Author: Invest for Impact Nepal
Original Publication Date: 20th September 2022
Regulatory Reforms for Facilitating Efficient Fund Investment in Nepal
Private Equity Funds (“PE”) and Venture Capital Funds (“VC”) (collectively “PE/VC”) can operate in Nepal under two legal regimes; (i) as a limited liability company registered pursuant to Companies Act, 2006, or (ii) as a specialized investment fund registered pursuant to Specialized Investment Fund Regulation, 2019 (“SIFR”). SIFR is the first specific legislation introduced to deal with PE/VC in Nepal by the Securities Board of Nepal on 6 March 2019. SIFR provides a licensing mechanism for funds and fund managers to operate in Nepal, their governance, reporting and documentation.
Before the introduction of SIFR, PE/VC were established as limited liability companies with the objective akin to an investment company where the interest of the general partner and limited partners were aligned by means of various class of shares with suitable rights. The SIFR currently provides the option to register three categories of funds with a limited life cycle of 5 to 15 years:
- Private equity fund, which has been defined as a fund with the objective to initial provide equity, convertible security, debt instrument or loan, or other instruments related to equity;
- Venture capital fund, which has been defined as funds that invest equity, debt instrument or loan for the operation of businesses based on innovative knowledge, skills and competency or are related with new products, services or intellectual property that are not listed in securities market and are either in operation or in the initial phase of operation; and
- Hedge fund has been defined as a fund established to invest in any sector with high risks.
The current legal regime permits the following PE/VCs to operate in Nepal: (a) Offshore PE/VC funds that is not registered in Nepal and make direct investment into different portfolio companies (“Offshore Fund”), (b) Onshore PE/VC fund that is established as an investment company with either only foreign investment or jointly with Nepali investment (“Onshore FDI Fund”), (c) Onshore PE/VC fund that is established as an investment company with investment exclusively from Nepali investors (“Onshore Local Fund”), (d) PE/VC licensed as a fund by SEBON that can have both foreign and local investment (“SIFR Fund”), and (e) Foreign PE/VC that does not have a commercial presence in Nepal but is registered with SEBON (“Foreign Fund”).
This article identifies some of the key issues that arise during the establishment and operation of funds in Nepal and during the exit of fund investment. The later part of the article provides recommendations for resolving the procedural and policy issues related with the issues identified.
Issues identified in the current and evolving regulatory framework to increase fund investment in Nepal
- Issues related to establishment and structuring of PE/VC funds
The foremost issue relating to the establishment of PE/VC fund is the the minimum capital of an investment company. The guidelines for Investment Companies issued by Ministry of Industry, Commerce and Supplies, 2021 (the “Investment Company Guidelines”), provides that the minimum capital of an investment company should be NPR 1,000,000,000 (approx. USD 8 Million). This requirement is applicable to both foreign investors and Nepali investors willing to set up a PE/VC under investment company structure. For Onshore FDI Funds and Onshore Local Funds, this requirement poses a challenge as it severely restricts smaller sized funds targeting small and medium sized enterprises (“SMEs”) with their investment portfolios.
Moreover, the Investment Company Guidelines prohibits Onshore FDI Fund and Onshore Local Fund to raise loan from local banks and financial institutes. This provision is counterintuitive to fostering the entry of PE/VC funds as options available for raising capital and funds in the marketplace should be flexible and easily accessible as opposed to restrictive and rigid.
The Specialized Investment Fund Regulation, 2019 (2075) (the “SIFR”) are required to pay fees to SEBON for their operation. The fees imposed are relatively high and makes a significant impact to the overall operational costs of fund management services. Fund managers are required to pay three kinds of fees to SEBON: (i) One-time registration fees of NPR 300,000, (ii) Recurring annual fees of NPR 150,000 payable within 3 months from the end of fiscal year, and (iii) Recurring fees calculated at the rate of 2% of the service fee received by the fund manager from the fund payable within 2 months from receipt of these service fees by the fund manager. A delay penalty at the rate of 10% p.a. is also payable if this fee is not paid to SEBON within the prescribed time. This has resulted in the payment of two kinds of recurring annual fees which is both burdensome and increases costs for the fund managers.
For foreign funds, the SIFR provides opportunities for funds registered outside Nepal to register with SEBON by submitting an application with the prescribed documents and paying registration fees. However, a foreign fund is required to enter into fund management agreement with a local fund manager licensed by SEBON as a pre-requisite to making application for registration with SEBON. However, there is limited incentives for foreign funds which as incorporated and operating outside of Nepal to be regulated by SIFR. Thus, the mandatory requirement for foreign funds to receive fund management services from local fund managers can deter foreign funds from registering with SEBON.
- Issues related to the deployment of investment by PE/VC funds
There is a lack of clarity on the permissible capital threshold of investment under the prevailing laws of Nepal. The Companies Act, 2006 (2063) (the “Companies Act”) restricts a company to invest in excess of (i) sum total of 60% of its paid-up capital and free reserve or (ii) 100% of free reserve, whichever is higher. However, the investment companies are exempted from this ceiling. The Companies Directive, however, mentions that the business excluded from application of investment ceiling can make investment only up to the sum total of 90% of its paid-up capital and 100% of free reserve. The Companies Directive is not consistent with the Companies Act. Due to the restriction imposed by Companies Directive, funds structured as investment companies are barred from deploying 10% of their paid-up capital. This restriction implies that onshore FDI fund and onshore local fund cannot deploy 100% of the capital in investments. Further, if the fund is set up with some portion of debt, investments from debt will also not be permitted.
Few of the substantial issues applicable for offshore fund and onshore FDI fund under the purview of Foreign Investment and Technology Transfer Act, 2015 (2075) (the “FITTA”) relate to the sector and threshold of investment. It imposes restrictions on foreign investment in the certain Nepalese industries like; (a) Real estate business (excluding construction industries), (b) Cottage and small industries, (c) Mass communication media, (d) Management, accounting, engineering, (e) Consultancy services having foreign investment of more than 51%., and (f) Poultry farming, fisheries and primary agriculture-based business. This restricts the scope of sectors where funds can investment in. Furthermore, offshore PE/VCs are deprived of the opportunity to set up a wholly owned fund management company in Nepal due to investment cap on consultancy service businesses.
In addition, the Department of Industries (the “DOI”) requires any company with foreign investment such as an onshore FDI fund to obtain prior approval of the DOI or IBN before making equity investments into other entities pursuant to FITTA. This fosters an inefficiencies and delays, as onshore FDI funds are subjected to multiple layers of regulatory approvals prior to making investments. After receiving approval for foreign investment during its establishment, the onshore FDI fund will again need to obtain approval for foreign investment from DOI every time it invests in a portfolio company. Further, an onshore FDI fund will also need to comply with the minimum investment threshold of NPR 50 million (GoN announced reduction of threshold to NPR 20 Million, however yet to publish in official gazette), which means the onshore FDI fund will have to invest at least NPR 50 million in each portfolio company. These requirements hamper the pace at which the PE/VC funds can operate since obtaining DOI/IBN approval for each investment into other companies is both time consuming and inefficient. Further, complying with minimum investment threshold for every investment may not be feasible for portfolio companies such as SMEs.
- Issues related to the operation of PE/VC funds
One of the major issues in relating to the operation of PE/VC Funds in Nepal is concerned with blacklisting of funds. The Directive No. 12/078 related to Credit Information and Blacklisting (“Blacklisting Directive”) provides that when a borrower defaults on loan, the lender can recommend Credit Information Bureau to blacklist the borrower. Some of the consequences of blacklisting is that it prohibits the borrower from assuming new or additional debts or renewing existing loan facilities, operating a bank account etc. The directive lists several parties to be included in the blacklist, including: the borrower, directors of borrower entity, shareholders holding at least 15% of the borrowing entity and persons or companies having the right to nominate the director of the borrowing entity. In addition, if the blacklisted entity owns more than 15% of the shares in any other company, the director and CEO of such company are also blacklisted.
There is an exemption facility from blacklisting which is only limited to offshore funds as per the Blacklisting Directive. Onshore funds, however, are not exempted from potentially far-reaching implication of blacklisting. As a result, if any of the portfolio company of an onshore funds where it has a right to nominate director or holds more than 15% shares is blacklisted:
- Such onshore fund will be blacklisted, thereby affecting the operations of the entire onshore fund.
- Directors and CEO of other portfolio companies of the onshore fund where it holds more than 15% shares will be blacklisted.
The risk of blacklisting is a major deterrent for PE/VCs to use leverage at the portfolio company level.
- Taxation issues related to PE/VC funds
The “Change in Control” tax is a major challenge for funds who generally prefer to invest in a company for short duration and make an exit after their investment tenure is completed. This is because Income Tax Act 2002 (2058) (the “ITA 2002”) provides that if the ownership of any entity changes by 50% or more within a period of three (3) years, then such entity will be regarded to have disposed of its assets or liabilities. Pursuant to ITA 2002, change of ownership by 50% or more will require the company to prepare separate accounts for period up to the change and after the change in ownership and “the assets and liabilities” of the company will have to be evaluated at the market price and the company will be subject to tax on any gain amount. Frequent entry and exit of investors over period of numerous years triggers payment of several taxes like the Capital Gains Tax and Change in Control Tax, which includes high costs and hampers status of balance sheet of a company. Further, there is restriction in carrying forward losses if a change in control takes place in a company. As there is no substantial change in business activities, restriction in carry forward of losses is not logical and imposes an additional challenge for the business.
- Exit issues related to PE/VC funds
In relation to exit of PE/VCs from investment portfolios, the Securities Registration and Issuance Regulation, 2017 (“Securities Regulation”) restricts transfer of shares that are existing pre-IPO for up to three years from the date of allotment of shares issued through IPO. The SIFR has limited the lock-in period of funds registered by SEBON to one year. However, this reduced lock-in period is only applicable for SIFR Funds and not available to funds operating under other structures like offshore funds, onshore FDI funds and onshore local funds. This restriction has affected the exit plans of funds not registered with SEBON and has made IPO a less desirable exit form.
At the time of the exit, there have been issues in relation to the valuations and methodology to be done. There is a prior requirement from Department of Industries as well as from the Nepal Rastra Bank for repatriating the sale proceeds by a foreign investor. Foreign Investment and Loan Management Bylaw requires investee company/foreign investor to submit a copy of due diligence audit of assets and liabilities conducted by an auditor so as to indicate per share value in the case of sale of shares of institution/ organization not listed in securities market while applying for repatriation approval from NRB. NRB has not prescribed the valuation model that needs to be used for such due diligence. In the absence of any prescribed valuation methodology, NRB has been accepting valuation done using the DCF method.
Mitigation Measures
Based on the procedural and policy issues identified, the following mitigation measures are recommended:
- Mitigation measures related to establishment and structuring of PE/VC funds
In relation to the establishment of PE/VC Funds, the minimum capital requirement NPR 1,000,000,000 (approx. USD 8 Million) for onshore FDI funds and onshore local funds should be reduced to pave the way for investment by smaller size funds. Moreover, regulations should allow an onshore FDI fund and onshore local fund to raise debt capital from banks and financial institutions to improve their operational efficiencies. Similarly, SEBON and Ministry of Finance must allow SIFR Funds to raise debt capital from individual and corporate investors, banks and financial institution both locally and internationally to diversify their funding options.
With regards to the ambiguity in the timeline for incorporation of funds, there is need to clearly state a timeline for granting fund registration in the SIFR. In additional, it is imperative for SEBON and Ministry of Finance to clarify the various legal structures permissible for setting up of a SIFR Fund in Nepal. This would improve clarity regarding fund structuring.
In the interest of reducing the financial burden of SIFR registered funds, SEBON and Ministry of Finance should remove the recurring fees payable to SEBON as calculated at 2% of the service fees received by the fund manager. Lastly, it is recommended to remove the mandatory requirement by SEBON of engaging licensed local fund managers for registered foreign funds.
- Mitigation measures related to the deployment of investment by PE/VC funds
The investment ceiling prescribed by the Companies Directive should be removed as it contravenes with the flexibility provided in the Companies Act. This will provide scope for 100% deployment of paid-up capital of investment companies without any investment limitation. Further, with reference to the existing restrictions on the investment of SIFR Funds in debt instrument, it is necessary for SEBON to issue a notice prescribing the permissible limit for SIFR Funds to invest in debt instruments.
In order to attract investment, it is essential to carve out the multiple layers of regulatory approvals for investment. Thus, there is a need for a policy decision to provide blanket FDI approval for onshore FDI fund instead of multiple approvals.
- Mitigation measures related to the operation of PE/VC funds
Due to the adverse impact of blacklisting to the investor in the case of default of the investee company, it is pertinent to consult with the NRB to exempt all PE/VC funds from the broad application of blacklisting regime. Such amendment would encourage PE/VCs to invest in multiple portfolios across various sectors without the fear of backlisting.
- Mitigation measures related to taxation and exit
In relation to taxation, GON and tax authorities should consider amending the ITA 2002 and change its practice of (a) Change in control assessment and (b) Implement the business continuity principle to reduce the burden to tax payments to PE/VC funds.
