Investment in P-notes at year's highest in October

Mumbai: Participatory notes (P-notes), the offshore derivative instruments that allow foreign investors not registered in India to bet on Indian securities, are back in vogue.

add_main_imageAs equity markets rise and the Securities and Exchange Board of India (Sebi) refuses to register foreign institutional investors (FIIs) without broad-based sub-accounts in the country, overseas funds are once again opting for P-notes—an investment vehicle on which the regulator has clamped down in the past, questioning their legitimacy.

According to Sebi, the value of investments through P-notes touched the fiscal year’s highest — ₹ 1.76 trillion—in October after dropping to a near three-year low of ₹ 1.28 trillion in May.NextMAds

P-notes are offshore derivatives based on stocks, debt or indices. Foreign investors who do not register themselves as FIIs with Sebi buy into Indian securities using this channel.

FIIs, the key driver of Indian markets, have pumped at least $22 billion (around ₹ 1.2 trillion today) into Indian equities this calendar year, the second highest ever since India opened the doors to this class of investors in 1993.

In October 2007, P-note investments were a record ₹ 4.49 trillion. In 2008, Sebi questioned the transparency of P-notes as an investment vehicle and said they may pose a liquidity risk to Indian markets. The regulator barred P-notes and ordered all foreign investors to unwind their positions, leading to a sharp drop in P-note investments.

The rules were reversed a year after the global credit crunch that ensued from the September 2008 collapse of US investment bank Lehman Brothers, when Indian markets needed the support of foreign money. That failed to enthuse investors, though, as they were wary about Sebi’s changing stance towards P-notes.

In 2010, norms for P-note investments were changed again to ensure that only genuine investors used the route.

Last year, to ensure that the overseas money coming directly through FIIs is legitimate and stays in the market for the long term, Sebi ordered foreign investment managers to have at least one broad-based sub-account if they wanted to keep their licence valid in India. A broad-based sub-account is one that has a wide investor base.sixthMAds

Sebi norms required a broad-based sub-account to have at least 20 investors, and none holding more than 49% of the funds. Such accounts typically belong to large overseas wealth funds and the money coming in through them is typically long-term in nature and the investors’ identities are known, ensuring quality and stability.

Consequently, the number of registered FIIs fell from 1,770 in January to 1,750 now. Market experts and FIIs say foreign investors who could not invest in Indian stocks through direct registration following the enforcement of broad-based sub-account norms are coming in through P-notes.

“Foreign investors’ confidence on P-notes is back. Money through P-notes is coming from those who lost their direct registration and from international hedge funds who frequently churn their portfolio and find P-notes more convenient to do so,” said Siddharth Shah, a partner and head of the fund practice at Nishith Desai Associates, a legal and tax consulting firm that manages several FII accounts.

“Sebi has reconciled its acceptability of P-notes and this is certainly encouraging for foreign investors. In the coming months, P-note investments are likely to go up further if other accesses of foreign investments like QFIs (qualified foreign investors) are not relaxed,” said Shah.

Overseas investors are also being drawn to Indian markets because of rising share prices. Government attempts to address contentious tax norms for foreign investors have helped. The government has delayed the controversial general anti-avoidance rules (GAAR) that sought to crack down on suspected tax evaders.

Indian market indices have risen 25% during the year, though most of the gains came after September as the government pushed long-pending reforms, allowing foreign direct investment in multi-brand retail, permitting overseas airlines to buy stakes in domestic ones, and liberalizing investment in insurance and pension funds

“As clarity on GAAR emerged, P-notes have made a comeback. The government, too, has made it clear that it requires foreign money to support Indian balance of payments. In the past three months, more than $7 billion of foreign money has come into India, and a large portion of that was through P-notes,” said U.R. Bhat, managing director of Dalton Capital Advisors (India) Pvt. Ltd.

According to Bhat, the money coming in through P-notes is mostly being routed through global exchange-traded funds (ETFs) and is likely to be short-term in nature. “India-dedicated funds are redeeming investments, and unless there is a long-term story, these funds will not start any meaningful investment,” he said. “The ETF money based on the popular Indian indices is currently coming into India through P-notes.”

The money is not chasing individual stocks, Bhatt added.