Current regulations are choking the development of the education sector. Siddharth Hariani and Rohith Ashok examine the restrictions and outline innovative ways to get past them

In a nation of over a billion, where a significant chunk of the younger population suffers from the lack of educational opportunities, medical resources and basic infrastructure, the need for investment in these areas cannot be overemphasized.

India’s economic development over the past decade has opened up new employment opportunities for educated youth and triggered a growing realization of the importance of education. With the passing of the Right of Children to Free and Compulsory Education Act, 2009, the government has shown its resolve to make primary education a fundamental right. The Ministry of Human Resource Development has set for itself the daunting target of doubling the country’s gross enrolment ratio by 2020.

In these times of burgeoning demand, the educational infrastructure in India falls far short both quantitatively and qualitatively. For its part, the government has sought to remedy this mismatch in demand and supply by allocating funds to the tune of ₹850 billion (US$16.3 billion) to the education sector in the country’s 11th five-year plan (2007-2012).

But the real solution to this problem could well come from the ranks of resource-rich private players. Encouraging global leaders in education to set up shop in India is also an integral part of the government’s strategy to transform India into a hub for world-class education.

Current state of play

India’s education sector is open to both government and private players. While some of the country’s oldest, largest and most prestigious educational institutions are government controlled, in recent years, many private institutions have made their presence felt in this field.

The education industry is broadly classified into two categories: (a) the core or regulated segment consisting of schools providing kindergarten, primary and secondary education (the K-12 sector) and institutions of higher education (universities, deemed universities, colleges, etc.); and (b) the non-core or unregulated segment (preschool, tutoring services, vocational training, etc.).

While the non-core segment is largely free from regulatory control, all core-segment educational institutions are required to be affiliated to governmental or other bodies. As education falls under the Indian constitution’s concurrent list, it is regulated by both the central government and state governments. Therefore, institutions may, depending on their nature and type, affiliate themselves to either a central or state body, which would mean they would be bound by the regulations of that body.

Obtaining affiliation can be a challenging process. It involves procuring numerous approvals and permissions, and fulfilling various conditions. Most importantly, the entity being established has to be of a not-for-profit nature, i.e. a trust, a society or a not-for-profit company (incorporated under section 25 of the Companies Act, 1956).

Additionally, institutions imparting certain types of education may need to obtain recognition from a statutory professional council – for example, the Bar Council of India in respect of law and the Medical Council of India for medicine – and comply with the council’s requirements.

International interest

Many leading foreign universities have sought to establish campuses in India as they realize the potential of the Indian higher education market. The entry and operation of foreign universities offering technical courses in India is regulated by the AICTE Regulations for Entry and Operation of Foreign Universities in India Imparting Technical Education, 2005.

These regulations prohibit franchises and require that an Indian not-for-profit entity be set up to impart technical education. The regulations also empower the All India Council for Technical Education to regulate the intake of students and fee charged for courses offered by such a university.

Recognizing that the education sector will benefit from foreign universities establishing themselves in India, the government has tabled the Foreign Educational Institutions (Regulation of Entry and Operations) Bill, 2010, in the parliament.

The bill would allow foreign educational institutions to offer courses in India either independently or in collaboration with an Indian educational institution. The foreign institution would need to be notified as an approved foreign education provider, after fulfilling criteria such as setting up a corpus fund of ₹500 million.

Crucially, any surplus revenue generated in India by a foreign education provider could only be invested for the growth and development of the educational institution established in India.

Rules for foreign players

The regulatory scenario surrounding foreign investments into India has come a long way over the past two decades. The period has witnessed a push for liberalization in policies to permit and encourage greater participation of foreign players in the Indian marketplace.

Since February 2000, foreign direct investment (FDI) of up to 100% has been allowed under the automatic route (without prior approval of the Reserve Bank of India) in the education sector, subject to the Foreign Exchange Management Act, 1999, and the regulations and the regulatory framework under it.

Further, the FDI policy was recently amended to permit FDI for construction and development activities in the education sector, and to exempt such activities from certain conditions that apply to construction and development in general, such as minimum capitalization, area of development and restrictions on repatriation.

While this seemingly liberal stance may appear encouraging to foreign investors, a close reading of the FDI policy reveals potential concerns. A key issue is that foreign investors are subject to the restrictive regulations governing the education sector, according to which an entity that sets up a school or college or any other educational institution in India must be of a not-for-profit character, i.e. a society, a trust or a section 25 company.

Societies and trusts are not permitted to receive FDI and while a section 25 company can receive FDI, it is not permitted to use its profits or other income to pay dividends to its members. Therefore, an educational institution in India may find it difficult to receive any FDI.

Finding a way in

Nevertheless, given the demand for education and potential growth prospects in the sector, investors are determined to chalk out possible structures within the regulatory steel frame. An innovative structure often used to overcome the regulatory hurdles involves the simultaneous setting up of one or more education-services companies (usually a private limited company) along with a not-for-profit entity.

As a not-for-profit entity is permitted to pay for services provided by a third party, it may be possible for the education-services company so established to provide various legitimate services to the not-for-profit entity. These could include management services, teacher-training services, curriculum design and course development, for which the education-services company receives payment from the not-for-profit entity.

As an education-services company will not be bound by the regulations governing not-for-profit entities, the investor will be able to use the company as a channel to draw returns from the not-for-profit entity. This structure may also be envisaged to set up an infrastructure company to provide land and infrastructure to the not-for-profit entity.

A brighter future ahead?: India’s education system needs better infrastructure, management and organization, which for-profit entities could provide
A brighter future ahead?: India’s education system needs better infrastructure, management and organization, which for-profit entities could provide

Care must be taken to ensure that the relationship between the entities is real and meaningful. Transactions between these entities should be conducted on an arm’s length basis, in accordance with applicable laws.

In structuring the investment in this manner, it is assumed that the educational institution will be in a position to generate significant returns through fees paid to it, which in turn will be paid to the education-services company for services provided. Such a structure would not be suitable in situations where a statutory or other body regulates the collection of fees or imposes a cap on the fees that can be charged by the educational institution.

Another crucial drawback of this structure is that the only rights available to the investor will be in the education-services company, which earns a single stream of revenue under the management contract. The investor will not have any direct control over the assets or actions of the educational entity.

Investors seeking a more cautious route into the K-12 sector in India may consider investing in schools that are accredited to prepare students for international qualifications such as the International Baccalaureate or the International General Certificate of Secondary Education. Schools that are affiliated to international bodies are subject to relatively less stringent regulatory controls than their domestically affiliated counterparts.

Non-core segment

Over the years, a parallel education system has grown and developed alongside mainstream education, from the pre-school to the postgraduate level. Millions of Indian students attend additional classes that complement their formal schooling or prepare them for various competitive exams.

Further, many college graduates find that despite completing their higher education, they are not employable. Holding a recognized degree does not guarantee them a job as they lack the skills and know-how to put their learning into action. Vocational training courses help bridge these gaps in knowledge and equip young people with the necessary skills to enter the job market.

This segment has emerged as an avenue for high-yielding investment by private equity (PE) and venture capital (VC) funds, and has seen a recent spurt of investment activity. Media reports suggest that PE investment in the education sector is on the upswing, with transactions worth US$126 million being reported for 2011 alone, mainly in the non-core segment.

The benefit of operating in this segment of the educational sector is that it is relatively less regulated, which grants participants the operational flexibility to tailor their activities to suit specific needs and objectives. Successful IPOs over the years by companies such as Everonn Education, Educomp and NIIT have convinced PE and VC investors that they will be able to achieve lucrative exits.

The way forward

The current volume of investment, even in the non-core segment, is negligible compared with India’s education needs. Although FDI in principle is freely permitted in the education sector, onerous regulations and the need for numerous approvals and regulatory compliances have discouraged foreign investment into the core segment of the Indian education market.

While the government’s efforts to protect the public from the fallout of commercialization of the education sector by retaining its not-for-profit character is laudable, there is no denying that India’s education system needs better infrastructure, management and organization, which for-profit entities could provide.

India’s policy makers are increasingly alive to the need to attract foreign players to help meet the needs of the masses, so the liberalization of the education policy may be inevitable. A well thought out change in policy, which reduces restrictions on investing in the core segment, could be a win-win move for the government, the youth of the country and investors.

Siddharth Hariani is a partner in the Mumbai office of Phoenix Legal. He specializes in general corporate, private equity and real estate work and has represented clients in the field of education. Rohith Ashok is an associate at the firm. Phoenix Legal is a full-service law firm that has offices in Mumbai and Delhi. It has six partners and 26 associates.