INDIA BUSINESS WORLD - March 1^st - March 15^th - 2008

ONLY PROFESSIONALS MAY GET VENTURE CAPITAL FUNDS (VCF) LICENCE

Only professionals are likely to be allowed to float venture capital funds (VCF) in future. In what could be a major change in India's venture capital regulations, no business house, financial services group or big corporate would be allowed to set up a VCF. The capital market regulator has veered around to this view, possibly driven by instances where large groups have used funds sponsored by them to invest in companies where they have strategic or business interests.

"Since VCFs operate under a special regime in relation to taxation, foreign capital and investment lockin, and are meant to encourage new entrepreneurs, the vehicle should not be misused by established players," a source said. While no formal guidelines have been issued, the change in regulatory stance on VCFs follows views expressed by an informal panel to look into regulations for venture capital. Some of the top names in the financial services industry figure in the panel. No final decision has been taken on the matter. Existing VCFs set up by business houses and banking groups will not be affected.

The perceived conflict of interest, though not applicable to all VCFs sponsored by big groups, is more apparent in sectors such as real estate where institutional finance is difficult. However, industry circles do not rule out the possibility that a VC arm of a banking group or a large corporate may find it tough to distance itself from investments that further group interests.

Internationally, there is no special classification, primarily because in most countries VCFs are not regulated entities. It would be interesting to see how the regulations are tweaked in India to ensure that only professionals can come together to sponsor a fund. In this case, it would be important how a professional is defined.

In India, VCFs can be structured in such a way that they function as tax-transparent entities, where the original investors pay tax and not the fund's trust.

Besides, there are other advantages: a VCF, unlike other financial investors, can sell its stake soon after a company it has invested in goes for an initial public offering — the only condition is that the VC must be an investor in the unlisted firm for at least one year before the IPO. Such funds also have an easier access to foreign investors; for instance, a foreign venture capital entity can invest in a local VCF through the automatic route under the foreign direct investment policy.

With more and more corporates planning to diversify into financial services, the new stand on VCF is unlikely to go down well. "Sebi has not spelt out its stand in black and white. But corporates and financial services companies whose applications for local VCFs are pending, have sensed the regulator's reluctance," said a source. If the door to VCF is shut down for corporates and large groups, they will float private equity (PE) funds. A few large groups have already announced their decisions to set up PE funds. Unlike VCFs, PEs don't enjoy tax and some of the other benefits. But the advantage is that PEs don't come under any regulatory framework.

It may be mentioned that foreign venture capital funds are clearly discouraged by the Reserve Bank of India which has refused to clear several foreign VCF applications for months. The central bank fears that the money is chasing assets in an already inflated property market.

As far as local VCFs are concerned, even though the government had retained the direct tax advantage for a handful of sectors, the fund managers and their legal advisors have found a way to restructure the fund to claim tax benefit. The way a VCF works is that it issues 'units', just like mutual funds, to investors who put money in different funds that are raised. The pooled fund is then invested in various unlisted stocks. Here, the fund's trust owns the shares. After the government changed the rules last year, some of the funds transferred the ownership of the shares from the trust to investors. This was a way to spare the trust of tax.