<div>The RBI in its monetary policy dated 1 April 2014, announced that as regards foreign direct investment (FDI), it has been decided to withdraw all the existing guidelines relating to valuation in case of any acquisition/sale of shares and accordingly, such transactions will henceforth be based on acceptable market practices. <br /><br />While the operating guidelines in respect of the above have not been notified as yet, the immediate reaction of the foreign investing community to this announcement has been very positive and they have been jubilant at the prospect of free pricing.<br /><br />In this backdrop, it is important to understand the true ramifications of the announcement and what impact it would have on deal activity in India, going forward.<br /><br />FDI in India has been regulated and has been subject to pricing norms. The thumb rule on pricing for foreign investors has been to invest at not less that the prescribed valuation price and to exit at not more than the prescribed valuation price. The principle being to conserve foreign exchange and to protect the Indian promoters from getting a raw deal.<br /><br />Earlier, the valuation methodology prescribed was as per the Controller of Capital Issues (‘CCI’) method. The CCI method provided for an average of net asset value and profit earning capacity value. This method was essentially backward looking and was based on past performance of the company. In 2010, this was changed to valuation as per discounted cash flow (‘DCF’) method. <br /><br />In the above context, what does the RBI announcement mean? Is there going to be absolute free pricing going forward? Ie will foreign investors be permitted to invest at below fair price and exit at a premium to fair price? Or does this just mean that while entry and exit need to be in accordance with the fair price, the valuation methodology will no longer be prescribed by the regulator and will have to be based on accepted market practice?<br /><br />I would concur with the latter interpretation. In my view, the RBI is inclined to give a free hand to the market players to determine the valuation methodology; while having to meet the pricing guidelines. Given that we are still some way from full capital account convertibility, the overall pricing restrictions, to my mind, will continue.<br /><br />Nonetheless, this is a welcome move to give a free hand to investors as regards choice of valuation methodology.<br /><br />While transitioning from the archaic CCI method to DCF was a progressive move, one has to appreciate that DCF may not be the appropriate valuation method in all situations. Choice of an appropriate valuation method depends on the industry and the sector that the company belongs to and the stage at which the company is in its life cycle.<br /><br />No valuation is “right” in any absolute sense. It is appropriate to use several scenarios about the future and even several valuation methods to arrive at the target’s value. Also, it may be more accurate to value the divisions or product lines of a target, than to value the whole company. Also, different valuation methods may be appropriate for different components of a company. It is not prudent to have a “one size fits all” approach as regards valuation. And it is best to leave the choice of valuation methodology to the professional valuers.<br /><br /><br />Clearly, this is a step in the right direction and will boost deal activity in India. It signals less regulatory interference and higher trust and faith in the investors and professional valuers, which is welcome. The investing community is eagerly waiting for the operating guidelines to be released and one hopes that the guidelines have a positive bent. It would be a further boost if RBI can apply the same logic of flexibility in valuation methodology in the case of put and call option as well, instead of tying it down to a regressive ROE based method.<br /><br />Lastly, foreign investors are faced with the pricing issue on multiple fronts – Section 56 tax, transfer pricing, Companies Act, SEBI, exchange control and so on; and there is no consistency qua these myriad set of regulations as regards the valuation methodology. While RBI’s announcement is clearly a welcome move and does address one of the various moving parts of a deal; at some stage, all the regulators need to speak the same language and arrive at a common ground on valuation methodology. <br /><br />To conclude, with this positive announcement, expectation is rife that the trend of liberalization will continue. Further policy reforms are expected as regards dispensing with the lock in and minimum capitalization requirement in real estate as also relaxing some of the sectoral caps that still prevail. Investors are looking for more…..<br /><br /><br /><strong>The article is authored by Punit Shah, Co Head of Tax, KPMG in India with inputs from Sheetal Nagle, Director- Tax, KPMG in India</strong></div>
