INDIA ANNOUNCES POLICY FOR STRATEGIC PARTNERSHIPS IN THE DEFENCE SECTOR
15 June 2017
A conspicuous absence in the Defence Procurement Policy 2016 (DPP 2016), released on 29 July 2016, was the chapter on Strategic Partners (SPs). Having been given considerable emphasis in the Dhirendra Singh Committee Report (Committee Report), on which the DPP 2016 was largely based, and having since garnered significant media and industry attention, the rolling out of this policy measure was eagerly awaited.
The Ministry of Defence (MOD) has put such speculations to rest by releasing Chapter VII of the DPP 2016 on SPs on 31 May 2017. Although defence manufacturing has been open to private sector participation for well over a decade, grievances have been aired in relation to the lack of a level playing field in comparison to defence public sector undertakings (DPSUs) and Ordnance Factory Boards (OFBs), which are favoured by the Government in respect of long term purchase arrangements for major defence platforms and equipment such as aircrafts, submarines, helicopters and armoured vehicles. The SP construct seeks to assuage the grievances of the private sector and envisages a partnership structure to enhance competition, increase efficiencies, facilitate faster absorption of technology, create a tiered industrial ecosystem and promote participation in global value chains including exports. The emphasis in the DPP 2016 continues to be on the competitive bidding process. The SP model is also designed to achieve self-reliance and self-sufficiency through the assimilation of technology, extensive indigenisation and long term research and development (R&D) capacity building over and above the capacity and infrastructure that exists amongst DPSUs and OFBs.
In this paper, we examine some of the salient features of the SP model. For this purpose, we have divided our analysis into the following broad categories:
Part A: In this section, we examine the process of shortlisting both domestic SPs and potential foreign original equipment manufacturers (OEMs), avenues for tie-ups and structuring considerations including implications of foreign direct investment (FDI) regulations.
Part B: In this section, we identify the principal business segments that will be served by the SP route and the manner in which this route will be expanded for broader ammunition procurement. This section will examine some of the technical, financial and other parameters.
Part C: We conclude with our analysis of the SP model and what this means for business opportunities.
PART A – SHORTLISTING OF OEMS, FDI RESTRICTIONS AND STRUCTURING CONSIDERATIONS
Shortlisting the OEMs
The MOD will shortlist OEMs entitled to participate in the SP model taking into account the quantum, range, depth and scope of technology to be transferred, the extent of indigenous content proposed, value addition to the proposed eco‑system of Indian vendors/manufacturers, measures to aid the SP in integrating platforms, plans to train skilled manpower and extent of future R&D planned for India. Indian companies shortlisted to act as SP are free to engage with any of the shortlisted OEMs to jointly finalize the techno-commercial offer to the MOD. Under the SP route, an Indian company is entitled to submit only one bid in collaboration with a single OEM. An exception to this rule has been provided for segments with diverse platforms (such as helicopters) where potential SPs may submit responses with more than one OEM to have the best technology solution. A minimum number of platforms (not exceeding 10-15% of the number of units being procured) are to be manufactured in the OEM’s premises. It is unclear whether this requirement may be waived or modified in relation to any specific system.
Potential Tie-ups with OEMs and FDI restrictions
The SP route envisages a tie-up between shortlisted Indian SPs and foreign OEMs for technology transfer, indigenous capacity building and assistance in training skilled human resources and other support throughout the life-cycle of the platform. Such tie-ups could be in the form of joint ventures (JVs), equity partnerships, technology sharing, royalty or other arrangements between the companies concerned. The applicant SP must be an Indian public company (as understood under the Companies Act, 2013) owned and controlled by resident Indian citizens. This requires the management of such a company to be in Indian hands with majority representation on the board of directors. Furthermore, chief executive(s) of the SP must be resident Indians who are part of the Indian group owning and controlling the applicant. For FDI purposes, calculation of foreign investment in the applicant SP must include:
the paid up equity share capital held by the OEM either by itself or through its subsidiaries or nominees; the paid up equity share capital held by other foreign investors; and the foreign investment held by an OEM or other foreign investors in accordance with (i) and (ii) above in any Indian company or limited liability partnership which is a shareholder in the applicant SP.
However, it has been clarified that for the calculation of foreign equity in the applicant SP, equity held by foreign portfolio investors (category I and II only) and Indian mutual funds would be excluded. Changes in ownership structure or shareholding pattern of the SP require prior approval of the MOD. The ownership and control thresholds adopted under the SP model are consistent with the extant FDI policy. This means that the maximum permissible FDI in an applicant SP cannot exceed 49% (including indirect foreign investment). While it may not be possible to draw a very fine line here, the implication appears to be that overreaching affirmative vote rights and other operational control levers by the OEM will be frowned upon. The rules, however, recognise that equity participation of foreign OEMs will not prevent other arrangements for sharing management rights in the JV mutually agreed between the SP and the OEM. It is unclear how far the Government will permit strong operational oversight and control rights in the JV, whether as a part of the JV agreement or other technology (and similar) agreements. There does not appear to be a “bright line” test for control. Therefore, there is some risk that OEMs will struggle to achieve a balance with their desired level of comfort in terms of operational oversight and governance and the need to ensure these rights do not overstep the control threshold as understood under the FDI regulations. In fact, to underscore the need for simplicity and clarity, the rules unequivocally state that no pyramiding of FDI in Indian holding companies or in Indian entities subscribing to the shares or securities of the applicant SP would be permitted. Aggressive structuring and back door financing options will not be looked at favourably as it appears that anti-avoidance structures will be resisted. A business-friendly approach is evident from the flexibility provided to the applicant SP in relying upon its group company(ies) experience in an identified segment, where such a group company with requisite experience and expertise may synergise its capabilities with the SP by executing a deed of adherence providing the MOD and the SP an irrevocable right to access, enter upon and use its facilities for duration of the strategic partnership. However, in such situations, it has been clarified that the FDI restrictions on the applicant SP shall also apply to such segment group company. It is not clear if the group company will be subject to additional restrictions (e.g. on change in ownership / control or raising financing etc.). OEMs are expected to be jointly responsible, along with the SP, for certification and quality assurance of the platforms supplied to the MOD. Importantly, OEMs are required to provide a formal acceptance by their relevant governments in relation to the proposed technology transfer arrangements prior to the issue of a Request for Proposal (RFP). Such a commitment may also be supported by inter-governmental arrangements signed between the countries at the award stage in relation to the defence contract. It is unclear how this requirement will be met at the RFP stage. This needs to be monitored.
Using special purpose vehicles
SPs are allowed to incorporate project specific special purpose vehicles or use existing subsidiaries (SPVs) in respect of specific projects or contracts awarded by the MOD when procurement contracts are required. The rules, however, provide that SP will be the primary contracting party with a clear restriction on assignment of such a contract while allowing the integration of the required system of systems by the SP or its SPV. Shareholding of an SP in the SPV must be locked in for the term of the strategic partnership. A limited carve out is provided in the case of companies providing technology for a project or a contract. Such companies will be permitted a maximum of 49% ownership in such an SPV subject to ownership and control of such an SPV continuing to remain with the SP. The FDI restrictions applicable to SPs would also apply to such SPVs. From a liability standpoint, SP would have overall responsibility of performance to the MOD. The SP and the SPV would be jointly and severally liable in respect of the contract so awarded. It has been clarified that the SPV’s joint and several liability with the SP will be prorated to the extent of its workshare, as agreed at the time of approval of the SPV by the MOD.
Part B – CLASSIFICATION OF SEGMENTS AND PARAMETERS FOR SELECTION OF SPs
Segments for SPs
There are identified segments in which strategic partnerships will be allowed. Presently, Chapter VII of the DPP only provides the following segments for which SPs can be formed:
Submarines Fighter aircrafts Armoured fighting vehicles (AFV)/ main battle tanks (MBT) Helicopters
(collectively, Group 1 Segments)
However, it is interesting to note that a Task Force Report (TF Report) published by the MOD in December 2016 suggested the same segments for SPs and classified them as Group 1 Segments. Apart from the general parameters for selection as SP in any of the Group 1 Segments, the applicant would also have to adhere to segment specific conditions. We are not covering these in detail as we expect these to be described in much more detail in the relevant RFPs.
In addition to the products mentioned above, the TF Report also mentioned a second set of segments which comprise of the following:
Ammunition, including smart ammunition (recommended by TF Report) Metallic material and alloys (crystallised by TF Report but not immediately recommended) Non-metallic material, including composites and polymers (crystallised by TF Report but not immediately recommended)
(collectively, Group 2 Segments)
Chapter VII of the DPP currently does not mention Group 2 Segments, however, the Group 2 Segments may be notified later by the MOD.
Selection of SPs is subject to various parameters which are summarised below for both the Group 1 and Group 2 Segments. Apart from the following parameters, it is unclear whether selection of an SP will also be subject to verification and comparison by the MOD amongst bidders from each category (as suggested in the TF Report). A verification and comparative evaluation amongst bidders was suggested in the TF Report, but has not been incorporated into Chapter VII of the DPP. Currently, it is difficult to envisage the timeline for the MOD to be able to select the SP for any category.
Group 1 Segment
Group 2 Segment
Restriction on Segments
Only one SP per Segment.
Two (or more) SPs may be allowed by the MOD.
Demonstrable capability for integration of “System of Systems” i.e. integration of a system with multiple technologies of major systems like aircrafts, ships, chemical plants, power plants, automobiles, etc. as specified in the expression of interest (EOI).
Demonstrable that the applicant is an engineering and/or a process technology company having commercially supplied products.
No specific thresholds specified; would be indicated in the EOI / RFP.
The TF Report, however, suggests the following thresholds which may be indicative of what is to be expected in this Segment:
Turnover: a consolidated turnover of INR 40,000,000,000 (Indian Rupees Forty billion) for each of the last 3 (Three) financial years.
Assets: consolidated capital assets at gross book value of INR 20,000,000,000 (Indian Rupees Twenty billion).
Revenue growth: consolidated revenue growth of 5% (Five per cent) per annum in at least 3 (three) of the last 5 (five) financial years.
Credit score: minimum credit rating (long term/issuer rating) equivalent to CRISIL/ICRA “A” (stable) as on the date of the application.
The TF Report has suggested the following thresholds:
Turnover: consolidated turnover of INR 5,000,000,000 (Indian Rupees Five billion) for each of last 3 (Three) financial years.
Assets: capital assets at gross book value should be INR 1,000,000,000 (Indian Rupees One billion).
Promoters and directors of the applicant SP and its group companies must not be wilful defaulters (as classified by the RBI). In addition, the TF Report has prescribed the following additional conditions which have not been incorporated into Chapter VII of the DPP:
that the applicant must show robust governance practices (including no qualifications in an applicant SP’s audit report) thorough evaluation of the debt restructuring and non‑performing assets of the applicant SP.
Same as TF Report suggestions for Group 1 Segments.
Rationale for focus under Segment 1
Chapter VII of DPP currently requires an SP to maintain focus on a core area of expertise with only one SP selected per segment. The ‘single SP per segment’ concept is aimed to foster economies of scale and prevent wastage and leakages which will may increase the risk premium and costs for the applicant SPs due to competition.
Since Group II Segments are more bulk produced products, it is expected that two (or more) SPs for a particular Group II Segment may be allowed by the MOD.
The verification stage suggested by the TF Report envisages an on-site verification by an evaluation committee set up by the MOD. The assessment of an applicant SP in this stage will be based on the criteria mentioned below (on the basis of figures certified by a statutory auditor):
Applicant SP solvency ratio should not be higher than 1.5:1 (total outside debt to net worth ratio); Modified applicant SP solvency ratio should not be higher than: 2.5:1 (total outside debt plus financial guarantees to net worth ratio); Return on invested capital (ROI) of the applicant SP (EBIDTA divided by average invested capital): Average of ROI for last 3 (Three) financial years should not be less than 9% (Nine per cent); and Debt divided by EBITDA for the applicant SP should not be higher than 3:1.
It is unclear why the TF Report recommended a verification, since it is safe to assume that compliance with all the financial, technical and other criteria would be required at the time of the contract award and later.
Comparative Analysis and final selection of SP
While not incorporated in the DPP, final stage as per the TF Report would include a simple comparative analysis done by a marking system of all the applicant SPs. The TF Report contemplated the following weightage for each of the criteria:
Segment Specific Conditions
PART C - CONCLUSION
Currently under ‘Buy and Make’ category of the DPP 2016, foreign OEMs are heavily relied on to provide technology which is otherwise not available in India. The aim of this policy measure is to reduce reliance on foreign OEMs and develop indigenous capability in line with the ‘Make-in-India’ drive. The SP policy is aiming to develop not only the private sector but also the Ministry of Micro, Small & Medium Enterprises sector. To ensure that a larger number of companies participate in the process of defence manufacturing in the private sector, and the SP maintains a focus on a core area of expertise, only one SP will be selected per segment. It will be worthwhile to wait and examine if the Government is able to balance the strategic national security objective with the commercial interests of the SPs to develop India’s defence sector as a force to be reckoned with.
The SP model is akin to the Raksha Udyog Ratna (RUR) concept which was first suggested by the Kelkar Committee in 2005. This concept of giving the private players a special status and granting them the same status as Defence Public Sector Undertakings (DPSUs) and Ordnance Factories (OFs) was swiftly rejected. The idea was then opposed by smaller companies and was said to be discriminatory as it would not give equal opportunities to everyone in the sector. Considering this, it can be argued that the SP model also visualises selective identification of a few big private players and allowing them to participate in procurement programmes over others. The notion of a SP in the defence sector has not been easy, it has previously been subjected to some contention due to the obvious potential for corruption and bias. Given the earlier experience in the selection of RURs, it would be fruitful to see how the Government implements the selection procedure envisaged in Chapter VII of the DPP. Hopefully, courts will be less sympathetic to challenges of the selection criteria or process by opposing stakeholders.
From the point of view of a foreign OEM, this policy drive may very well provide an entry route for global firms that were otherwise unwilling to experiment with the tendering route followed for conventional defence procurements and seek to establish a long-term commitment with private companies (who are allied with the Government as SPs). The real concern for foreign OEMs and their respective host countries is that in extreme circumstances of conflict, like war, the Government does have a right to acquire control over the intellectual property used and the facilities developed pursuant to the strategic partnership. However, this is counterweighed by the increasingly investor-friendly and transparent FDI framework that is being implemented in India. It is hoped that this announcement of the Strategic Partnership policy at such an opportune time will further accentuate the interest and appetite of foreign OEMs in the Indian defence sector.
Bharat Anand (Partner), Bhaskar Banerji (Senior Associate) and Divya Gupta (Associate)
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