India’s New Alternative Investment Funds Regulations

On August 1, 2011, the Securities and Exchange Board of India (“SEBI”) introduced the draft SEBI (Alternative Investment Funds) Regulations, 2011 (“Draft Regulations”), a comprehensive regulatory framework for regulating private pools of capital, i.e., alternative investment funds (“AIFs”). The Draft Regulations, which contained provisions proposing to drastically alter the mechanics for the Indian funds industry, came as a total surprise to the industry (see analysis by the authors at WSLR, September 2011, page 22).

In response to the Draft Regulations, innumerable representations were made before SEBI by various industry players and associations highlighting the over-regulation and the potential crippling effect of some of the provisions on the industry. After much deliberation, SEBI, in its April 2, 2012, board meeting, approved certain amendments to the Draft Regulations which address most of the concerns raised by the industry players.

Then, on May 21, 2012, SEBI notified the SEBI (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”), replacing the extant SEBI (Venture Capital Funds) Regulations, 1996 (“VCF Regulations”).

The final version of the AIF Regulations represents a substantial revision of the Draft Regulations.

In this article, we examine the AIF Regulations, which in our view will shape the future of this asset class in India. As we bid farewell to the VCF Regulations, which played their role in recognizing and nurturing the growth of this industry since 1996, the AIF Regulations are now expected to play the role of taking this asset class to the next level of maturity.

Highlights

• Hedge funds, debt funds and funds of funds now permitted

• Continuing manager/sponsor commitment (cannot be met through waiver of management fees):

• Category I and II AIFs: INR50 million (U.S.$898,392) or 2.5% of the corpus, whichever is lesser

• Category III AIFs: INR100 million (U.S.$1.8 million) or 5% of the corpus, whichever is lesser

• Maximum investors: 1,000

• Minimum fund size: INR200 million (U.S.$3.6 million)

• Minimum commitment per investor: INR10 million (U.S.$179,678)

• Tenure for Category I and II AIFs: Minimum three years

• Custodian to be appointed (except where the corpus of a Category I or II AIF is less than INR5 billion (U.S.$89.8 million))

• The manager may co-invest in investee companies

• AIFs may invest in limited liability partnerships

• AIFs may invest in “associates” with the approval of 75% of investors (by value)

• Units of close-ended AIFs may be listed after the final closing, subject to minimum tradable lot of INR10 million (U.S.$179,678)

• Reporting requirement to SEBI in case of change in control of AIF, sponsor or manager

Who is Regulated by the AIF Regulations?

Every fund established in India for the purpose of pooling moneys from investors, Indian or foreign, on a private basis, for investing such moneys further shall fall within the ambit of the AIF Regulations and will have to be registered under these regulations, unless a fund has been specifically excluded from the said regulations. Currently, the AIF Regulations do not apply to mutual funds, collective investment schemes, family trusts, employee stock ownership plans and other employee welfare trusts, holding companies, special purpose vehicles, funds managed by securitization or reconstruction companies, etc. Thus, going forward, no AIF can operate in India without registration, unless it falls within one of the aforementioned exclusions. Accordingly, some vehicles, like investment specific co-investing vehicles, multifamily investment vehicles or private investment vehicles, employee co-investing vehicles, etc., may need closer examination and may not squarely fall within the given exemptions.

What Happens to Existing Funds?

Existing venture capital funds registered with SEBI and unregistered pools of capital have been grandfathered in the following manner:

• Venture capital funds that are registered under the VCF Regulations will continue to be governed by the VCF Regulations; however, they are prohibited from launching any new schemes or increasing the targeted corpus of their existing schemes. Hence, SEBI seems to have rolled back its earlier proposal to prohibit such existing venture capital funds from raising fresh capital commitments subsequent to the enactment of the AIF Regulations. Also, these funds are permitted to migrate to the AIF Regulations by re-registering under these regulations after receiving the approval of two-thirds of their investors (by value).

• While from the minutes of the board meeting it appeared that SEBI had proposed to allow an unregistered pool of capital to continue until maturity (except that no rollover/extension or fresh fund raising was permitted), the language in the AIF Regulations seems to suggest otherwise. From the manner in which the law has been drafted, it appears that such unregistered pools of capital are now required to mandatorily register under the AIF Regulations within six months (or 12 months at SEBI’s discretion) of the enactment of the AIF Regulations, and are not permitted to raise any fresh capital until such registration is obtained.

We believe the practical approach adopted by SEBI in grandfathering all the existing VCF schemes which have been launched to the extent of the their targeted corpus is truly commendable, and comes as a big relief for players who are at different stages of fund raising in their launched schemes.

Categories of AIFs

With the intention of distinguishing the investment criteria and relevant regulatory concessions that are allowed to AIFs, SEBI has classified AIFs into three categories. The following table shows the three categories of AIFs:

Application for Seeking Fresh Registration/Launch of New Scheme under the AIF Regulations

The eligibility criteria for seeking registration under the AIF Regulations include a requirement that at least one key member of the applicant’s management team should have more than five years of relevant experience. The intention may have been to limit fund management under the AIF Regulations to seasoned players. This should be a welcomed move. However, the fact that SEBI expects the “launch” of a fund to be preceded by the placement memorandum being placed before it for its comments seems to suggest that SEBI intends to closely monitor the terms of fund raising. This could potentially lead to the regulator’s infiltrating matters that may essentially be a matter of commercial negotiations between the limited partner and the general partner, a possible outcome that cannot now be ruled out.

Tax ‘Pass-Through’ Benefit Only for Category I AIFs

Prior to 2007, venture capital funds that were registered with SEBI under the VCF Regulations were provided a tax “pass-through” benefit on their income that arose from investments in any venture capital undertaking. Under Section 10 (23FB) read with Section 115U of the Indian Income Tax Act, 1961, the income of a venture capital fund earned from its investment in any venture capital undertaking was exempt from tax in the hands of the fund and was taxable only in the hands of the investors of the fund. In 2007, the Income Tax Act, 1961 was amended and this tax “pass-through” benefit was restricted to only income from venture capital undertakings that operated in nine specified sectors.

However, in a welcome move, the Finance Bill, 2012 (“Finance Bill”), which was recently passed by the Lok Sabha (the lower house of the Indian Parliament), has once again reverted to the pre-2007 position by extending this tax “pass-through” benefit to income of a venture capital fund arising from investment in any venture capital undertaking, regardless of the sector in which the venture capital undertaking operates. The private and venture industry lauded this move as a step in the right direction, and it was expected that this benefit was to be extended to all AIFs as well. This also appeared to be SEBI’s intent, as gathered from the previous version of the AIF Regulations, which specified that SEBI “may represent that similar provision for tax pass through may be provided for AIFs once the VCF Regulations are repealed and the AIF Regulations are notified”.

However, unfortunately, at this stage, neither the Finance Bill, 2012 nor the AIF Regulations clarifies whether the much desired “pass-through” will be available to other categories of AIF other than Category I, for which the AIF Regulations specifically clarify the eligibility under Section 10(23FB) of the Income Tax Act, 1961. The assured pass-through is almost a must and a right on top of the expectations from the industry. A spillover effect of this restrictive interpretation may also mean that the proposal in the Finance Bill to tax consideration received by a company for an issue of shares which exceeds fair market value will also apply where the payer is a Category II AIF or a Category III AIF. The Finance Bill had exempted from such levy payments made by a “venture capital fund” to a “venture capital undertaking”, an exemption which, given the lack of clarity, may now apply only to Category I AIFs.

Matters of Fund Governance: Investor Consent Required

Until now, matters of fund governance, to a large extent, were dictated by the negotiating power of the parties involved. Seeking to protect investors and emphasizing the fiduciary responsibility of the sponsor/AIF manager, SEBI has introduced a few checks and balances in the AIF Regulations, and, accordingly, made it compulsory for managers to seek the approval of investors in certain situations relating to the operation of the AIF, as shown in the table below:

As compared to the highly prescriptive standards of governance which were proposed in the Draft Regulations, this is a welcome move, achieving the objectives of investor protection without disrupting the limited partner-general partner relationship in such asset class.

Valuation and Reporting Obligations

In order to ensure accountability and transparency, SEBI has prescribed certain reporting and valuation requirements for AIFs:

Valuation

AIFs are now required to provide to their investors the methodology for valuing their assets, and such valuations are required to be done by an independent valuer appointed by the AIF for Category I and II AIFs. In the case of a Category III AIF, there is no requirement for the appointment of an independent valuer; however, calculations of net asset value are required to be independent from the fund management function of the AIF.

Category I and II AIFs are required to undertake a valuation exercise once every six months; however, this period may be increased to one year with the approval of at least 75% of the investors by value. Similarly, Category III AIFs are required to calculate their net asset value and disclose the same to their investors at intervals not longer than a quarter for a close-ended fund and at intervals not longer than a month for open-ended funds.

Reporting

All AIFs are required to provide annual reports to their investors within 180 days from the end of the year. In addition to the annual report, Category III AIFs are required to provide quarterly reports to their investors within 60 days from the end of the quarter.

In addition to the above, AIFs are also required to disclose to their investors the following information:

• on a periodical basis, the financial, risk management, operational, portfolio and transactional information regarding fund investments;

• fees ascribed to the manager or sponsor, and any fees charged to the AIF or investee company by an associate of the manager;

• any inquiries/legal action by legal or regulatory bodies, as and when they occur;

• any material liability arising during the tenure of the AIF, as and when it occurs;

• any breach of a provision of the placement memorandum or agreement with investors; and

• a change in control of the sponsor or manager or investee company.

Conclusion: The Way Forward

The roadmap for the Indian fund industry laid out by the AIF Regulations is a clear departure from the existing regulatory platform, especially in terms of the control being sought to be exercised by SEBI. However, the proposals formalized under the AIF Regulations could lead to a few unintended complications.

An unintended issue could arise in respect of the choice of entities that can be used to set up the fund vehicle. While trusts do not have any specified monitoring regulator, companies and limited liability partnerships do have such a regulator (the Registrar of Companies under the Ministry of Corporate Affairs). Therefore, unlike trusts, companies and limited liability partnerships are answerable to two separate regulators (once registered with SEBI as AIFs).

To summarize, the AIF regime seems to be geared with the fundamental objective of effectively channelizing incentives as well as ensuring adequate supervision by the regulator. It is commendable that several aspects on which the industry has been lobbying seem to have been addressed, including that of limiting the minimum sponsor commitment to thresholds that could reasonably be expected to be met by non-institutional management teams. Further, the introduction of the new category of domestic hedge fund, which hitherto didn’t exist, will surely go towards creating newer products for discerning investors, filling a void greatly felt by domestic investors and managers on account of the lack of a conducive regulatory framework.

To conclude, if one looks at the AIF Regulations from a short-term perspective, in light of the difficult fund raising environment today, the higher ticket size for investors could potentially throw up some challenges, and could in a manner constrict the growth of the asset class. But clearly, in the long run, these regulations appear to have an element of maturity to play a pivotal role in the development and shaping of the future of alternative asset classes in India.

Siddharth Shah and Bijal Ajinkya are Partners in the Mumbai office of Nishith Desai Associates. They may be contacted at siddharth@nishithdesai.com and bijal@nishithdesai.com.