Debt in Disguise?

The RBI wants equity to be equity, with no guarantee of a payback. But foreign PE firms insist on fixed returns on investments

On 11 March this year, the Reserve Bank of India (RBI) clarified that it wasn’t interested in details related to foreign direct investment (FDI) inflows. In a letter to the Finance Ministry, the central bank stated that while FDI figures were being collected by its regional offices, it did not ‘envisage [either] tracking [the] source of funds of the non-resident investor, or its end use…’ In fact, the only purpose of the data was to reconcile India’s balance of payment statistics—overall inflows and outflows. 

Within four months, the RBI did an about-turn. It sent out signals to foreign investors that FDI, which comes in as plain vanilla equity, should not be masked as debt. This put a question mark on a crucial clause that is included in almost all agreements inked between global private equity (PE) firms and Indian business owners. This sub-section allows foreign investors to sell their minority stakes back to Indian promoters on a fixed-return basis (at a 10–25 per cent compounded interest rate) under certain circumstances.

According to the RBI, such equity that earns a fixed return should be deemed a foreign loan, unless it is in the form of convertible debentures, which earn a specific interest until their conversion into equity shares. Therefore, it should follow the rules for external commercial borrowings, which are capped at $30 billion a year (for all firms). In addition, the RBI felt that such a clause is illegal, as PE firms use the mechanism of a ‘put option’ to sell shares back to owners. A put option, which gives a holder the right to sell someone an asset within a specific time at a particular price, is essentially a derivative, and so can only be sold on Indian stock exchanges, not via private deals and contracts. 

However, PE firms are up in arms against the RBI’s stance. Experts contend this will affect FDI inflows. The reason: the fixed-return clause enables foreign investors to protect their investment in case there are problems with Indian managements, or the latter are unable to provide an exit route through an IPO within the planned time frame. Without such a shield, promoters can easily hoodwink foreign investors, taking them for a financial ride. Now, the courts will decide who is right, the RBI or PE players.

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Alam Srinivas