Given the recent news SEBI considering (but not doing anything yet) about revoking the P-note ban, I thought it might be a good idea to revisit the topic. Thank you to Akshay for passing on info that has helped me better write this post.

In India, only domestic investors, or ‘Foreign Institutional Investors’ (FIIs) - those foreign institutions that have registered with SEBI, are allow to invest into the equity markets directly. Participatory notes (P-notes) allow foreign investors, such as hedge funds, which are not registered with SEBI to invest easily in the Indian equity market.

Practically, the way that P-notes work is that a foreign investor - say a hedge fund - would deposit funds with an FII that is authorized to issue P-notes, who would use the funds to purchase shares as instructed by the hedge fund. The FII would then issue a P-note to the hedge fund, which is essentially a certificate that says that it is entitled to X shares of company ABC, and any capital gains or losses and dividend payments would be passed onto the hedge fund. In return for this service, the hedge fund would pay the FII a fee.

A crude example: If a hedge fund not registered with SEBI wants to buy one share of Hindustan Unilever Limited (HUL), their FII would pick up a share of HUL for Rs. 240 and write a contract that says that in return for a fee and the Rs. 240 paid by the hedge fund, when the hedge fund asks the broker to sell the share they will comply and pay back the hedge the Rs. 240 plus or minus the rise or fall of the share price and the dividends if there were any.

Because foreign investors bought P-notes from reputable FIIs (they knew that they wouldn’t go back on the agreement), and there was a healthy supply of P-notes going around, foreign institutions were able to trade these P-notes amongst themselves.

On October 16, 2007, N. Damodaran, the then SEBI chief issued a decision to curb foreign participation through P-notes as he felt that there was excess money being pumped into the Indian market unchecked leading to volatility - which is always bad thing, especially for the retail investor (Its even worse for the retail investor that is trading cash equities on margin or trading in the Equity Futures and Options segment). The foreign investors were given 18 months to square off their positions and no issuing of further P-notes was banned. At the time (Oct 16) because SEBI’s proposals were unclear, investors panicked and on October 17, within one minute of trading, the Sensex plummetted by over 1700 points, by 9% of its value at the time. The next day the index fell by another 700 points.

Bhave, the new SEBI chief was expected to overturn this curb today, but no such decision was made (see my post).

P-notes made it much more convenient for foreign investors to participate in the Indian market - rather than having to go through the headache of registering with SEBI and thereby, incurring administrative and oversight costs, many foreign investors, especially smaller who could afford the overhead preferred to go through this route.

The other advantage of a P-note is anonymity - a foreign investor could build up a large position in a company’s stocks by buying P-notes not through one but many Indian brokers, without alerting the market or the authorities who they were. By soaking up the shares in the market, they would be a position to profit by driving up the prices and then slowly offloading them to unsuspecting domestic investors. The smaller the number of shares of the company in question that are in the market, the easier it would be for a foreign investor to carry out such a manipulation.

Anonymity also ensures that this rise in price is smooth and not a spike. For example, if people got to know that a Private Equity Fund such as KKR intended to buy 10% of a company’s stock then the price would spike, not allowing KKR to build up the position relatively cheaply. This is because people would rush to buy it either because they think that there must be something special about the stock or because they think that by the time KKR are done accumulating 10% of the stock the price would have risen considerably so it would be sensible to get in now and sell when the price rises.

Another advantage of using P-notes is that these are more efficient than investing in equities directly, because the foreign investor can essentially profit from the Indian markets sitting (and sipping on cocktails) in some tax efficient jurisdiction like Mauritius or the Cayman Islands.

Anecdotally, some 2-3 years ago some 50% of foreign investment in the equity markets was through P-notes. Now the question is whether - in the absence of this instrument, with all its advantages for foreign investors - we will be able to see the kind of foreign participation that we saw pre October 16, 2007. Maybe not. While P-notes are a good way to drive short term gains, they did contribute to the euphoric and irrational rise of the markets up to January 21, 2008. I’m only glad that Damodaran stepped into the picture in October 07, otherwise who knows, rather than a 40% drop in the Sensex, we might have seen a 50/60/70% drop. Phew. It scares me just thinking about it.

Tags: Bhave, Damodaran, Economics, Economy, Equity Markets, Finance, Foreign Investment, History, Investing, Investment, Investor Essentials, P-notes, Participatory Notes, Regulation, Regulatory, SEBI, Sensex, Stock Market

This entry was posted on Thursday, August 14th, 2008 at 12:23 pm and is filed under Economy, Educational. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.