Portfolio investors banned from buying stakes in defence firms

New Delhi: The government has quietly banned portfolio investors from buying stakes in defence companies, making it the only sector where foreign direct investment (FDI) is permitted while foreign institutional investors (FIIs) are not welcome.

The policy was changed on the insistence of the defence ministry and will apply only prospectively, a government official said, requesting anonymity.

Till last month, 26% foreign investment was allowed in defence companies, including from FIIs. As a part of overhauling FDI limits in many sectors, the government in August effectively raised the FDI limit in the defence sector to 100% by not putting an upper limit on such investments.

The defence ministry was long opposed to the foreign investment cap being raised, but it agreed to allow this on the condition that any foreign investment proposal above 26% should be sent for approval to the cabinet committee on security, where defence minister A.K. Antony holds the key in matters of national security.

The government official said FDI above 26% would be allowed only if it brings access to advanced technology.

The notification of the policy change last month says any proposal for FDI up to 26% in the defence sector will require approval from the Foreign Investment Promotion Board, those above that limit will need the cabinet committee's nod. The notification also states that "investment by FIIs through the portfolio investment is not permitted" in defence companies.

The policy change is surprising because defence becomes the only sector where FDI is permitted while FIIs are not allowed, according to Akash Gupt, executive director at consulting firm PricewaterhouseCoopers. "This also means all present investments by FIIs in the defence companies are frozen as if they sell their stakes, they can't buy into them again," Gupt said.

At end-June, FIIs had a 35.82% stake in Mahindra and Mahindra Ltd, 16.06% in Larsen and Toubro Ltd, 13.96% in Punj Lloyd Ltd and 2.2% in Pipavav Defence and Offshore Engineering Ltd, all listed companies that have defence-related businesses, BSE data show.

The government seems to have become cautious about what kind of money comes into defence companies, said Prithvi Haldea, chairman and managing director, Prime Database, a Delhi-based capital market data aggregator.

"The government seems to be fine with strategic investors through the FDI route but not trading investors through the portfolio investment route," Haldea said.

The guidelines notified last month also require that applications seeking permission for FDI beyond 26% in defence companies will need to be additionally examined by the department of defence production to validate whether the proposal would bring in state-of-the-art technology.

Applications for FDI up to 26% need to follow the existing procedure with proposals involving inflows in excess of Rs.1,200 crore being approved by cabinet committee on economic affairs. However, if the proposal involves FDI beyond 26% and inflows more than Rs.1,200 crore, it will not need to be placed before this committee if the ministerial panel on security gives its nod.
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