PNs to rise after Sebi ban on structured vehicles

Investments through off-shore derivatives instruments, also known as participatory notes (PNs), are set to rise yet again. This is after the Securities and Exchange Board of India’s (Sebi’s) ban on foreign investment in equity markets through multi-class share vehicles (MCVs).

After Sebi’s restrictions on PNs in 2008, MCVs had become popular with hedge funds and a large number of individual investors. The notional value of investments in equities through PNs was 13 per cent of the over Rs 8.18 lakh crore foreign institutional investor (FII) investment in the country in February. Experts said this could rise to over 25 per cent by the next year.

“Individual accounts and several small hedge funds, which were investing through MCVs, will now look at PNs as a better option,” said Sameer Gupta, a partner with accounting firm Ernst & Young.

MCVs, or protected cell companies, are entities with several cells within the same vehicle. Registered in tax havens, MCVs provide cover for disguised investors. Each MCV cell functions as an independent unit with its own assets, liabilities, cellular capital, dividends and accounts. So, when an MCV, registered with Sebi as an FII, buys shares for a particular cell, it becomes difficult for the regulator to track the ultimate owners of each cell.

For instance, individuals or hedge funds bought a single category of assets in one cell and opened a new cell for another category.

“However, PNs will be relatively easy to handle for Sebi as the regulator can know the names of ultimate holders,” said Gupta.

Experts said investors had switched to MCVs as they were cheaper than PNs. There are around 25 PN-issuing FIIs in India who charge 60-80 basis points for the total amount of PNs. The cost of investing through MCVs is nearly half of this.

Also, it was easy to form an MCV for an FII as it required only 20 investors and it could later open multiple cells. This gave rise to round-tripping of money, said another tax consultant.

Now, Sebi has banned MCVs and segregated portfolio companies. In addition, it said FIIs declaring that they were not MCVs would have to ensure that they had only single category of investors, also referred to as a single class of shares. Also, any change in the structure or an addition of a class will require regulatory approval.