A guide to foreign investment in India
An overview of India's regulatory framework for foreign investment in securities
Authors:
Rajesh H. Gandhi: Partner, Deloitte India
Vijay Morarka: Senior Manager, Deloitte Haskins & Sells
Nikki Mutreja: Manager, Deloitte Haskins & Sells
Krisha Shah: Deputy Manager, Deloitte Haskins & Sells
Performance Magazine Issue 45 - Article 1
To the point
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In 2023, foreign investment surged in India, flowing in from a variety of jurisdictions. The year also saw a spate of regulatory developments that underscored India’s unwavering commitment to fostering economic growth, streamlining investment processes, enhancing transparency, and nurturing a favorable environment for foreign investors.
As the global economy continues to intertwine with India’s financial markets, it’s increasingly essential for foreign investors to understand the country’s regulatory framework and keep abreast of its changes.
This article summarizes the different routes available to foreign investors, taking a closer look at the regulations governing foreign portfolio investments (FPIs) and alternative investment funds (AIFs) in India. It also breaks down the Securities and Exchange Board of India’s (SEBI) rules and compliance requirements for these avenues.
In 2023, foreign investment surged in India, flowing in from a variety of jurisdictions. The year also saw a spate of regulatory developments that underscored India’s unwavering commitment to fostering economic growth, streamlining investment processes, enhancing transparency, and nurturing a favorable environment for foreign investors.
As the global economy continues to intertwine with India’s financial markets, it’s increasingly essential for foreign investors to understand the country’s regulatory framework and keep abreast of its changes.
This article summarizes the different routes available to foreign investors, taking a closer look at the regulations governing foreign portfolio investments (FPIs) and alternative investment funds (AIFs) in India. It also breaks down the Securities and Exchange Board of India’s (SEBI) rules and compliance requirements for these avenues.
When exploring investment opportunities in India, foreign investors have a range of avenues to choose from based on the type of securities and the nature of the investments.
Direct investment in India
- Foreign direct investment (FDI): This route allows foreign private investment in listed and unlisted Indian companies with a 10% minimum equity stake without having to register in India, subject to sectoral caps.
- Foreign portfolio investors (FPIs): This route permits investment in listed securities (such as equities, bonds, derivatives, and other securities) on public markets, once FPI registration is obtained with the sub-custodian bank on behalf of the Indian regulator.
- Foreign venture capital investment (FVCI): This route directs investments toward Indian entities operating in critical sectors, including technology, healthcare, biotechnology, e-commerce, infrastructure, and other emerging sectors.
- External commercial borrowings (ECBs): Foreign entities meeting specific eligibility criteria can extend loans to specified Indian entities, subject to conditions regarding maturity, fund usage, cost limits, borrowing currency, etc.
Indirect exposure to India
- Depository receipts (DRs): Foreign investors can gain exposure to Indian securities by investing in American depository receipts (ADRs) or global depository receipts (GDRs). These foreign currency-denominated instruments are issued abroad and linked to the securities of Indian companies.
- Overseas derivative instruments (ODIs): Foreign investors can also invest in ODIs (which may be issued by Category I FPIs) with Indian securities as the underlying assets.
Foreign investors can also establish a presence in India in different ways, including:
- Setting up an AIF, which enables investments in both listed and unlisted securities;
- Establishing a real estate investment trust (REIT) to invest in the real estate market; or
- Forming an infrastructure investment trust (InvIT) for investments in India's infrastructure sector.
Investors can also establish a presence in the International Financial Services Centre (IFSC) located in the Gujarat International Finance Tec-City (GIFT City). This is India’s global financial hub, designed to facilitate international financial transactions and provide an enabling environment for financial services firms to operate within the country. Foreign investors can also trade securities listed on stock exchanges within the IFSC.
The FPI route
With the FPI route, foreign investors obtain registration from the sub-custodian or designated depository bank on behalf of SEBI to trade on India's stock exchanges and invest in the debt securities market. The SEBI (FPI) Regulations, 2019 (“FPI Regulations”) set out the compliance standards and guidelines for FPIs, including eligibility criteria, permissible investments, investment limits, and reporting requirements.
FPIs are classified into two main groups:
- Category I FPIs are typically entities with a higher level of regulatory oversight and lower risk profiles, such as government and government-related entities, pension funds, sovereign wealth funds, and appropriately regulated entities. Unregulated funds can also qualify if their investment manager is appropriately regulated and registered as a Category I FPI.
- Category II FPIs include entities not meeting the Category I FPI eligibility criteria, such as corporate bodies, family offices, limited partnerships, and individuals.
Registering to trade as an FPI
To trade in Indian-listed securities, foreign entities must submit a common application form (CAF) with their local sub-custodian in India, along with supporting documents and know-your-customer (KYC) details. Upon approval, the CAF provides the FPI registration and a Permanent Account Number (i.e., the India tax ID) and establishes a security and depository account in India.
FPIs must identify ultimate beneficial owners (UBOs) and report this information to their local custodian. UBOs are determined based on ownership and control, and the FPI’s senior managing official (SMO) is considered the UBO if none is otherwise identified. SEBI has recently mandated additional disclosures from certain objectively identified FPIs, which requires detailed information on entities holding an ownership or economic interest in the FPI on a full look-through basis, including natural persons, without any threshold.
Investments by non-resident Indians (NRIs), overseas citizens of India (OCIs), and resident Indians in an FPI are subject to an aggregate limit of less than 50%, with each NRI, OCI and resident Indian allowed to invest up to 25%.
Permissible investment and investment limits
FPIs can invest in a variety of securities, including listed or to-be-listed equity instruments, debt instruments (such as corporate bonds and government securities), derivatives, units of mutual funds, exchange-traded funds (ETFs), REITs and InvITs.
The FPI Regulations also stipulate that any FPI (along with its investor group) can invest less than 10% of the paid-up value (on a fully diluted basis) in the equity instruments of a listed Indian company. Entities with more than 50% common ownership or control are considered part of the same investor group. FPIs investing in debt securities must comply with allocation limits notified by SEBI or the Reserve Bank of India (RBI) and are subject to conditions.
Recent changes
Recent regulatory changes affecting FPIs include SEBI's requirement for all non-individual FPIs to obtain a legal entity identifier (LEI). Additionally, SEBI has introduced a beta version of a T+0 settlement cycle for the Indian equities cash market on an optional basis, alongside the existing T+1 cycle, for a limited number of scrips.
Overall, the FPI route provides foreign investors a regulated framework to make portfolio investments (<10%) in entities listed on India's stock exchanges.
AIFs in India
Foreign investors can also set up a presence in India through an AIF, which can pool money from investors (both in and outside India) and invest in portfolio companies, based on their registration category. The SEBI (AIF) Regulations, 2012 (“AIF Regulations”) regulate the establishment and operation of AIFs in India, and are supplemented by the SEBI’s issued guidelines and circulars. Additionally, certain requirements from other laws also apply to AIFs.
AIFs can be set up as trusts, limited liability partnerships (LLPs), companies, or other corporate bodies. They must appoint:
- A trustee, in the case of a trust;
- An investment manager to manage the assets; and
- A sponsor, who sets up the AIF and infuses sponsor contribution.
AIFs broadly fall into three categories:
- Category I AIFs invest in early-stage ventures, startups, social ventures, small and medium enterprises (SMEs), infrastructure, or other sectors deemed socially or economically beneficial by the government or regulators. Category I AIFs include venture capital funds (including angel funds), SME funds, social impact funds, infrastructure funds, and special situation funds.
- Category II AIFs do not fall under Categories I and III and do not employ leverage except for day-to-day operational requirements.
- Category III AIFs employ complex trading strategies and can use leverage within prescribed limits, including through investment in listed or unlisted derivatives.
Setting up an AIF in India
To register as an AIF, an application must be filed with SEBI along with the necessary fees and documentation. This includes a private placement memorandum detailing the fund's structure in a SEBI-prescribed format and a merchant banker due diligence certificate.
Key regulatory conditions for AIFs
AIFs must have a minimum corpus of INR20 crores (~USD2.5 million), with a minimum investment of INR1 crore (~USD 0.12 million) by each investor. They are restricted to a maximum of 1,000 investors and must raise funds exclusively through private placement.
Category I and II AIFs are typically closed-ended funds, with a minimum tenure of 3 years, while Category III may be open or close ended. A close-ended fund’s maximum tenure is defined upfront and may be extended by 2 years with the investors’ consent, post which further extension can be availed only for the process of liquidation of AIF investments.
Sponsors of AIFs must maintain the following continuing interest:
- Category I and II AIFs: 2.5% of the corpus or INR50 million (~USD0.6 million), whichever is lower.
- Category III AIFs: 5% of the corpus or INR100 million (~USD1.2 million), whichever is lower.
While Category I and II AIFs can invest a maximum of 25% of the investible funds in one investee company, a Category III AIF can only invest up to 10% of its investible funds or net asset value (NAV) in a single listed investee company.
Category I and II AIFs cannot borrow funds directly or indirectly or engage in leverage, except to meet temporary fund requirements. However, Category III AIFs may leverage or borrow, subject to the consent of the fund’s investors and no more than twice the AIF’s NAV.
Other requirements
AIFs must appoint a custodian for securities safekeeping and only issue units in dematerialized form. They must periodically perform investment valuations and report the NAV to investors as per the AIF Regulations. Additionally, AIFs must provide periodic reports to SEBI and their investors.
Setting up an AIF in the IFSC
Foreign investors can also establish a presence in India's IFSC. Here, they can set up AIFs that pool funds from non-resident investors and invest worldwide, including in India.
Although their categorization and compliance requirements are similar to India’s AIF regime, IFSC AIFs enjoy several regulatory advantages. These include the non-applicability of diversification norms (allowing greater flexibility in investment strategies), no restriction on leverage, exemption from applicability of aggregate investment limit for NRI/OCI/RI (applicable to FPIs) and no requirement to provide a merchant banker certificate or to issue units in dematerialized form.
Conclusion
India's regulatory landscape for foreign investors is dynamic and evolving. Its robust framework for FPIs, AIFs, and other investment avenues offers an attractive environment for foreign investment across various sectors. Establishing a presence in the IFSC also provides a range of regulatory advantages.
As India continues to integrate with the global economy, understanding and navigating its regulatory terrain will be essential for foreign investors seeking to capitalize on the country’s investment opportunities.
