Debt Funding in India: Options Available to Foreign Investors, Entrepreneurs

We explain the debt funding options available to foreign companies and investors in India, including onshore and offshore options, and their regulation.

Availability of resources and viable funding options determine the development and success of a business enterprise, including the quality of the products and services provided. Apart from the availability of funds, the mode of funding is an equally essential decision that must be made after assessing the cost benefit ratio.

Modes of funding

There are two modes of funding options available to a company – equity financing and debt financing.

Equity financing, done either by private placement of stock with investors or by public stock offerings, mainly caters to the short-term cash requirement of companies by selling company stock, along with substantial ownership rights.

Debt financing refers to borrowing funds for working capital or capital expenditure by selling debt instruments to individuals or institutional investors. These institutional investors or individuals, in turn, become the company’s creditors who must be repaid the original debt, along with the accruing interest, in a time bound manner. Unlike equity instruments, debt instruments do not transfer any ownership or control rights to their holders.

In India, companies have been increasingly inclined towards the ‘hybrid’ mode of funding. In this mode, which offers greater risk mitigation potential, companies opt to raise funds by issuing financial instruments that combine the characteristics of both debt and equity instruments – thereby allowing the company to employ equity-like funding while also retaining capital security and returns. However, identifying them is often an issue of contention, prompting Indian Courts from time to time to identify certain hybrids as debts or stocks. Presently, hybrid instruments are classified as debt, and are governed by the country’s central bank – Reserve Bank of India (RBI) – under its External Commercial Borrowings (ECB) policy.

What are the debt funding options available in India?

Debt funding as a means for financing businesses has gained popularity among companies due to factors like retention of ownership rights, availability of tax deductions and subsequent lowering of interest rates, easy accessibility irrespective of the business size etc. In India, various types of investment instruments like non-convertible debentures (NCDs), security receipts etc. are employed, depending on their merits as well as suitability from the entrepreneur’s point of view.

It is interesting to note that debt financing as an investment option has garnered the attention of global investors as it offers downside protection on investment, minimizing losses on the portfolio, along with easy and efficient repatriation.

India’s regulatory framework outlines multiple options for routing debt investments into India, which can be classified under the following two heads: onshore debt funding and offshore debt funding.

Onshore debt funding options

Under this option, foreign investors provide capital to the Indian debt issuers through vehicles like non-banking financial companies (NBFC), alternative investment funds (AIF), asset reconstruction companies (ARC) etc. These Indian entities, which act as intermediaries, first receive funds from foreign investors, and then further on-lend these proceeds to the ultimate borrowers.

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These vehicles challenge borrowers and lenders with respect to repatriation issues, tax inefficiency, and minimum capitalization requirements.

Some of these vehicles are also at par with the offshore funding models from a taxation standpoint and offer good alternative routes for investment to offshore investors, especially global debt funds.

Onshore lending generally does not require compliance with the Foreign Exchange Management Act, 1999 (FEMA) and is generally less regulated. The onshore lending vehicles are listed below.

Non-banking financial companies

They are Indian companies registered under the provisions of the RBI Act, 1934, and are usually engaged in retail and corporate lending. Depending on the short-term as well as long-term goals of the foreign investors, they may choose from various options available for investment through NBFCs. These options are:

• Captive NBFC: It involves acquiring or registering an NBFC in India and using it for on-lending This strategy is popular among investors looking at a long-term growth prospects. However, it is not a tax efficient method and may not provide investor returns in the short run.
• On-lending NBFC: It involves using an existing NBFC as an intermediary entity for on-lending. This strategy is considered lucrative from both the yield (short-term) and growth (long-term) perspective. It is also a tax efficient option, since the NBFC is taxed only on the margin or spread, that is, the difference between cost of borrowing and return from lending.
• Securitization: In this method, NBFCs generate loans and securitize/convert them into marketable securities. The pass-through certificates issued by the securitization trusts are acquired by foreign investors directly. It is the most preferred strategy since it is tax efficient and provides the foreign investors exposure to Indian markets, along with easy repatriation options.

Alternative investment funds

They are investment funds registered with India’s securities regulator, the Securities and Exchange Board of India (SEBI). AIFs are Indian entities and possess more flexibility with regard to debt investment from the Indian regulatory perspective.

AIFs are permitted to only invest in securities through debenture instruments and cannot invest in a company by way of loan. In case of AIF, there is no taxation at the fund level, and any income or loss generated by these funds is taxed directly in the hands of the unit/investment holder.

Asset reconstruction companies

These onshore vehicles are registered with the RBI under the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI). ARCs are permitted to acquire only sub-standard or non-performing loans. Accordingly, this strategy is preferred by distressed banks or financial institutions and entails the acquisition of bad assets or non-performing assets (NPA) by ARCs in exchange of security receipts, which are then acquired by foreign investors. This helps banks or financial institution clean up their balance sheets and helps revive the stressed company. To aid the growth of ARCs, various sops, such as reduced stamp duty, easier registration charges, and tax benefits etc., have been provided.

Venture debt

This vehicle of onshore debt financing has emerged and evolved in India over the last five years. Described as a bridge between equity financing and traditional debt, this medium-term debt instrument entails investment by venture debt funds with valuations linked to the next round of portfolio funding, providing the venture debt fund suitable security and coupon (interest which the investor gets on this debt instrument), along with equity rights to convert or invest. This vehicle mainly serves the debt requirements of the start-up ecosystem in its early and growth stages.

Offshore debt funding options

Under this option, debt investors prefer direct funding to the final borrowers, as this option is not only more tax efficient, but also allows the investor to retain direct control over enforcement and exercise of rights. This option also allows the investor to mitigate currency exchange risk, incurred on the international financial transaction due to currency fluctuations.

In India, offshore funds are highly regulated and are required to comply with the guidelines issued by SEBI and the RBI. We list the various offshore debt funding options available to foreign investors in India.

Compulsorily convertible debentures – foreign direct investment

Foreign investors are permitted to invest into compulsorily convertible debentures (CCD) issued by Indian companies under the foreign direct investment (FDI) route. This investment is on a non-repatriable basis, which means that the foreign investors are not permitted to repatriate funds back from India. Also, these CCDs must mandatorily be converted into equity shares and the pricing norms shall apply. The equity shares issued subsequently after the conversion, can be transferred by the investor.

FDI is permitted in equity shares, fully and compulsorily convertible debentures, fully and compulsorily convertible preference shares and shares warrants, and in any sector except those sectors that are prohibited. The FDI route cannot be utilized to make debt investment.

This method is preferred by lenders with a long-term perspective, who have bullish (optimistic, forward looking) expectations from the investee company and intend to convert their loan into ownership rights in the future. However, unlike pure equity, this method does provide the tax efficient option of generating cash on an annual basis in the form of interest. Investment under FDI is subject to pricing guidelines and other FDI-linked requirements, such as:

• Optionality: Instruments subscribed by foreign investors may contain an optionality clause (such as a put/call option), subject to a minimum lock-in period of one year, or the prescribed lock-in period for the relevant sector, as applicable.
• Pricing guidelines: Unless otherwise mentioned, any foreign investment in equity instrument or to the capital of LLP will be subject to pricing guidelines.
• No assured returns: While interest payments on CCDs is permissible, due to RBI guidelines on pricing, the price/ conversion formula must be determined at the time of issue, and the price at the time of conversion cannot be lower than fair market value. Further, instruments issued with optionality clauses will be considered FDI compliant only if they comply with RBI guidelines in this regard, including minimum lock-in of one year and obtaining exit only according to the prevailing market price. The intent is that foreign investors subscribing to instruments with optionality clauses should not be guaranteed an exit price.

In India, FDI is subject to entry route restrictions and sectoral caps. The two entry routes are as follows:

• Automatic route: Under this route, the non-resident or Indian company willing to make a foreign direct investment in India does not require prior nod of the RBI or the Indian government.
• Government route: Under this route, the government’s approval is mandatory for investment made by non-resident investors, and such investment shall be subject to the conditions stipulated in the approval

Rupee denominated lending – foreign venture capital investment

In India, foreign venture capital investors (FVCI) are registered with SEBI. FVCIs are permitted to invest in debt instruments issued by Indian companies engaged in 11 specified sectors, including infrastructure, pharmaceuticals, nanotechnology, and information technology. In fact, they are the most preferred debt funding option in the infrastructure sector.

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They can be issued by means of optionally convertible debentures (OCD), compulsorily convertible debentures (CCDs), and non-convertible debentures (NCD).

Investment into NCDs by FVCIs can be made only in companies where the FVCI already has equity or equity linked instruments (optionally or compulsorily convertible instruments), and cannot exceed 33 percent of the total investment by the FVCI.

This method is most preferred by some investors as they have the option to invest directly in optionally convertible debt instruments. Additionally, unlike CCDs and FDI, FVCIs are not subject to pricing norms, neither at the time of entry, nor exit. Furthermore, FVCIs registered with SEBI have been accorded the qualified institutional buyer (QIB) status under the International Centre for Dispute resolution (ICDR) Regulations and are eligible for subscribing to securities at an Initial Public Offering (IPO) through the book building route.

Rupee denominated non-convertible debentures – foreign portfolio investment

Non-convertible debentures (NCD) are the most preferred offshore route for foreign investors. Under this option, those investors registered with SEBI as foreign portfolio investors (FPI) can directly acquire listed/ unlisted rupee denominated NCDs issued by Indian corporations.

However, this option is recently rendered unviable for structured or negotiated transactions as the new regulatory changes restrict each FPI (at a group level, that is, along with other related FPIs) to not to invest more than 50 percent of each issue of NCD. Despite the restrictions, this method continues to remain the most preferred funding option due to following benefits:

• FPIs permit security creation in favor of a resident trustee (on behalf of the investor).
• They provide free transferability of the NCDs.
• It is a tax efficient option.
• FPIs permit tracking underlying stocks, and investors can be passed on the equity upside as well.

An applicant can obtain the FPI license under SEBI regulations in one of the three categories mentioned below:

Category I

• Government and government related foreign investors, such as foreign central banks, governmental agencies, sovereign wealth funds, and international/ multilateral organizations/ agencies.
• Pension funds and university funds

Category II

• • Appropriately regulated funds not eligible as Category-I FPIs
  • Endowments and foundations
  • Charitable organizations
  • Corporate bodies
  • Unregulated funds in the form of limited partnership and trusts

Category III

• All other eligible foreign investors not eligible under Category I and II, such as endowments, charitable societies/trust, and foundations

External commercial borrowing – Rupee denominated or foreign currency

External commercial borrowings (ECB) as a funding option is most widely used by foreign banks and foreign institutions. ECBs are loans raised abroad by Indian companies by way of foreign currency convertible bonds or loans. The funds raised through ECBs are generally used for purposes like working capital finance, purchase of capital assets, repayment, or refinancing of existing debt.

They have proven effective in aiding Indian firms and organizations in their efforts to raise funds from beyond India’s borders, especially with regard to bringing in fresh investments. Certain forms of ECBs have also been given preferential tax treatment, making it a better option than other forms of debt funding for investors.

However, the Indian ECB policy imposes certain cumbersome conditions, such as the minimum average maturity period of three years and the all-in-cost ceiling (the maximum amounts that can be paid by the borrower to the lender). 

This longer tenure requirement makes it a suitable route for foreign banking institutions, social impact funds, and global funds engaged in sectors like infrastructure that have a long gestation period.

As of today, there exist two paths to raise funds by employing ECBs:

• Approval route: It mandates that companies that fall under certain pre-specified sectors must obtain the RBI’s or the government’s explicit permission, prior to raising funds through ECB. The RBI has issued circulars and formal guidelines, specifying the borrowing structure.
• Automatic route: There are various eligibility regulations prescribed by the government for availing finance under the automatic route. These regulations pertain to amounts, industry, the end-use of the funds, etc. Companies that desire to raise finance via ECB must necessarily meet these eligibility criteria. Thereafter, funds can be raised without the need for approval.

Rupee denominated bonds (Masala bonds)

A Masala bond is a rupee (INR) denominated bond issued by certain Indian entities to international investors for raising funds in the international market. These Masala bonds are offered to foreign investors willing to invest in India.

It must be noted that in the case of these bonds, all transactions including buying of bonds, interest payments, and repayment, are done in the Indian currency, that is, the Indian rupee.

For the foreign investor, these bonds are attractive as they offer approximately two to three percent higher rate of interest as compared to the standard LIBOR (London Interbank Offer Rate).

The framework for issuance of rupee denominated bonds overseas is different from the framework for ECBs.

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