Debt funding from foreign shareholders: A viable alternative to equity

As per a recent UN release, foreign investment in India in the year 2015 was $44 billion - 26 per cent more than in 2014. The interest from overseas investors and multinational companies has certainly increased, thanks to the significant liberalisation in foreign investment rules and the government's incessant emphasis on ease of doing business in India.

Several multinationals have committed to invest billions of dollars over the next few years in greenfield projects as part of the Make in India initiative.

As Indian operations of foreign businesses grow, multinationals grapple with best ways to finance these operations as well as repatriate some of the profits. Equity investments are not always the optimum  method as shareholders do not want to lock in capital for inordinately long periods.

Repatriation of profits and equity capital also has certain restrictions under Indian foreign direct investment (FDI) regulations and company law, and is coupled with attendant tax leakages. Third party loans may either not be easily available or may be costly. Given this, here are some viable debt alternatives which foreign entities can explore to finance their Indian affiliates, earn some interest (which may be cheaper than the cost of third party borrowing) and receive back the money in due course.

External commercial borrowings

Under the guidelines framed by the Reserve Bank of India (RBI) on external commercial borrowings (ECBs), a direct foreign equity holder with minimum 25 per cent direct equity holding in the Indian borrower, or an indirect equity holder with minimum indirect equity holding of 51 per cent in the Indian borrower, or a group company with common overseas parent is permitted to provide an ECB to an Indian borrower.

Depending on the business of the Indian borrower, the end use of the ECB proceeds, the currency of borrowing and the average tenure of the ECB, the borrowings may fall under any one of the three tracks available under the ECB guidelines.

If the ECB is being raised from the foreign equity holder without prior RBI approval, then the ECB liability to foreign equity ratio should not be more than 4:1. If the ECB is being availed with prior RBI approval, the ECB equity ratio should not be more than 7:1. However, this ratio is not applicable if total of all ECBs raised by an Indian entity is up to $5 million or equivalent.

In order to avail an ECB, the foreign equity holder and Indian borrower will need to enter into a loan agreement and obtain a loan registration number from the RBI. ECBs must have a minimum average maturity of at least 3 years.

Borrowers can pay interest and certain other fees and expenses of up to LIBOR plus 300 basis points on ECBs with an average maturity of 3 to 5 years, and LIBOR plus 450 basis points on ECBs with an average maturity of more than 5 years. If the ECB has an average life of 10 years or more, the Indian borrower can pay up to LIBOR plus 500 basis points on the ECB. ECBs can also be availed in rupees from foreign equity holders at market rates.

Ordinarily, ECBs availed in foreign currency with an average maturity of less than 10 years cannot be used for general corporate (including working capital) purposes. However, an exception is provided if the ECB is raised from direct or indirect equity holders or group companies as long as the ECB has a minimum average maturity of 5 years. This route can be considered in cases where the Indian subsidiary is unable to raise cheap credit from third party lenders and is in dire need of funds to keep the business running.

ECB lenders also have the option to convert the ECB into equity if agreed with the Indian borrower at a later stage. Therefore, they can retain the flexibility to convert into equity if either the Indian company's business is performing well or it does not have the money to repay the debt.

Masala bonds

In September 2015, RBI permitted Indian corporates to issue of rupee denominated bonds (colloquially nicknamed as Masala Bonds) under the ECB regime. The Masala Bonds regime is more liberal than the ECB one. The pool of lenders is increased and any person from a Financial Action Task Force (FATF) compliant jurisdiction can subscribe to such bonds. The requirement of holding a minimum equity percentage as per the ECB guidelines for foreign equity holders is not applicable and an equity holder with less than 25 per cent equity in the Indian company would also be eligible to subscribe to such bonds. Further, for the ECB: equity ratio also does not apply to a Masala Bond issue.

Issuers have been given the flexibility to privately place the bonds or even list them on overseas stock exchanges - if the bond is listed overseas, it may also provide liquidity to the foreign parent /equity holder. The minimum tenure of the bond is also only 3 years (irrespective of the end use) and therefore, the foreign equity holders do not have to wait for a long period to receive back their money. The interest payable on the Masala Bonds is also not capped at Libor plus 450 or 500 basis points, but can be what is commensurate with prevailing market conditions. However, this should not be excessive and in line with the general cost of borrowing for the Indian company from Indian lenders. The foreign exchange risk stays with the foreign investor, but which can be hedged through derivatives. The end use restrictions are also limited compared to those under the ECB policy and thereby offering greater flexibility to the Indian issuers. Foreign corporates have already started using this route for the purpose of funding their Indian operations.

Non-convertible debentures

Another avenue available is the corporate debt market. Under this route, a group company of a foreign equity holder can register as a foreign portfolio investor (FPI) under the SEBI's prescribed regulations. The registration process is straightforward and typically an FPI registration can be completed within a few weeks. An FPI is permitted to subscribe to or purchase rupee denominated non-convertible debentures (NCDs) that are listed or to be listed on a recognised stock exchange in India. The NCDs must have a minimum duration of three years at the time an FPI subscribes to or purchases the NCDs. The NCDs can be secured or unsecured. The issuer has considerable flexibility on how to use the proceeds and the amount of interest or redemption premium to be paid on such instruments. This route has been used amply, especially by foreign funds, to finance Indian portfolio companies.

However, an important point to note is that once the NCDs are listed, the Indian issuer will have to make several disclosures, including its financials, with the stock exchanges where the NCDs are listed. The Indian issuer will become a 'listed company' from a company law and securities law perspective, and therefore, various provisions applicable to listed companies would be applicable to the Indian issuer. While this may increase the compliance requirements, it provides an additional and more flexible route of raising funds from foreign shareholders.

While each of the above modes have their benefits and limitations, it will really depend on the facts and circumstances in each case to determine which route is best suited for a particular borrower. Also, given that each of these routes have various nuances that need to be kept in mind, it is advisable for the borrower and potential lenders to obtain appropriate professional advice before treading a particular path.

Aashit Shah is Partner at J. Sagar Associates.