The recent financial crisis has lumped together fund managers of various hues, making little distinction between private equity (PE) and hedge funds or traders in securitized assets. That’s unfair, since most PE funds are the antithesis of the short-term, opportunistic approach that is a natural corollary of trading desks. Most PE funds indulge in considerable amounts of due diligence, usually have a deep understanding of the target industry, and stay invested for five to seven years.

This clubbing of PE with traders has resulted in a reluctance to concede that this sector merits special consideration from a regulatory perspective. So far, there has been no attempt at building a mechanism to distinguish PE, particularly from overseas, from other forms of financing. Non-public forms of financing are especially essential when a country is at an early stage of its growth path. Distinguishing long-term risk capital from other forms will enable PE to get the regulatory forbearance commensurate with the risks it takes.

Several regulations could benefit from being able to make such a distinction. The Direct Taxes Code Bill is less than favourable towards the taxation of capital gains on investments in unlisted companies—not the most encouraging signal for entrepreneurship. Similarly, some elements of the general anti-avoidance rule, though created in good faith, are amenable to uncertain executive implementation and could discourage those seeking to invest in India through the PE route. Also, pricing of entry into and exit from private firms of foreign investors sometimes requires the use of incentive mechanisms, ratchet pricing structures, and so on, which are at times complicated by extant exchange control related rules.

Keeping in view that entrepreneurship, employment generation and growth are driven by industries that are small, entrepreneurial and potential targets for PE, there is a case for a distinct framework to support growth capital. This, however, requires a belief that PE reflects a different risk-reward paradigm—one that can be beneficial to the economy—and, therefore, needs to be treated differently. This, in turn, needs us to be able to define PE more clearly than in the past, so that regulation may be fine-tuned to serve entrepreneurship.

In making a case for distinguishing PE from other forms of investment, one needs to recognize that India, despite its strong growth potential, also faces considerable risks. The temptation for investors will, therefore, be to operate within a limited set of companies, usually those that are well known and well managed. This, however, does not achieve the full capital absorption that our country needs. Further, there remains a large category of publicly listed entities that, for all practical purposes, operate privately. At least 90% of listed companies trade infrequently and are subject to relatively little oversight. Listing these companies may have once provided an opportunity for promoters to monetize a part of their holding, but has not been accompanied by improvements in governance. The advent of PE in such companies, with its strong focus on strategy and governance, can undoubtedly benefit this part of the market.

Given the very strong growth prospects for India, regulators may well feel that a lot of PE funding will flow into the country in any case. This is partially true, but a harsh tax regime combined with exit difficulties will only make investors demand a higher hurdle rate for investment. In the process, a large number of companies may lose access to capital as they fall through the investment filter.

Hence, there could be a strong case for distinguishing PE from other forms of capital, from the perspective of both taxation as well as certain capital market regulations. This is not an easy task. But for a growing economy, it may well be worth the while.

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Govind Sankaranarayanan is chief financial officer, Tata Capital Ltd. He writes on issues related to governance.