DEBT FUNDING THROUGH NBFCs

With liberalization of the legal regime regulating foreign direct investment ("FDI") in financial services and continuing restrictions under the FDI route on directly infusing debt in Indian companies, foreign investors are actively looking to set up or acquire existing NBFCs and use such NBFCs to further lend to or invest in Indian companies

India's non-banking financial company ("NBFC") sector is undergoing rapid growth and is emerging as a preferred choice for foreign investors to route their investment into India. With the liberalization of the legal regime regulating foreign direct investment ("FDI") in the financial services sector and continuing restrictions under the FDI route on directly infusing debt in an Indian company, foreign investors are actively exploring the option of setting up or acquiring existing NBFCs and using such NBFCs to further lend to or invest in Indian companies. The onward lending or investment is mostly through structured instruments like non-convertible debentures which have an advantage of protected downside and equity upside by way of redemption premium or coupons.

This article highlights the key issues to be considered by foreign investors while structuring debt funding through the NBFC route.

Part A: Key Considerations For Foreign Investment In NBFCs

FDI liberalization

The regulatory regime relating to FDI in the financial services sector and specifically NBFCs has been significantly liberalized. Earlier, 100% FDI was permitted only in 18 specified activities, but now, 100% FDI is allowed under automatic route in all financial services activities regulated by financial sector regulators. Minimum capitalization requirements prescribed for NBFCs under the FDI Policy have also been removed, and NBFCs are now only required to comply with the net owned fund requirement prescribed by the Reserve Bank of India ("RBI") or any other applicable financial sector regulator. Before the amendment to the FDI Policy, setting up a 100% subsidiary would have required a non-resident to capitalize the subsidiary by USD 50 million, out of which, USD 7.5 million was to be brought upfront and rest within 24 months. In the liberalized regime, a 100% subsidiary can be set up by a non-resident with a net owned fund of INR 2 crores (approximately USD 300,000).

In the liberalized FDI regime, there was an interpretational ambiguity with respect to the word 'regulated'. It was not clearly laid out if the requirement to qualify for 100% FDI under automatic route is for the financial services entity to be 'registered' with the relevant financial sector regulator. This was specifically pertinent for determining whether government approval would be required for foreign investment in non-systemically core investment companies ("CICs"). While systemically important CICs are required to obtain registration with the RBI, non-systemically important CICs are exempt from registration, and hence, it was not clear if non-systemically important CICs would be considered regulated or not. However, paragraphs 3.8.3.1 and 4.1.1 in the FDI Policy of 2017 make it clear that CICs (both systemically important and non-systemically important) and an investment company would require government approval through the Department of Economic Affairs prior to getting any foreign investment under the FDI route.

Setting up new NBFCs or acquisition of existing NBFCs

A foreign investor can consider two options for investing in an NBFC. The investor can either set up a new company as NBFC or acquire an existing NBFC. While both the options are feasible, the investor may make the choice considering the time and process involved in both these options.

Incorporating a new company with the Registrar of Companies may take around 3 weeks and obtaining a registration as NBFC with the RBI may take around 4-6 months. The RBI has introduced a fast-track process for registration of NBFCs basis the type of NBFC proposed to be registered. The fast-track process is still at a nascent stage, and in due course, we can expect reduction in time required for obtaining NBFC registrations. The major cost in setting up an NBFC is the requirement of minimum net owned fund of INR 2 crores, which is usually not seen as a major concern by a foreign investor in light of the long-term investment goal.

Acquisition of an existing NBFC is another route for investment into an NBFC. This route would require time for diligence and documentation. Change in management or acquisition of control of an NBFC would require RBI approval. Obtaining this RBI approval may take around 3-4 months, and one month public notice has to be given for the proposed acquisition after receipt of RBI approval. These timelines can be expedited with the timely submission of satisfactory information and documentation with the Registrar of Companies and the RBI.

Capital adequacy requirements

Foreign investors can make investment in an Indian NBFC through a combination of equity and compulsorily convertible instruments. Investors should be mindful of the following points while structuring the investment:

• Leverage ratio of a non-deposit-taking NBFC should not be more than 7, which means that the total outside liabilities of such NBFC cannot exceed seven times the owned funds ('owned funds' include paid-up equity capital, compulsorily convertible preference shares, free reserves, and balance in share premium account).
• Tier II Capital of a non-deposit-taking NBFC should not exceed 100% of the Tier I Capital. Tier II Capital includes preference shares other than compulsorily convertible preference shares and hybrid debt capital instruments like compulsorily convertible debentures ("CCDs"). Tier I Capital includes owned funds reduced by: (a) investment in shares of other NBFCs, and (b) investments in shares, debentures, outstanding loans, etc. made to companies in the same group exceeding, in aggregate, 10% of the owned funds.
• If a non-deposit-taking NBFC has total assets of INR 500 crores or more as per the last audited balance sheet ("NBFC-ND-SI"), then such NBFC-ND-SI should maintain: (i) a minimum capital ratio consisting of Tier I Capital and Tier II Capital of at least 15% of its aggregate risk-weighted assets on balance sheet and of risk-adjusted value of off-balance sheet items, wherein assets and investment of the NBFC are given risk weights, for instance, shares and debentures of all companies have risk-weight of 100%; and (ii) Tier I Capital of at least 10% of its aggregate risk-weighted assets on balance sheet and of risk-adjusted value of off-balance sheet items.
• In case of systemically important CICs, the outside liability (which includes debt but excludes CCDs convertible into equity in less than 10 years) should not be more than 2.5 times its adjusted net worth and the adjusted net worth should be at least 30% of its aggregate risk-weighted assets on balance sheet and of risk-adjusted value of off-balance sheet items.

Few simple examples to illustrate the abovementioned capital adequacy requirements in case of a NBFC-ND-SI and to illustrate possible structuring options are:

Part B: Key Considerations For Onward Lending/Investment By NBFCs

Issuance of NCDs and deployment of funds

Investments received by NBFCs can be further lent by way of loan or through instruments like non-convertible debentures ("NCDs") which have an advantage of protected downside and equity upside. There are divergent views in the market about downstream investment in NCDs by a foreign owned and controlled company ("FOCC"). One view is that since NCDs are not permitted instruments under the FDI Policy, an FOCC cannot subscribe to NCDs while the other view is that an FOCC investing in non-FDI-compliant instruments issued by another Indian company will not be considered as an indirect foreign investment for the investee company and thus, does not have to comply with the FDI Policy. The latter view is supported by FAQs issued by the RBI on 'Foreign Investments in India'.

NBFCs have to comply with certain conditions for issuance of NCDs. The most relevant condition is that an NBFC (excluding CICs) can issue NCDs only for the deployment of funds on its own balance sheet and not to facilitate resource requests of group entities / parent company / associates. Therefore, proceeds from issuance of NCDs cannot be used by NBFCs (other than CICs) to either provide funds to their group companies or to their parent company. This restriction will not be an issue if the proceeds from NCDs are used to lend to or invest in portfolio companies.

Credit concentration norms

Any investment or lending by an NBFC-ND-SI has to comply with credit concentration norms as per which an NBFC-NDSI cannot invest in the shares of a company in excess of 15% of its owned funds, and investment in the shares of a single group of companies cannot exceed 25% of its owned fund. An NBFC-ND-SI cannot lend to a single borrower in excess of 15% of its owned fund and lend to a single group of borrowers exceeding 25% of its owned fund. Further, the loans and investments of an NBFC-ND-SI, taken together, cannot exceed 25% (twenty five percent) of its owned fund to or in a single party and 40% (forty percent) of its owned fund to or in a single group of parties. Every NBFC-ND-SI has to formulate a policy in respect of its exposure to a single party/group of parties.

The following are exempt from concentration norms: (i) an NBFC-ND-SI not accessing public funds (which include funds raised through public deposits, inter-corporate deposits, bank finance, debentures, and instruments compulsorily convertible into equity shares after 5 years from the date of issue) either directly or indirectly and not issuing guarantees; (ii) investment in equity capital of an insurance company; (iii) infrastructure loan or investment; (iv) investments in shares of or book value of debentures, outstanding loans, and advances made to its subsidiaries or companies in the same group (to the extent investments have been reduced from owned funds for calculation of net owned funds). Credit concentration norms are also not applicable to CICs; however, 90% of the net assets of a CIC have to be invested in group companies and at least 60% of its net assets have to be invested in equity shares (including instruments which are compulsorily convertible into equity shares within 10 years from the date of issuance) of group companies.

Creation of security and SARFAESI protection

While the creation of security in favor of a non-resident remains a challenge, security interest can be created in favor of an NBFC. The process of enforceability of security interest created in favor of NBFCs has also been eased. Last year, in total, 196 systematically important NBFCs, with assets of INR 500 crores or more as per their last balance sheets, were notified as 'secured lenders' under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 ("SARFAESI"). As such, these NBFCs may now enforce security interests on assets charged to them under SARFAESI without having to resort to courts or arbitration. While the benefit of SARFAESI is not available to all NBFCs generally, 196 notified NBFCs and NBFCs (through a debenture trustee) which subscribe to listed secured NCDs can take the benefit of SARFAESI.

Benefits of NBFC route over other debt investment routes

Other typical debt investment routes include investment by foreign portfolio investment and through external commercial borrowing. However, there are certain limitations in such routes which are not applicable to the NBFC route. These limitations include minimum maturity period and end-use restrictions wherein proceeds from the debt investment cannot be utilized for certain purposes such as real-estate activities, investment in capital markets etc. Debt investment through the NBFC route does not have these restrictions and hence have clear advantages over other routes.

Conclusion

The NBFC sector has undergone significant transformation over the past few years, and with the liberalized foreign investment regime and SARFAESI protection, it has become even more attractive for foreign investors. It also provides for an indirect way for foreign investment through the debt route in Indian portfolio companies, which is not allowed under the FDI Policy. Going forward, the NBFC route is expected to boost foreign investment into India.

Disclaimer – The views expressed in this article are the personal views of the author(s) and are purely informative in nature.