More P-note investors might take direct route

Tightening should reduce attractiveness of this route but might not impact flows in a big way

The tightening of the rules on Participatory Notes (P-notes) by the Securities and Exchange Board of India (Sebi) might further reduce the instruments' attractiveness. However, flows into the domestic market might not be impacted in a big way, say those in the sector.

Changes to the P-note regime have blunted the advantage the instrument provided over direct investing through the foreign institutional investor route, they say. Sebi on Thursday increased the Know Your Customer (KYC) requirement, issued curbs on transferability and prescribed more stringent reporting for P-notes issuers and holders.

P-notes, also offshore derivative instruments (ODIs), allow foreign investors to take exposure to Indian stocks without registering with Sebi. These instruments are issued by foreign portfolio investors (FPIs) registered with Sebi.

“The latest changes mean there isn’t much difference in investing directly or through the P-note route. The KYC requirement for both will have to be the same. Also, an investor who doesn’t qualify to register as an overseas investor will also not be eligible to subscribe to a P-note,” said a senior official with a global brokerage.

Business Standard spoke to several P-note issuers and most of them requested not to be named, as they were not authorised to speak to the media. Morgan Stanley, Goldman Sachs, JPMorgan and Credit Suisse are among the biggest P-note issuers on the Indian market.

“Currently, a tenth of foreign flows into India come through this route. Dependence on P-notes to take exposure to the Indian market might go down further. In the next one year, P-note assets could be only five per cent of total foreign assets,” said an official with a leading brokerage.

As of March, the equity assets under custody (AUC) of P-note holders stood at Rs 2.23 lakh crore, a tenth of the total FPI AUC of nearly Rs 19 lakh crore. At the peak, a little over half of FPI AUC belonged to P-note holders.

Liquidation of some P-notes in the short term is possible, feel some. “Holders who don’t wish to comply with the stricter KYC norms might liquidate their positions. Also, if some investors who have taken exposure in excess of the permitted 10 per cent limit through opaque structures might be forced to unwind,” said the official quoted earlier.

By Sebi rules, a foreign investors cannot hold more than 10 per cent stake in a listed company. It is thought that some investors might be breaching this limit by investing through the P-note route. The new Sebi guidelines emphasise on identifying the ultimate beneficiaries.

“The most substantial change is compliance with domestic money laundering laws to all ODI issuers. It will certainly bring transparency and should not have impact on quantity and quality of flows,” said Sandeep Parekh, founder, Finsec Law Advisors.

Legal experts believe the increase in compliance will also make the P-note route more costly. “These changes will not only make the route difficult to access the India market but also make it more expensive. P-note issuers will have to put in place a robust mechanism to track the end-beneficial owner,” added Suresh Swamy, partner at PwC India.

Following the introduction of FPI Regulations by Sebi in 2014, a lot of foreign investors have preferred to take the direct route. The trend might gather momentum, feel experts. “Liberalisation of FPI registration regime over the past few years has brought down P-note volumes substantially. The liberal registration regime, coupled with further tightening of the P-note route, is likely to eventually make these less lucrative,” said Tejesh Chitlangi, partner, IC Legal.

“The same should not lead to any adverse market movement or any substantial fall in inflows, as today’s mature markets seem to have already factored in any potential impact and, in any event, the P-note issuance is at all-time low levels,” he added.