Defence ministry plans to fund promising start-ups using an offsets fund

In May, the ministry put out a draft amendment to the offsets guidelines and sought stakeholders' comments
To fund promising defence start-ups, the defence ministry intends to canalise money that accrues from the discharge of offsets into a Defence Offsets Fund (DOF), and leverage that with market funding. 

Describing the plan for the first time, Secretary for Defence Production Ajay Kumar said the DOF will be modelled on the successful Electronics Development Fund (EDF), which kicked off in 2015 during his previous assignment in the Ministry of Electronics and Information Technology (MeitY).

The EDF is a “Fund of Funds” contributing 15 per cent of the value of professionally managed “Daughter Funds”, required to raise the remaining 85 per cent from the market. The funds choose and fund start-ups for developing technologies in electronics, nano-electronics and information technology. 

The MeitY nominated Canara Bank Venture Capital to select the Daughter Funds. These must be private- or government-run funds following SEBI rules. 

Underlining success of this model, Kumar said MeitY had approved 22 daughter funds. These had raised a corpus of Rs 108.16 billion, with the government contributing Rs 12.27 billion more as its share. 

Now, Kumar said, the defence ministry plans to follow the same model with two major differences. “In the Defence Offsets Fund, the government's contribution to the daughter funds will be 30 per cent. Since defence is a closed market, we feel the government's share should be higher than in electronics,” said Kumar. “Second, in the EDF, the government pays 15 per cent; but in the DOF, the 30 per cent contribution would come from a foreign vendor in discharge of an offset obligation.”

A key benefit for the defence ministry is its disassociation from the start-up selection process for funding, with that left to the fund managers. “A risk-averse bureaucrat would play it safe; so selection by private fund managers is faster and better. Some start-ups will inevitably fail, but an unintended failure should not result in a witch hunt,” Kumar said. 

To create the DOF corpus, the defence ministry is amending the defence offsets guidelines that are set out in the Defence Procurement Procedure of 2016. The guidelines proposed allowing of foreign vendors to discharge offset liabilities by contributing to the DOF. 

In May, the ministry put out a draft amendment to the offsets guidelines and sought stakeholders' comments. “After examining the comments, we will amend the offset guidelines in one-two months,” said Kumar.

The proposed offset guidelines allow foreign arms vendors to discharge offsets — which amount to at least 30 per cent of the actual value of all contracts above Rs 20 billion — by investing in Indian defence related infrastructure, providing specified critical technologies, through equity investment in defence manufacturing companies and “Investment in MoD registered professionally managed Sebi-regulated funds dedicated for development of start-ups and MSMEs of defence, aerospace and internal security-related enterprises in the country.” 

Contributions to the DOF will be eligible for a multiplier of three, which means that by contributing $100 million, a vendor would extinguish offset liabilities worth $300 million. The policy also proposes that investment be subject to a ceiling of 30 per cent of the fund's corpus.

Kumar said investing the DOF corpus through Daughter Funds would allow the government to leverage a 30 per cent contribution with 70 per cent of market money. “This proposal will please foreign vendors as it provides an attractive route for discharged offsets cleanly. Further, there could be attractive payback on vendors' investments, if the fund makes profits. The ministry is happy because we would have multiplied R&D money. And for defence start-ups and MSMEs, there is funding for design and development that translates into defence manufacture,” says Kumar.

Acknowledging that DOF presents an attractive route for discharging offsets, an Indian defence industrialist said, given the uncertainties of defence ministry orders and cash flows, the managers of daughter funds would face difficulties in raising the 70 per cent market component. 

A key element of the new policy's success will be the selection of a DOF manager with expertise in defence technology investment. “We will select a fund manager in due course,” the Secretary DP, said.

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