03 Aug 2015 18:07 IST

Market-driven pricing needed in M&As

Dismantling a major barrier to foreign investment will be beneficial

Restrictive entry and exit pricing norms have long vexed foreign investors contemplating equity and equity-linked investments in private enterprises in India. The winds of change promised by the recent legislative actions of the Union Government may, finally, usher in a new era for foreign investments in India.

Over the years, the Reserve Bank of India’s pricing norms have eased considerably, moving from requiring a specific regulatory nod to the ‘automatic’ route. The pricing, however, had to conform with the guidelines prescribed by the erstwhile Controller of Capital Issues and subsequently, from May 2010 onwards, with the discounted cash flow method.

Thereafter, in January 2014, the RBI permitted foreign investors to exit under put and call ‘optionality’ clauses attached to equity shares and compulsorily convertible securities at a price not exceeding that arrived at (i) on a return on equity basis for equity shares, and (ii) in accordance with any internationally accepted pricing methodology for compulsorily convertible securities.

Fortunately, in the RBI’s bi-monthly Monetary Policy Statement issued on April 1, 2014 (and many may have doubted it, given that it was also, co-incidentally, All Fools’ Day) all pricing guidelines with regard to foreign direct investment were withdrawn. From July 2014, pricing of foreign investments and exits only needs to conform to an ‘internationally accepted pricing methodology’ on arm’s length basis. India currently ranks 142 out of 189 nations in World Bank’s ease of doing business index.

Paradigm shift

The Budget Statement of 2015 introduced a paradigm shift by amending the Foreign Exchange Management Act, 1999, to limit the RBI’s powers to prescribe rules with respect to permissible capital account transactions to only those involving debt instruments. The Ministry of Finance is, instead, allowed to prescribe rules with respect to the classes of permissible capital account transactions (not involving debt instruments), the limit up to which foreign exchange shall be admissible for such transactions, and the conditions which may be placed on such transactions. Further, what would constitute ‘debt instruments’ is also to be determined by the Union Government.

While the Union Government is yet to prescribe rules in furtherance to the announcement, it is expected that norms would only continue to become more liberal and market-driven. That said, one questions whether it would be opportune to completely step away from policing entry and exit pricing and instead allow market forces and commercial prudence to guide transactions. The pricing norms as they currently stand, effectively, allow for parties to freely choose and apply any internationally accepted (read commercially suitable) pricing methodology to transactions, albeit subject to (i) an entry floor and an exit cap determined in accordance with such pricing methodology and (ii) no ‘assured returns’ for the foreign investor.

Easing business

One would expect that the next logical step would be to completely withdraw the requirement of an entry floor and an exit cap. Such a step would also be in consonance with the government’s stated intent of being among the top 30 countries in the ‘World Bank’s ease of doing business index’. India has, over the past few years, slid to 142 out of 189 nations in this index.

Given that the current pricing norms already allow parties the freedom to apply varied methodologies to suit the specifics of a transaction, this should not be a challenging move. The benefits of being perceived to have finally dismantled a significant barrier to foreign investment may be quite meaningful. Fittingly, there is urgent need for the Union Government to press ahead and issue simple, cogent, and market-driven rules at the earliest. That said, as always, the devil lies in the detail and the manner in which the new guidelines address existing issues will be key: for example, while re-defining ‘debt’, the new rules must unambiguously distinguish what would be included and excluded from the scope of ‘debt’, and must especially provide clarity on the treatment of mezzanine/hybrid instruments.

Also, the guidelines should address whether some form of ‘downside protection’, at a discount to the sovereign yield curve (as indicated in the RBI’s Bi-Monthly Monetary Policy Statement of February 2015) or otherwise, will be permitted or would continue to be prohibited as an ‘assured return’. Additionally, the new guidelines must lucidly tackle how existing investment structures and instruments would be permitted to transition.

Regulatory powers

Ministry of Finance will govern non-debt instruments

RBI will regulate debt instruments

Government will decide what constitutes debt

(The writer is Managing Partner, BMR Legal. With assistance from Roshan Thomas)

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