Private Equity, Venture Capital & SIF Regulation

15 Jul 2019

– Deepak Sharma

Background

Private Equity and Venture capital (PEVC) is newly introduced alternative financing model in Nepal. Looking at the current trend PEVC could gain importance in Nepal. According to World Bank Enterprise Survey 2013, 364 percent collateral is needed for bank loans in Nepal which is way above the South Asian average. Only 35 percent of Nepali firms have access to bank loans and access to finance has been identified as a major constraint for 40 percent of Nepali firms. So, an alternative source of finance, risk capital to be specific, was to give vibrancy to the business sector in Nepal. Nepal’s first onshore PE fund with FDI, Business Oxygen Pvt. Limited, was established in 2012. At present there are several offshore and onshore (with and without FDI) PEVC funds for Nepal. The fiscal year 2018-19 budget mentioned about the promotion of alternative investment such as private equity, venture capital and hedge funds. Until now, PE funds are set up in traditional company form as investment company and are governed by Companies Act like any other company. However soon after the announcement in the last budget speech, Securities Board of Nepal (SEBON) took initiative to enact regulatory instruments to govern PEVC in Nepal.

PEVC Regulations

SEBON issued “Specialised Investment Fund Regulation, 2075” (SIF Regulation) to promote PEVC industry with effect from 6 March 2019 (22 Falgun 2075). This is a milestone in Nepal’s PEVC industry. The regulation has been welcomed by related stakeholders given the sector was waiting for a legal recognition and a framework for its operation. The regulation recognises ‘fund’ and ‘fund manager’ separately. Fund manager should be a company which can manage multiple funds and fund should be registered as fund with SEBON. Since the industry is in a very nascent stage, there is a need of facilitator than a regulator. The regulation encompasses this concept and has allowed hurdle rate, management fees, fund tenure and size (within the limits provided by the regulation) and carry to be as per the investment agreement. Qualification of fund manager, CEO & director of fund manager, provision of independent director, roles and responsibilities of fund manager, minimum requirement of a fund, content of an investment agreement and statute of fund have been outlined in the regulations.

Equity Investment Made Easy

Companies Act restricts a company to invest in excess of 60 percent of its paid-up capital and free reserves or 100 percent of free reserves whichever is higher in any other company. First amendment to Companies Act included “Investment Companies” in the exclusion list from this restriction. Company Directive 2015 (Clause 90) again put investment limit of 90 percent of paid up capital and 100 percent of free reserves on those companies in the exclusion list. This means investment company wouldn’t be able to invest 10 percent of their paid-up capital. What if an investment company uses debt to make the investment? It was an ambiguous topic. Now a PE fund can be set up as a fund and provisions of Companies act will no longer be applicable to a fund. The regulation has solved the problem allowing a fund to take loan from international investors for investment, however domestic loan has not been allowed yet.

Decision Making for PEVC Fund

In a typical PE fund, all investment decisions are made by an independent Investment Committee and is supervised by an Advisory Committee. In a company structure, decisions made by investment committee had to be reapproved by board of directors as Office of Company Registrar only accepts board minute for investment decision. This made the process redundant and Investment Committee could not make independent investment decision. Now, the regulation recognizes both Investment Committee and Advisory Committee allowing a PE fund to operate as per international practice.

Streamlining of Approval Process

PEVC fund is one of the most effective means to provide businesses an access to international fund. Large size projects and businesses may, on their own, pitch for FDI but SMEs may not be able to access FDI which can be bridged by a PE fund. FDI in PE fund, only from bilateral and multilateral organisations to begin with, is allowed by the regulation which is a very welcome step. At the same time, FDI is not allowed in investment business as Industrial Enterprise Act doesn’t classify investment business as an industry. This issue needs to be addressed to avail funds with FDI. Each FDI must pass through Department of Industries (DOI)/ Investment Board and Nepal Rastra Bank for approval and Office of company registrar (OCR) for recording of investment in share registry. Offshore funds have to go through all three bodies for each investment whereas incase of onshore fund, it has to go through all three bodies once and thereafter go through DOI and OCR for each investment to be made. How will the regulation help to simplify this process? If the regulation is going to add SEBON as another layer in the process, it will lose its essence.

Blacklisting Exclusion & FDI restrictions for PEVC

NRB’s provision on blacklisting of defaulter blacklists shareholder holding more than 15 percent equity and director of defaulter company which is a draconian provision for PEVC funds. FDI investors are waived of the blacklisting provision but onshore funds with FDI are not considered FDI investor for this purpose. Whereas Investment by onshore fund with FDI is considered as FDI by DOI and needs to go through FDI process at DOI for each investment. Current provisions seem to be biased against onshore fund. Banks and Financials institutions are immune of blacklisting provision, similar immunity should be provided to PEVC funds for level playing field. FDI is restricted in certain sectors as outlined in negative list and minimum amount of FDI has been revised to NPR 5 crore. In case of onshore fund with FDI, there arises two questions – 1. Will the negative list be applicable when onshore fund with FDI makes its investment in portfolio companies? (probably yes), and 2. Does FDI limit apply only when a foreign investor makes investment into the onshore fund or also when the fund makes investment in portfolio companies? It would be logical to apply the limit when FDI is brought into the fund. If FDI limit applies to onward investment by fund, it will restrict SMEs, larger segment of the economy, from access to funds with FDI.

Avoiding double taxation of PEVC Funds

Another important aspect to be discussed here is tax treatment on PEVC fund. The regulation has allowed PEVC fund to register as fund but tax treatment is still not spelled of which means there will be double taxation. Mutual funds have been exempted of income tax as per Finance Ordinance 2070-71 and only 5 percent withholding needs to be deducted while distributing income to unit holders. This is basically a pass-through treatment of tax with a logic that mutual funds are just a SPV for investment and don’t create income on their own, but pass return generated through investment to unit holders. PEVC fund is special purpose vehicle which pools investment from different investors and invests in portfolio companies. It is very much like a mutual fund from taxation point of view, so same logic should apply to PEVC fund as well. Once pass-through treatment of tax is available, more onshore fund will be attracted against current trend of offshore fund.

Lucrative Investment Sector

Investors assess return, liquidity and risk aspects before investment. Regulation has reduced post IPO lock-in period to 1 year for promoter shares held by funds. Investors (both domestic and foreign) would be more comfortable investing in PEVC funds managed by professionals than invest in individual projects. In frontier markets like Nepal, government’s approach towards a sector matters a lot for international investors. Since PEVC sector is now formally recognised and regulated, this can be a lucrative investment sector for domestic as well as international investors. We have been talking about investment requirement for Nepal, Nepal is investment ready and others, at the same time we also need to discuss of creative ways of channeling investment into Nepal. PEVC is one of those channels.

Conclusion

SIF regulations is a beginning and one cannot expect it to be perfect already. Harmonisation of different Act and regulation (like Industrial Enterprise Act, Income Tax Act, FITTA etc.) in line with SIF regulations is needed. SIF regulations itself needs to clarify lots of issues. SEBON should be able to function as facilitator on approvals, regulatory compliance, tax matters and provide one-point solution in bringing investment, creating fund and make investments. We have smaller funds at present, we can attract sector agnostic and sector specific bigger size funds by simplifying the process. Growth of PEVC industry can create a significant impact in Nepal’s economy by availing collateral free risk capital making PEVC funds “an impact fund” in real sense.

 

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