Venture Debt Funds in India: Regulatory Hurdles and Structuring Strategies (2023–2025)

Posted On - 19 August, 2025 • By - Nivedita Bhardwaj

India’s startup ecosystem has grown into one of the world’s largest, with thousands of funded ventures across technology, healthcare, logistics, and financial services. While venture capital and private equity have traditionally dominated the financing landscape, venture debt has emerged as a complementary asset class, providing growth capital without diluting equity.

 For foreign venture debt funds seeking to enter India, the opportunities are vast—but so are the regulatory complexities. The Foreign Direct Investment (FDI) framework, India’s External Commercial Borrowing (ECB) regulations, and rules around non-debt instruments, repatriation, and taxation significantly shape how such funds can structure their entry.

FDI Rules: Entry Conditions for Foreign Venture Debt

Automatic vs. Approval Routes

India’s FDI framework, governed by the Foreign Exchange Management Act (FEMA) and consolidated FDI policy, distinguishes between sectors where 100% foreign investment is permitted automatically and sectors where government approval is required.

For venture debt funds, the crucial distinction is whether their Indian entity will be treated as an NBFC (Non-Banking Financial Company), a fund manager, or a registered AIF (Alternative Investment Fund):

  • NBFC model: requires prior registration with the Reserve Bank of India (RBI). 100% FDI is permitted under the automatic route in regulated financial services, provided relevant licensing is obtained.
  • AIF model: Category II AIFs can receive foreign investment, but must comply with SEBI rules, including conditions on sponsor/manager ownership and downstream investment norms.
  • Fund manager model: if the venture debt fund operates offshore and only provides capital to Indian startups, it may structure through an FPI (Foreign Portfolio Investor) or FVCI (Foreign Venture Capital Investor) route, both requiring SEBI registration.

Press Note 3 (PN3) and Beneficial Ownership

Since April 2020, investments from countries sharing land borders with India (or where the ultimate beneficial owner is from such a country) require prior government approval. This condition applies even to financial investors, meaning a venture debt fund with limited partners from restricted jurisdictions may inadvertently trigger the approval route.

Practical implication: Funds must conduct beneficial ownership mapping early to determine whether the automatic route is available.

Debt vs. Non-Debt Instruments

Non-Debt Instruments

  • Equity shares, compulsorily convertible preference shares (CCPS), and compulsorily convertible debentures (CCDs) are treated as non-debt instruments under FEMA. Venture capital and private equity funds typically invest through these instruments.
  • For venture debt, however, these are less attractive since the fund’s objective is fixed return with downside protection, not equity-linked upside.

Debt Instruments and the ECB Framework

Pure debt instruments: such as non-convertible debentures (NCDs), bonds, and loans, fall within the External Commercial Borrowing (ECB) framework when subscribed to by foreign investors. The ECB regime imposes conditions on:

  • Eligible borrowers: certain NBFCs, infrastructure companies, and startups are permitted to raise ECB.
  • Recognised lenders: foreign equity holders or regulated financial institutions are allowed lenders.
  • Maturity and cost caps: minimum average maturity (often 3 years or more), and caps on all-in-cost ceilings linked to benchmark rates.
  • End-use restrictions: ECB proceeds cannot be used for equity investments, capital market deployment, or real estate.

For startups, RBI has created a special ECB window with relaxed conditions, but the compliance burden remains high.

Challenge: Venture debt requires flexibility in structuring repayments and shorter tenors, which may not align with the ECB framework’s restrictions.

Repatriation and Exit Mechanisms

  1. Dividend and Interest Repatriation
    • Interest on ECB is freely repatriable subject to adherence to pricing caps and withholding tax obligations.
    • Dividends from equity or quasi-equity instruments are repatriable, provided taxes are paid.
  2. Redemption of Instruments
    • Fully and compulsorily convertible instruments are treated as equity and can be redeemed by conversion.
    • Optionality clauses on convertible instruments require compliance with RBI pricing norms, exit cannot guarantee fixed IRR beyond fair market value.
    • Non-convertible instruments held by foreign investors may require adherence to ECB maturity conditions before redemption and repatriation.
  3. Tax Implications: Withholding tax on interest (typically 5%–20%, depending on treaties) and capital gains tax on sale/redemption affect overall fund returns. Structuring through favourable jurisdictions with tax treaties (e.g., Singapore, Mauritius, Netherlands) continues to be a common strategy, though GAAR (General Anti-Avoidance Rules) requires robust commercial substance.
  4. Regulatory Hurdles in Practice
    • Overlap of regulators – RBI regulates debt and NBFCs, SEBI regulates funds and FPIs/FVCIs, and DIPP (now DPIIT) manages FDI policy. Navigating multiple regulators increases compliance costs.
    • Ambiguity in “venture debt” definition – Indian law does not separately recognise venture debt as an asset class, often forcing funds to fit into NBFC, AIF, or ECB frameworks.
    • Restrictions on downstream investments – Indian AIFs with foreign investment are treated as foreign-owned entities; their investments in downstream companies must comply with sectoral caps and pricing norms, limiting structuring flexibility.
    • Currency risk – Debt repayments in foreign currency expose startups to INR depreciation. While hedging is possible, costs are significant.
    • Repatriation delays – RBI reporting timelines (FC-GPR, FC-TRS, ECB returns) often slow down exit flows if not diligently monitored.

Structuring Strategies to Mitigate Risks

  1. Establishing an Onshore NBFC:One strategy is to establish an Indian NBFC (venture lending arm), owned by the offshore fund through the automatic FDI route. The NBFC can raise local borrowings and provide loans to startups without triggering ECB restrictions. However, this requires RBI licensing, minimum capitalisation, and adherence to prudential norms.
  2. Hybrid Instruments through AIFs: Category II AIFs can issue structured debt instruments such as non-convertible debentures with warrants or CCDs with debt-like returns. This allows funds to replicate venture debt economics within the non-debt instrument category, avoiding ECB hurdles.
  3. ECB Structures for Larger Tickets: For established startups with higher creditworthiness, raising ECB under the startup window may be viable. The venture debt fund acts as a recognised lender. Deals should be structured with maturities and interest spreads consistent with ECB guidelines.
  4. FVCI Route for Convertible Debt: A Foreign Venture Capital Investor (FVCI) registered with SEBI can invest in convertible debt of Indian startups without ECB restrictions. This provides flexibility for venture debt funds but requires regulatory approval for FVCI status.
  5. SPV and Holding Company Structures: Funds often establish an Indian SPV or holding company through which investments are routed. This allows compliance with FEMA property rules, easier downstream investments, and consolidation of FDI compliance at one entity level.
  6. Currency and Repatriation Planning:  Use hedging arrangements to mitigate currency risks. Structure exits through buyback, redemption, or promoter call options consistent with pricing norms. Route investments through tax-efficient jurisdictions with adequate substance to minimise withholding tax leakages.

Diligence and Risk Allocation in Deal Documents

Transaction documents should incorporate:

  • Representations on compliance with FDI, FEMA, and sectoral laws.
  • Covenants ensuring timely regulatory filings (ECB returns, RBI forms).
  • Event of default clauses linked to regulatory non-compliance.
  • Escrow mechanisms for interest and redemption payments.
  • Change-in-law protections to account for evolving ECB or FDI policies.

Strategic Outlook

India continues to promote foreign capital inflows, especially into startups and renewables. Yet for venture debt funds, the path is narrower than for equity investors. The key is to select the correct regulatory entry channel—NBFC, AIF, FVCI, or ECB—based on the fund’s strategy, ticket size, and investor base.

Conclusion

  • The Indian venture debt market offers compelling opportunities, but regulatory hurdles across FDI rules, debt vs. non-debt classifications, repatriation, and taxation require careful structuring.
  • Funds seeking long-term presence may prefer the NBFC model.
  • Those aiming for flexible instruments may adopt the AIF or FVCI route.
  • Larger credit exposures may be structured under the ECB framework, despite its restrictions.

Ultimately, success lies in combining robust legal structuring with proactive regulatory engagement and precise compliance management. With these safeguards, venture debt funds can participate meaningfully in India’s growth story while protecting investor returns.