India Considers Venture Capital Funds To Discharge Offsets

5 August 2016

Overseas defense companies could invest in select Indian venture capital funds (VCF) to discharge compulsory defense offsets if a proposal, currently under consideration, is implemented by the Indian Ministry of Defence (MoD), according to a senior ministry official.

Investments by overseas companies in approved VCFs could be used in mainly startup defense companies in the micro, small and medium enterprises (MSME) either through equity stakes or direct investment in these small companies. Under the proposal, only domestic VCFs approved by the MoD could used for this purpose.

According to the senior official, the government wants to boost MSMEs in the defense sector, which number more than 5,000, as they face fund crunch.

"The rates of interest to seek funding for MSMEs are very high right now and with stiff conditions. The government wants to create jobs and this can come from the MSME sector. The sickness of good defense MSME sector will get reduced to a large extent through the VCF route, which also will enable original equipment manufacturers (OEM) and tier I companies to create a large supply chain and thus create jobs," the official said.

Overseas defense companies are finding it difficult to execute defense obligations because India's defense manufacturing industry lacks the requisite depth to absorb the billions of dollars worth of offset business coming its way. OEMs find it uneconomical to procure defense components and subassemblies from India manufacturers. Low productivity and experience of labor manufacturing in India offsets the cost advantage of cheaper labor.

It is estimated that India's offset market is worth more than $10-15 billion in the next 10 years.

Several overseas defense companies had to pay fines for not fulfilling offset obligations, according to another MoD source.

Between 2008 and 2014, overseas companies have been able to fulfill only half of the $1.3 billion worth of offset obligations, the source added.

VCF can be one way of letting an overseas defense company fulfil its mandatory defense offsets, but overseas defense companies want VCFs to be foreign-owned, too.

"VCF targeted at MSMEs would enable the fund to provide equity to MSMEs in the defense space. This could provide much-needed risk capital for MSMEs," said Vivek Rae, the MoD's former director general of acquisition.

Rae, however, added: "The VCF would need to be an Indian fund."

Jan Widerström, chairman and managing director at Saab India Technologies, welcomed the VCF method of discharging. "The idea of a VCF to discharge offsets is definitely innovative, and shows the willingness and openness of the government to try new and interesting methods of supporting Indian defense MSMEs. We are not fully familiar with how this would work in practice, though, and will have a better appreciation once we have seen more details about the plan."

In India, VCFs are registered with the investment regulator Securities and Exchange Board of India. There are around 200 registered domestic VCFs and more than 100 foreign VCFs mostly operating from Mauritius that can be invested in designated sectors of the economy but not defense.

However, investment consultants say VCFs have often been used to pump unaccounted money from overseas. Vijay Karol, the director of financial firm Kamakshi Securities said: "Offshore funds can use venture capital funds as their India-based conduits to channel investments into defense companies and not much can be known about the source of the money."

The overseas companies will not, however, be allowed to repatriate capital employed at home except for dividends or rate of interest. In other words, investments involving VCFs can't be removed from their designated fund and sent back home, except for dividends or interest.

Defense analyst Nitin Mehta was wary about the new concept to use VCFs as another way to discharge offsets because investments in MSME are already risky, and investors or OEMs may not want to take the risk involved in investing in these funds.

"The whole concept of venture capital investments is that a large majority of such investments fail, so there is inherent risk in such investments — especially in a sector like defense and in a geography like India," Mehta said.

Apart from ownership of the VCF, another major issue is the criteria for the selection of MSME companies, which will get the benefit of the capital infusion.

Ashok Kanodia, managing director of defense MSME at Precision Electronics Limited, said: "The investor (OEMS, etc.) would like some control or oversight on his investment. How does he [the OEM] redeem his investment and what role [will] he ... play in selection of a borrower? These are some of the issues which need to be thrashed out before the VCF could actually take off."

Amit Cowshish, the MoD's former financial adviser, has said the VCF proposal under consideration will create yet another avenue for the discharge of offset obligations.

"Under the existing procedure, offsets can be discharged through a combination or permutation of six avenues laid down in the guidelines. These include direct purchase of defense products/services from Indian entities; investing in Indian defense industry through the Foreign Direct Investment route; transfer of technology/equipment to Indian private/state-owned companies; and transfer of identified critical technologies to the state-owned Defence Research and Development Organization," Cowshish said.


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