduced as a pilot program in late 2018 to embolden the Committee on Foreign Investment in the US (CFIUS) by extending its voiding rights from change-of-control transactions to include minority deals involving critical technologies and sensitive personal information. The change has created considerable uncertainty, not least among Chinese investors, which are widely seen as the unspoken primary target.

Any foreign participation in a qualifying deal must be disclosed to CFIUS at least 45 days prior to the completion of the transaction. Failure to do so may result in a fine equal to the value of the investment. An alternative approach is to claim exemption through passivity, but this might not suit many VCs.

FIRRMA offers a reasonable amount of clarity on the treatment of foreign LPs. There is an acknowledgement that even LPs with advisory committee seats have no control over the fund provided they do not participate in investment decision making or have access to non-public technical information pertaining to specific portfolio companies. Investments made by the fund would therefore not qualify for disclosure, although some groups still work to the assumption that at least 50% of the money should come from US LPs.

The legislation becomes more challenging at the GP level. CFIUS looks through the layers of an investment and establishes whether the ultimate decision-making authority – the GP – is a foreign entity. This means a firm’s entire structure, from the identities of those making investments to fund governance, comes under scrutiny. It is seen as possible that a deal would require CFIUS approval if executed by a firm with Chinese nationals among its partners. One investor chose to sell a position in a US unicorn for this reason.

Some VC firms that invest in China and the US – and whose teams comprise US and Asian members –  are exploring separate funds for US investments. These vehicles are typically domiciled in Delaware rather than Cayman, the LPs are all based in the US, and the non-US partners are excluded from management.

For its part, the Indian Venture Capital Association (IVCA) is lobbying the government, pointing out that most Chinese VC investors or funds with Chinese LPs seldom seek majority control of Indian companies. It has requested the authorities at least implement a fast-track mechanism, enabling minority stake deals to pass quickly. At present, government approval for deals means winning consent from multiple ministries and this rarely goes according to plan.

“[A few years back] the DPIIT issued a document outlining the standard operating procedure where they clearly defined a timeline for ministries to process the application but not a single application has been processed during that particular timeline,” says Atul Pandey, a partner at Khaitan.

Unhelpful nationalism

It does not help that a lot of the discussion within Indian media seems to be colored by a nationalistic streak. Many articles cite a report by Gateway House, a Mumbai-headquartered thinktank, that claims Chinese investors contributed $4 billion in venture capital funding to Indian start-ups over the years, even though the exact number is impossible to pin down.

An earlier report penned by a team working under Amit Bhandari, a fellow at Gateway House, details concerns that Chinese investment poses an unaddressed national security risk. The group believes that Indian companies with Chinese entities as investors could contribute to Chinese propaganda efforts, give away sensitive financial data, and pursue monopoly positions because they are backed by deep pools of state capital.

However, Bhandari concedes that there is a distinction between Hong Kong-based venture capital firms and China-headquartered conglomerates that appear to have been glossed over in the larger discussion. “There are two categories of investors – there are VCs and then there are the mainland-based companies,” he says. “While we have not spelled it out in as many words, we think that treatment should be different for these two.”

It is unclear when India’s Ministry of Commerce, considered to be the key decision-maker, will announce further guidelines but it’s hoped that industry representation by start-ups, VC firms and legal professionals will eventually have an impact. If they fall short, it is possible that GPs with links to Chinese individuals or entities might have to scale back or fundamentally restructure their involvement in India.

“Going by the earlier conduct of the Foreign Investment Promotion Board [a defunct entity that previously oversaw foreign investment], this is likely going to be an issue for any Chinese investment which has more than 10% equity,” warns Manish Kheterpal, founder of WaterBridge Ventures. “As always, the Indian government announces something and then backpedals or clarifies later.”

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• Topics
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