Indonesia VC regulation: One step at a time

When Indonesia's Financial Services Authority (OJK) announced earlier this year that it would introduce tighter restrictions on foreign venture capital investors doing business in the country, the news met with puzzlement. The new rules would require all offshore investors to obtain Indonesian business licenses, and to form joint ventures with local investors - a move seen by many as inconsistent with the government's recent focus on dismantling burdensome regulations. It made no sense.

"The government has committed to fully deregulating half the rules that govern Indonesia at the moment," says Donald Wihardja, a partner at Convergence Ventures who has advised the OJK on its regulatory approach. "The key KPI [key performance indicator] quarter-by-quarter is how many regulations have we killed. So they're not about to add one more, that's going in the other direction."

Some professionals dismissed the announcement as another skirmish in the ongoing turf wars between the country's various regulatory bodies, in this case the OJK and the Indonesian Investment Coordinating Board (BKPM). If true, this could be troubling in itself, as it suggests the authorities are not actually of one mind regarding their regulatory approach.

If you’re doing 30 or 40 investments, all of which are small-scale tech start-ups, you don't want to go through the hassle of converting every single one of those to a foreign ownership company - Joel Hogarth

While the government has shown increased support for the venture capital industry in recent years, its ability to follow through remains to be seen. Nevertheless, industry players are generally confident that regulators' hearts are in the right place.

History lesson

The OJK's announcement should be considered in the broader context of venture capital's history in Indonesia, which has at times been rocky. The origins of venture investing go back to the 1990s, when the government created a specialized investment vehicle, Modal Ventura, which was meant to facilitate investment in Indonesian start-ups.

A Modal Ventura entity is undeniably attractive to investors, who receive a number of tax incentives for setting up the structure. They pay no tax on interest from investments in Indonesian small and medium-sized enterprises (SMEs), and only 0.1% capital gains tax.

In addition, the format provides particular incentives for foreign investors. While part of the structure must be owned by Indonesian interests, that amount can be as low as 15%. As long as this requirement is met, the entity is still eligible for the tax incentives, foreign participants may remit the proceeds to their home countries for free, and portfolio companies do not have to register as foreign-owned.

"If you're doing 30 or 40 investments, all of which are small-scale tech start-ups, you don't want to go through the hassle of converting every single one of those to a foreign ownership company," says Joel Hogarth, a partner at Ashurst. "You have to think about the future implications of that, the additional regulatory burden, and additional reporting requirements."

In some ways, however, the Modal Ventura structure has proved too attractive. Its broad mandate allowed to be used for investments for which it was never intended, such as mining or infrastructure projects. These companies take advantage of the tax savings allowed in the entities, but place an unsustainable burden on the licensing infrastructure and block the rightful recipients from being able to participate.

As such, the OJK's steps toward greater control over venture capital investment become more understandable. The government had no intention of undoing the structure, which continued to have the potential for major benefits to legitimate venture capital entities. But clearly something had to give in order to return the Modal Ventura to its intended purpose - particularly given the desire to promote Indonesia's tech start-up ecosystem.

January's announcements were only the most recent phase of a conversation that has been ongoing for several years. In 2013, for example, the government introduced a purpose clause, tightening the restrictions on what kind of investment would be allowed. Late last year, it seemed to backtrack somewhat, saying that Modal Ventura shareholders could use up to 95% of their funds for non-SME investments as long as the rest was used for SMEs.

The OJK's move this year was intended to be another step toward clarity and to prevent fraud. Unfortunately for all concerned, it has sowed confusion in the venture investment community.

For one thing, by implying that foreign investors would be required to adopt the Modal Ventura model, the OJK had arguably overstepped its authority, as foreign investment is supposed to be regulated by the BKPM. On the other hand, not all companies are open to foreign direct investment, and those that do not meet that requirement could still fall under the OJK's jurisdiction.

"The financial services authority can say otherwise, but if the bureau of foreign investment says that the following companies are allowed to be foreign invested, then you don't have to have a local entity," notes Convergence's Wihardja. "But if we are investing in an area that is not included in the list of foreign direct investment, then we have to create a local entity, and a local entity can be Modal Ventura."

Many industry participants believe this confusion reflects the fact that Indonesia's regulators still are not completely comfortable with foreign investment, and are not sure how to use it to the country's best advantage. This discomfort has led to a cautious, arguably protectionist approach.

Needless to say, their stance could backfire. Foreign investors, unwilling to put in the time required for due diligence on potential partners, might decide to stay out of Indonesia entirely, or to partner only with established names in the domestic VC industry. In the end, tech start-ups will have fewer choices for capital support and face a longer wait before they can complete new funding rounds.

Up for debate

The Modal Ventura rules continue to be up for revision, with a new version being designed that would allow for investment in seed-stage businesses as well. Industry participants say that so far foreign GPs have shown little interest in taking advantage of the model, though this could be due to unfamiliarity.

"I think it's just a factor of the regulations being pretty new, and when they were raising capital, those regulations weren't at a state of maturity that everybody could get comfortable with," says Ashurt's Hogarth. "But I would definitely say that you should think very seriously about the efficiencies that you could realize for those sorts of companies if they were able to invest under this framework."

Nevertheless, for all its appeal, the Modal Ventura structure has significant limitations as well, most significantly in its differences from traditional venture capital firms.

First of all, the entity has a set lifespan of 20 years at most. This may work for funds making a limited number of investments, but those with a longer-term plan will find it inconvenient to have to form a new structure. Second, a Modal Ventura is required to have IDR50 billion ($3.7 billion) in capital. Most funds, which draw down capital only when they need it in order to invest, would have difficulty complying.

"The corporate VC structure doesn't really align with the way that modern funds do business internationally. And we've always said we'll figure out a way to work with it, but it's been sort of cumbersome and inconvenient," says Hogarth.

A step toward mitigating this inconvenience would be to allow foreign investors to adopt a standard VC fund model rather than having to go through the Modal Ventura. Industry players say this is in fact under consideration by the government.

Growing pains notwithstanding, this broader thinking is seen by some to reflect a greater appreciation of private capital and foreign investment, particularly in technology. Moreover, the government's willingness to seek input from the major players in the industry - as noted, Convergence has participated in OJK's regulatory review process, as has NSI Ventures - is a particularly promising sign.

As the government continues to develop its approach, VC investors say additional insights could come from examining other regional markets, such as Singapore, that have established thriving technology start-up scenes. The steps taken by neighboring countries to stimulate their ecosystems and attract foreign capital - for instance, by supporting educational institutions and incubator programs - can be applied domestically as well.

"I think Singapore is the blue-chip standard on government assistance, and I think Singapore also realizes that at a certain stage of the spectrum, these sort of things are best taken on by private capital," says Shane Chesson, co-founder of NSI. "It can assess a bunch of opportunities, invest in the best, and is not constrained by development-type factors. From an Indonesian perspective, the area they need to work on is support in the very early stages so that private capital can then go in to find really good candidates to invest in and grow."

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• Topics
• Southeast Asia
• Venture
• Regulation
• Technology
• Indonesia
• NSI Ventures