CS Rajeev Venugopal

“If you can dream it, you can do it.” – Walt Disney, founder of The Walt Disney Company

Yes, those are the famous words said (and history shows that his belief was not hollow) by the legendary Mr. Walter Elias Disney or Walt Disney, as know to the masses. These are the kind of words which are the ‘weapons’ of the dreamers – the start up entrepreneurs, the budding businessmen who embark on the journey where they only know one thing – realise their dreams at any cost and failure to them is not an option but may be an accident which they in shall overcome in all likelihood. However, apart from the burning desire, they also need the funds to fuel their high flying dreams. Here come the species or perhaps the ‘Angels’ known as venture capitalists (“VC”), private equity (“PE”) investors and their like breed who are known to be well heeled investors and who provide the necessary support and encouragement to these budding entrepreneurs thereby acquiring certain stake in such ventures, essentially with a long term horizon and unlike any speculative financial investor. VCs are more of strategic investors or rather say ‘partners’ although they certainly harbour their financial interest albeit they are for a long haul. Where do the VCs get the fund to invest? VCs invests out of the private pool of funds created with the help of various investors smitten by the prospect that their investment could one day result in formation of a la INFOSYS, COGNIZANT or RELIANCE etc.

Until now, the regulatory environment governing management of private pool of funds, albeit at a retail level, was restricted to Mutual Funds (“MF”), Collective Investment Schemes (“CIS”), Venture Capital Funds (“VCF”) etc. Hence, there was a need felt to address and focus on the non-retail segment. Moreover, the cardinal reason behind the Securities and Exchange Board of India (“SEBI”) coming up with the SEBI (Venture Capital Funds) Regulations, 1996 (“VCF Regulations”) was to provide impetus and encourage various start up enterprises, who are always on look out for ‘angel investors’ who could ‘hold their hands’ by provide the necessary seed fund so that their dream could sometime see the light of the day.

However, over the years, VCFs have come to be used as vehicles for funds such as PE, real estate, infrastructure etc. There is no doubting of the objectives of such funds but what happened in the process is that the objective and the principal reason in enactment of the VCF Regulations got diluted.

Registration of VCFs was not mandatory under VCF Regulation. Not all entities in the VCF and PE are registered with SEBI. These unregistered entities, by virtue of their non-registration, do not suffer the investment restrictions that are applicable to SEBI registered VCFs.

Thus, acknowledging the dynamic nature of the market and the ever evolving landscape of the capital market of a developing economy, such as India, time came to bring the much required revision to revise the old rules, so that they do not prove to be bottleneck in the progress and development of the economy. Thus, SEBI on May 21, 2012 finally notified the SEBI (Alternate Investment Fund) Regulations, 2012 (“AIF Regulations”) thereby aiming at a complete overhaul of the regulatory regime governing private pooled investment vehicles in India and in the process replacing the VCF Regulations.

With a view to provide a better understanding of the AIF Regulations, various aspects of the same have been discussed in the form of Question and Answers:

What are AIF Regulations and the need to VCF Regulations?

◊ The local managers and funds make investments across the investment spectrum—from early stage investments to PIPE investments on the one hand, and sector focussed investments on the other. However, in a one-shoe-fits-all policy, the only option available for such funds was to register as VCFs under the VCF Regulations and operate under a prescriptive regime originally intended to apply to a nascent industry.

VCFs began to be used as an omnibus investment fund, and the established organizations started reaping the concessions intended for start-up companies. To avoid regulatory gaps and to have a level playing field, the need was felt to have uniform norms for same type of fund or industry. There was a need to recognise these Alternative Investment Funds (AIF) to be recognised as a distinct asset class apart from promoter holdings, creditors and public investors.

The AIF Regulations are a broad-based legislation governing various kinds of private funds and permitting more investment opportunities for investment managers. The VCF Regulations restricted some of the accepted investment avenues worldwide—like secondary transactions in listed stock, derivative transactions, debt funds and investing using a fund of funds model. SEBI seems to have permitted such investments and has created a regulatory structure governing such investments under the AIF Regulations.

What is an AIF and the scope of the AIF Regulations?

AIF means any fund established or incorporated in India in the form of a trust or a company or a limited liability partnership or a body corporate which is a privately pooled investment vehicle which collects funds from investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors.

MFs under the SEBI (Mutual Funds) Regulation, 1996 and SEBI (Collective Investment Schemes) Regulations, 1999 are not covered under the AIF Regulations.

Any Exclusions?

Family trust, ESOP trusts, employee welfare trusts, collective investment schemes, holding companies etc. are expressly excluded.

Thus typically, after the enactment of the AIF Regulations, the following are the investment vehicles:

(a) MF (b) CIS and (c) AIF

What about the existing VCFs?

The existing VCFs will continue to be regulated by the earlier norms (read as the VCF Regulations) till the existing fund or scheme managed by the fund is wound up. Also, these funds are permitted to migrate to the AIF Regulations by re-registering under these regulations after receiving an approval of two-thirds of their investors (by value)

Any restriction on any existing fund?

Existing funds not registered under the VCF Regulations will not be allowed to float any new scheme without registration under AIF Regulations. However, schemes floated by such funds before coming into force of AIF Regulations, shall be allowed to continue to be governed till maturity by the contractual terms.

Also, existing funds not registered under the VCF Regulations, which seek registration but are not able to comply with all provisions of AIF Regulations may seek exemption from SEBI from strict compliance with the AIF Regulations.

All AIFs whether operating as Private Equity Funds, Real Estate Funds, Hedge Funds, etc. are required to register with SEBI under the AIF Regulations.

Whether mandatory registration required from SEBI?

No entity or person shall act as an AIF unless it has obtained a certificate of registration from SEBI. Any entity, which fails to make an application for grant of, a certificate within the specified period shall cease to carry on any activity as an AIF.

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Are there any Categories of Fund?

An application can be made to SEBI for registration as an AIF under one of the following 3 categories:

Category I AIF – those AIFs for which certain incentives or concessions might be considered by SEBI or Government of India or other regulators in India; and which shall include Venture Capital Funds, SME Funds, Social Venture Funds, Infrastructure Funds and such other Alternative Investment Funds as may be specified.

Category II AIF – those AIFs for which no specific incentives or concessions are given by the government or  any other Regulator; and which shall include Private Equity Funds, Debt Funds, Fund of Funds and such  other funds that are not classified as category I or III. These funds shall be close ended, shall not engage in leverage and have no other investment restrictions.

Category III AIF – those AIFs including hedge funds, which trade with a view to make short, term returns; which employs diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives. These funds can be open ended or close ended.

The features of the three categories of AIF can be summarised hereunder:

Category of AIF Terms and conditions under AIF Regulations
CATEGORY I AIF – Venture Capital Fund, Social Venture Fund, SME Fund, Infrastructure Fund and other funds which have a positive spill over effect on the economy Shall not invest more than 25% of its corpus in one Investee Company.
May invest units of Category I AIFs.
Shall not borrow / leverage (directly or indirectly) except for temporary funding requirements, which shall not exceed 30 days. The borrowing cannot be on more than four occasions in a year and cannot exceed 10% of corpus.

Sub-category under Category AIF Conditions on sub-category
Venture Capital Funds Shall invest at least 2/3rdof its corpus in unlisted equity shares or equity linked instruments of a venture capital undertaking (“VCU”) or in companies listed or proposed to be listed on a SME exchange or SME segment of an exchange.Shall not invest more than 1/3rd of its corpus in (i) subscription to IPO of a VCU whose shares are proposed to be listed; (ii) unlisted debt or debt instruments where equity investment has been made; (iii) preferential allotment of equity shares of a listed company subject to a lock in period of one year; (iv) equity shares or equity linked instruments of financially weak company or a sick industrial company whose shares are listed.
SME Funds Shall invest at least 75% of its corpus in unlisted securities or partnership interest of VCUs / investee companies which are SMEs or in companies listed or proposed to be listed on SME exchange or SME segment of an exchange.
Social Venture Funds Shall invest at least 75% of its corpus in unlisted securities or partnership interest of social ventures
Infrastructure Funds Shall invest at least 75% of its corpus in unlisted securities or partnership interest of VCUs / investee companies / SPVs, which are engaged in or formed for the purpose of operating, developing or holding infrastructure projects

 

CATEGORY II AIF – Private Equity Fund, Debt Fund and Real Estate Fund –  Shall not invest more than 25% of its corpus in one Investee Company.
– May invest units of Category I and II AIFs
CATEGORY III AIF – Hedge Fund – May invest in securities of listed or unlisted investee companies or derivative or complex or structured products.
-Shall not invest more than 10% of its corpus in one Investee Company.
– May invest in units of Category I and II AIFs.
– May leverage or borrow (subject to consent from investors and maximum limit specified by SEBI)

Are there any Investment and other conditions with respect to AIF?

 AIF may raise funds from any investor whether Indian, foreign or non-resident Indians by way of issue of units.

Each scheme of the AIF shall have corpus of at least Rs.20 crore.

AIF shall not accept from an investor, an investment of value less than Rs.1 crore.

No scheme of the AIF shall have more than 1000 investors.

AIF shall not invest in associates except with approval of 75% of investors.

The AIF shall not solicit or collect funds except by way of private placement.

All AIFs shall have QIB status as per SEBI (Issue of Capital and Disclosure Requirement), 2009 (“ICDR Regulations”).

Category I and II AIFs shall be close-ended and shall have a minimum tenure of 3 years. However, Category III AIF may either be close-ended or open-ended.

Units of AIF may be listed on stock exchange subject to a minimum tradable lot of Rs.1 crore. However, AIF shall not raise funds through Stock Exchange mechanism.

Category I and II AIFs shall not be permitted to invest more than 25% of the investible funds in one Investee Company. Category III AIFs shall invest not more than 10% of the corpus in one Investee Company.

Any restrictions on Manager or Sponsor?

The Manager or Sponsor shall have a continuing interest in the AIF (For Category I and II) of not less than two and half percent of the corpus or Rs.5 crore, whichever is lower and (For Category III) of not less than five percent of the corpus or Rs.10 crore, whichever is lower, respectively.

The Manager or Sponsor shall disclose their investment in the Alternative Investment Fund to the investors of the AIF.

The removal of the erstwhile requirement in the draft AIF Regulations for the Manager to buy out the investments at the time of winding down the AIF is a welcome move. The key investment team of the Manager should also have adequate experience, with at least one key personnel having not less than 5 years of fund management experience, along with relevant professional qualifications.

Till now, the Manager was not saddled with any mandatory reporting responsibilities to the Investors. The Manager will now have to make detailed reports to its Investors specifically with respect to financial, risk management, operation, portfolio and transactional information regarding fund investments.

Valuation of investments will be required to be done at least once every six months, and a description of the valuation and methodology adopted, will need to be provided to the Investors.

Requirement to set up a dispute resolution procedure through arbitration or any other mechanism can be termed as a breath of fresh air.

A custodian will be required to be appointed if the fund corpus exceeds Rs.500 crores.

How does a VCF ‘feel’ under the AIF Regulations?

A VCF under AIF Regulations attracts certain restrictions, which include investment restrictions (investment of at least 66% of the corpus in equity or equity linked instruments), adherence to the negative list, etc. A PE fund may however not be subject to such restrictions and could albeit now invest even in debt instruments or in NBFCs. In the earlier regime, Funds which could not meet the restrictions under the VCF Regulations, were set up as unregistered ‘Private Equity Funds’ or a ‘Debt Funds’ which ultimately invested across various sectors and stages of investment. These Funds will now benefit from the new regime by being able to register themselves with SEBI and also consequently provide comfort to institutional investors who prefer to invest only in regulated Funds.

AIF Regulations vis-à-vis Investors: whether Investors stand to gain?

  The AIF Regulations also seek to empower Investors by giving them certain rights in the Fund. For instance, the consent of investors shall be required for bringing about any alteration to the AIF, winding up the AIF and such other rights as more particularly provided under the table below:

Threshold for investor approval Matter
2/3rd by value
  • A material alteration to the AIF’s strategy.
  • An extension of up to two years of the tenure of a close ended AIF.
75% by value
  • In-specie distribution of assets of AIF at any time, including on winding up of the AIF (subject to conditions specified in the PPM / Contribution Agreement of AIF)
  • Early termination / winding up of the AIF.
  • Approving an investment by the AIF in an associate.
  • Extending the period for valuation of the investments of a Category I AIF and Category II AIF to one year.

AIF Regulations can potentially increase the investor participation as the AIF Regulations shall brings down the financial costs borne by investors and increases access to funds by new distribution channels. The investment options, as available to investors will, thus, will face increased regulation by SEBI which shall lead to minimizing the apprehension of risks. What the AIF Regulations shall further do is to infuse enhanced levels of transparency by imbibing proper checks and balances by stipulating the requirements of regular reporting, valuation requirement, disclosure of conflict of interest provisions and such other disclosure requirements.  

WAY FORWARD

Investments in the AIFs are not completely free from risks as the returns on the investments especially from avenues such as hedge funds shall solely rely on the performance of the investee companies. Moreover, the AIF Regulations provide multiple set of options with a view to invest their hard earned money which should lead to market efficiency and new fillip to investor protection along with ensuring adequate supervision by the regulator. However, the steep entry requirement for a potential investor could be liberalised further.

The interesting and rather a long waited thing is that the purview of the AIF Regulations have now extended to debt and other complex products thereby acknowledging the growing level and of investor awareness and the wide diversity of investors with varying risk appetites.

Also, the provision for grandfathering of the existing VCF under the VCF Regulations is another bright spot.

Category I AIF is exempted from the provisions of SEBI Insider Trading Regulations in respect of its investments in companies listed on SME platform or SME exchange.

As far as the tax pass through status to AIFs is concerned,  there is no clarity as to whether the much desired ‘pass-through’ will be available to other categories of AIF other than Category I, for which the AIF Regulation specifically clarify the eligibility under section 10(23FB) of the Income Tax Act, 1961. The assured pass-through is almost a must and right on top of the expectations from the Industry. The exemption, 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.

Also, exemption from post listing of lock-in in the investee companies as granted only to Category I AIFs.

As of now, it seems that the AIF Regulations are a step in the right direction. They will increase Investor confidence and monitor funds which till now have been unregulated. On the flip side, Fund Managers may need to chalk out their investment strategy and plans well in advance in order to determine the right category for registration, since the AIF Regulations may not give them enough flexibility to change the registration at a later date. The unprecedented level of compliances to be undertaken by the Manager of AIF, as provided under the AIF Regulations will in all likelihood increase the organizational expense, which may go on to reduce the return to the Investors.

Further, the AIF Regulations provide for listing of the units of AIFs. However, Indian AIF investors may not be prepared to give up ready returns during the fund’s tenure and take liquidity risk through listing of units.

From a fund sponsor’s perspective, the restrictions imposed on the funds could discourage sponsors from setting-up new funds. For instance, there is a provision that the manager or sponsor of the fund must have a continuing interest of at least 2.5% of the corpus or Rs.5 crores OR 5% of the corpus orRs.10 crores, whichever is lower.

In spite of the above concerns, at a time when the global and the Indian equity markets are not at their premium, the option of investing in AIFs seems a rather lucrative one and one can only hope that the introduction complex but matured products would only go in lead to the maturity of our markets and needless to add empowered and awakened investor class. Whether the AIF mechanism shall completely transform the PE and VC universe and could this new piece of regulations bring in a dawn of new age including a flicker of hope for the Indian economy……… Only time will tell!!!

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