Foreign Portfolio Investment (FPI) to Foreign Direct Investment (FDI)

The Reserve Bank of India has  issued an operational framework for reclassification of investment made by a foreign portfolio investor to foreign direct investment (FDI) if the entity breaches the prescribed limit. Markets regulator Sebi too has issued a circular on procedure for reclassification of FPI investment to FDI.

The reclassification of Foreign Portfolio Investment (FPI) to Foreign Direct Investment (FDI) refers to the process by which an investment initially classified as a portfolio investment is re-categorized as direct investment. This change occurs when an investor’s stake in an Indian company crosses a certain threshold, making the investment substantial enough to be considered direct rather than portfolio.

Key Concepts: FPI vs. FDI

1. Foreign Portfolio Investment (FPI): FPI consists of passive investments in financial assets like stocks and bonds, generally involving smaller ownership stakes without active control over a company’s operations. The FPI cap is usually set at below 10% of a company’s equity.
2. Foreign Direct Investment (FDI): FDI implies a larger stake in a company (often above 10%), allowing the investor to have a significant influence on management and operations. FDI is associated with long-term interest and strategic control rather than short-term financial returns.

Reclassification Process

The reclassification happens when an FPI crosses the 10% ownership threshold in an Indian company. Here’s how it works:

• Threshold Trigger: If an FPI investor, such as a foreign institutional investor (FII), holds more than 10% of a company’s equity, their investment is automatically reclassified as FDI.
• Regulatory Requirements: Once reclassified, the investment must comply with FDI rules, which may include additional disclosures, compliance with sectoral caps, and adherence to any specific sectoral regulations.
• Impact on the Investor: The investor may gain more influence over the company, potentially even a board seat or decision-making power, depending on the size of the holding and company policies.

Significance of Reclassification

1. Enhanced Control and Influence: Crossing into FDI territory allows foreign investors greater say in company management, enabling a longer-term and more strategic approach.
2. Regulatory Compliance: FDI and FPI are subject to different regulatory frameworks. The reclassification means the investment will be regulated under FDI guidelines, which may have different sectoral caps and restrictions.
3. Impact on Sector Caps: In sectors with FDI caps, additional investment may be restricted if the company’s aggregate FDI limit is close to the permissible maximum.

Example Scenario

Suppose a foreign investor owns 9.5% of shares in an Indian company under the FPI category. If the investor purchases additional shares that push their holding to 10.2%, their investment would be reclassified as FDI. The company would need to report this reclassification, and both the investor and company would need to ensure compliance with FDI regulations.

Why It Matters

Reclassification provides a pathway for foreign investors to increase their involvement in Indian businesses, especially in sectors like technology, finance, and manufacturing. This shift from FPI to FDI can lead to increased capital inflows, stronger investor commitments, and potentially greater economic stability for the host country by ensuring that foreign investments are more sustained and strategic rather than short-term and speculative.