Foreign fund flows into India through an obscure offshore derivative called participatory notes are rising, despite efforts by regulators to make it tougher for hedge funds and wealthy individuals to invest anonymously. Investments through participatory notes in Indian stocks, bonds, and hybrid securities have surged by 56% to reach 1.43 trillion rupees ($17.3 billion) at the end of January, compared to 914.6 billion rupees the previous year. This growth in investment comes even as regulators have introduced stricter disclosure requirements to verify the identities of clients. The rise in foreign fund inflows is driven by India’s booming stock market, which is attracting investors looking for alternatives to China. However, authorities remain cautious about participatory notes due to concerns of potential money laundering through this investment route.
Despite the regulatory hurdles, India continues to be a favored market for foreign investors, particularly in light of the economic growth potential and the recent downturn in China. Joshua Crabb, a fund manager at Robeco in Hong Kong, stated that India has been emphasized as an attractive market due to its economic growth, especially over the past year. Bankers have also been engaging with regulators to present their views on the additional disclosure requirements implemented last year.
The new rules were introduced to prevent round-tripping, a practice where funds are returned after being transferred to a shell company, by company founders using the foreign portfolio investment route. These measures were taken following criticism about the lack of oversight over inflows into major Indian conglomerates. The Adani Group, in particular, has faced accusations of opacity and lack of transparency in its funding structure.
Under the new regulations, global funds holding more than 5% of their equity assets in a single business group must provide details of all entities with any ownership, economic interest, and control rights in the investor. Similarly, foreign investors with more than 250 billion rupees in local equities are also subject to the disclosure requirements. However, university funds and endowments of a certain size have been exempted from this provision.
Regulators aim to deter investments in participatory notes as they are concerned that Indian promoters are misusing them to invest in their own companies and portray it as public shareholding. Additionally, Indian resident investors who are not allowed to invest in participatory notes may also route them through offshore accounts. To address these concerns, global banks that sell these instruments have been unwinding and reallocating the notes in the secondary market to ensure their exposures remain within the required thresholds. This approach allows them to protect their clients’ identities while still facilitating investments in India.
Last year, US short-seller Hidenburg Research released a critical report against the Adani Group, alleging that foreign funds with opaque ownership structures had been investing in the group’s companies, artificially inflating stock prices. The accusations had a negative impact on the group’s stocks and bonds initially, but they have since started to recover.
In conclusion, despite increased regulatory scrutiny and concerns about money laundering, foreign fund flows into India through participatory notes continue to rise. The allure of India’s growing stock market and the country’s economic growth potential have attracted investors seeking alternatives to China. Regulators have introduced stricter disclosure requirements to prevent misuse of participatory notes, and global banks are adjusting their strategies to comply with the regulations while still facilitating investments in India. However, caution is still warranted to ensure that foreign fund inflows are transparent and adhere to the prescribed regulations.
