Mumbai: India is evaluating an innovative model to allow foreign arms manufacturers to meet complex local sourcing obligations when striking a major deal with the world’s sixth biggest military spender.

The defence ministry’s idea is to float a venture capital (VC) fund that will infuse foreign funds into small defence firms in India.

Offsets are a provision in India’s defence procurement procedure that requires any foreign arms manufacturer securing an order worth more than ₹ 2,000 crore to source components worth 30% of the value of the order from Indian makers.

The defence ministry’s idea is that original equipment manufacturers or OEMs, such as Dassault Aviation SA of France and Lockheed Martin Corp. of the US, will have more channels available for the discharging of their offset obligations.

“With the intent of expanding the avenues for offset discharge, there is a thought process that OEMs could be allowed to discharge part of their offset obligations through investments in the ministry of defence approved VC funds which in turn would invest in micro, small and medium enterprises (MSMEs) in defence equipment manufacturing or research and development (R&D)," the defence ministry said in a note reviewed by Mint.

The VC fund will enable MSMEs to access funds to secure the technologies the country needs and thus contribute to the growth of Indian defence manufacturing and exports, so far crimped by a lack of access to funds.

Local manufacturing of defence equipment is an important part of Prime Minister Narendra Modi’s Make in India programme, but the country continues to import nearly 60% of its defence equipment.

Of late, Indian companies have shown interest in the defence equipment business and have applied for licences from the ministry of commerce to locally manufacture military equipment, including airplanes and warships.

India moved up one spot in the global rankings to reach the sixth position in 2015 for military spending, according to the Stockholm International Peace Research Institute, which monitors developments in military spending worldwide.

A senior executive with a large US defence manufacturer said that the company has received the note from the Indian defence ministry and that it is studying the concept, which it finds interesting.

The concept note said, “This is envisaged to be achieved by harmonising the subscription to the VC fund by vendors, investment by VC fund in MSMEs and performance of the eligible offset discharge activities by such MSME demonstrated by having credible linkages between them."

In the proposed mechanism, the vendors will have the flexibility to invest in any VC fund registered with the Securities and Exchange Board of India (Sebi), which would in turn invest through equity into enterprises that are engaged in manufacturing eligible products or providing eligible services.

“However, only upon approval from the ministry of defence would the said fund be eligible to aggregate investment from vendors and deploy the entire amount in equity of Indian enterprises engaged in eligible products and services," it said.

There are two distinct sides to this proposal, said Ankur Gupta, vice-president, aerospace and defence at consultancy firm EY India.

“Offsets are meant to be a tool to leverage India’s buying power; deepen and broaden the defence industrial base; help Indian companies become a part of the global supply chains and promote technology transfer. On the other hand, MSMEs traditionally are hard pressed for capital. In this (aerospace and defence) sector, where working capital cycles in steady state operations can stretch up to six months, performance bonds or bank guarantees are the norm, and domestic cost of capital is 14-16%, any help from an ‘investment’ angle will serve as a shot in the arm for them," Gupta said.

“Whether the invested capital can address the most pressing requirements and the ‘original’ objectives vis-a-vis offsets get diluted or encouraged remains to be seen. The impact will largely depend on how the OEM investments are channelled and managed by the designated authorities. Nonetheless, it is an innovative concept and one which will throw up some interesting results when and if implemented", added Gupta.

The concept note said that initially the vendors shall have an option of discharging up to 25% of their total offset obligations through the avenue of investment through VC fund.

It also has to be ensured that subscription to the VC fund generates directly corroborated realization of the stated objectives of the offset policy in a substantive manner, the note said.

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