Private Equity (PE) and Venture Capital (VC) have become indispensable drivers of economic growth and innovation globally. In Nepal, these investment vehicles have gradually gained traction, necessitating the development of legal frameworks to support their operation. Over the years, legislative amendments and regulatory directives have been introduced to accommodate the unique needs and challenges of PE and VC activities within the country. This article delves into the developmental journey of PE and VC laws in Nepal, focusing on key amendments, regulatory definitions, challenges, and recommendations for further enhancement.
Initially, PEVC operations in Nepal were regulated through various scattered legislations, primarily the Companies Act 2063. This legislation governed the formation and operations of PEVCs, typically structured as private limited companies with the objective of investing in equities of other companies. However, the Companies Act 2063 imposed investment limits on such companies, allowing them to invest only 60% of their paid-up capital and free reserves or 100% of their free reserves, whichever is higher. Subsequent amendments, notably the first amendment to the Companies Act 2063 in 2074, introduced exceptions for “investment companies,” easing the investment restrictions. The Companies Directives 2015 further regulated investment companies, permitting them an investment potential of an amount equating the sum of 90 percent of paid-up capital and 100% percent of free reserves.
Alternatively, the route of investment by a foreign private equity fund in the form of foreign direct investment in the investee company is also adopted. Such investments are categorized as foreign investment under the Foreign Investment and Technology Transfer Act 2075(2019) (FITTA) and are regulated by the Department of Industries, Office of Company Registrar, and Nepal Rastra Bank. However, this limits the sector in which the foreign PEVC invests, as FDI can only be made in the permissible industries not excluded by FITTA’s negative list.
The formulation of the Specialized Investment Fund (SIF) Regulations in 2075(2019) by the Securities Board of Nepal (SEBON) marked a significant milestone. These regulations recognized PE and VC as asset classes and provided a regulatory framework for their operation. The SIF Regulations set forth requirements for the establishment and operation of Specialized Investment Funds, known as alternative investment funds. Only licensed fund managers are permitted to create and operate such specialized funds, including private equity, venture capital, hedge funds, and any other funds approved by SEBON (collectively referred to as the SIF). Additionally, the FITTA expanded the scope of PEVC operations by allowing foreign investment in companies intending to establish venture capital funds.
With these regulations in place, private equity and venture capitals are currently operating in various models including (i) investment companies under the Companies Act (ii) foreign PEVC investing directly as foreign investors, or (iii) specialized investment funds under the SIF Regulations.
Investment companies regulate their relationships with investors and investees through specific contractual arrangements, with ultimate investment decisions lying with the Board of Directors. The notice published in the Nepal Gazette on 03 August 2020 added Investment Companies to the list of Service Industries in the Industrial Enterprise Act 2076(2020). Subsequently, the notice published by the Ministry of Industries, Commerce, and Supply in the Nepal Gazette on 02 March 2023 has imposed certain terms and conditions for the registration and operation of Investment Companies. Some of the provisions include a minimum capital of Rs. 1 arba, permissibility to invest in equity only in industries where foreign investment is permissible, and specific restrictions on investment through debt, debt instruments, bonds, or debentures. Additionally, an investment company having foreign investment is required to obtain foreign investment approval for investment in each industrial sector.
In the case of the foreign PEVCs investing directly, they are regulated by foreign investment laws. However, efforts were made in regulatory reforms to ensure additional protection to such investors. For instance, the NRB Unified Directives of 2074 for the first time exempted foreign investors and DFI’s from being blacklisted, ensuring that the foreign PEVCs are excluded from the ambit of the blacklisting laws. The SIF Regulations do not specifically apply to them unless such PEVC opt to register themselves as Foreign PE/VC with SEBON under the provisions of the Regulations.
The SIF funds exist independently from their fund manager and can operate beyond the ambits and limitations of the Companies Act. These funds are required to be registered with SEBON and adhere to the provisions of SIF Regulations, along with the terms and conditions imposed by SEBON, their fund constitutions, and the agreements entered with their general and limited partners. The SIF Regulations outline the minimum requirements for the registration of a fund in Nepal. To be eligible, the fund must have a capital of at least 15 crores (150 million) rupees. Additionally, the number of unit holders is limited to a maximum of two hundred, indicating a preference for a manageable and closely-knit investor base. The fund should be close-ended and should distribute dividends exclusively to its unit holders. Furthermore, each unit holder is required to purchase units worth a minimum of fifty lakh rupees, ensuring a substantial commitment from investors. The fund managers are mandated to inject and maintain a 2% stake in the total fund size at all times, allowing them to manage funds up to fifty times their contribution. However, this ownership requirement is waived for investments made by bilateral or multilateral international agencies. In return, fund managers may obtain management fees and carry interest for their role. Similarly, under the Regulations, SIFs are subject to a one-year lock-in period following an IPO, while other companies are bound by a three-year lock-in period. This shorter lock-in period offers SIFs a distinct advantage in post-IPO investments.
While the SIF Regulations attempted to introduce international practices in terms of the operation of PEVCs in Nepal, there is a lack of coherence between the Regulation and other prevailing laws. Ambiguity existed regarding the eligibility of investors intending to invest in the SIF. For instance, the Regulations provided a list of eligible investors, including foreign banks, financial institutions, insurance companies, foreign investors, foreign PEVCs, bilateral or multilateral agencies, etc. However, the investment directives of Nepal Rastra Bank and the Nepal Insurance Authority lacked provisions on SIF, thereby disabling both insurance companies and banks from investing in sectors not permissible by their respective directives.
The recent amendment to the Investment Directives of Reinsurance Companies 2079, Investment Directives for Life Insurance Companies 2079, and Investment Directives for Non-life Insurance Companies 2079 expanded the scope of investment into PEVC funds approved by SEBON under the SIF Regulations. According to the amendment, life insurance, non-life insurance, and reinsurance companies may invest up to 1.5% of their total investment in these PEVCs, while not exceeding 1% in a single fund.
Similarly, before 2080, the NRB Unified Directives for A, B, and C class licensed entities, as well as the Unified Directives for Infrastructure Banks, did not include PEVC as a defined investment sector. This meant that any investment in PEVC would have to be provisioned from undistributed reserves, thereby reducing distributable profit for banks as well as Tier I capital, which is highly valued by all banks. However, the current Unified Directives of 2080 ensure that investment by A, B, or C class BFIs or Infrastructure Banks need not be deducted from the core capital, thereby encouraging investments into PEVC. However, investment in PEVCs still carries a weighted risk of 150%. Similarly the Unified Directive 2080 now additionally exempts entities with over 50% foreign investment, investing in small and medium enterprises through PE/VC funds, from existing blacklisting provisions.
Additionally, there lack of appropriate legal provisions permitting foreign funds or foreign investors from subscribing to the units of the local specialized funds. The approval regime for the purchase of units of the local funds lacks clarity thereby limiting local PEVC’s access to foreign capital.
Further, ambiguities under the SIF Regulations loom uncertainty over the tax treatment of PE and VC funds. While mutual funds enjoy favorable tax exemptions, PE and VC funds require clarity on their tax obligations. Implementing a pass-through tax treatment for PE and VC funds, similar to that of mutual funds, could stimulate domestic investment and foster a conducive environment for economic growth. This tax regime would ensure that investors are not burdened with undue taxes, thereby incentivizing their participation in PE and VC activities within Nepal.
In conclusion, the development of PE and VC laws in Nepal reflects a concerted effort to adapt to evolving market dynamics and promote investment opportunities. While significant strides have been made, there remains scope for further refinement to address existing challenges and maximize the potential of PE and VC as catalysts for economic development. By embracing progressive regulatory reforms and adopting investor-friendly policies, Nepal can position itself as an attractive destination for both domestic and international investors seeking growth opportunities in the vibrant landscape of private equity and venture capital.
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