In 1991, Economic Liberalisation was ushered in India. The primary objective of the same being to globalise the Indian Economy and also empower it to access the global market. SEBI, the securities regulator of India promulgated certain regulations that brought forth a framework for the fund managers based in India to raise dedicated pools of capital in terms of investment funds. The regulations, however, did not make it requisite that the fund managers have to “necessarily ‘register’ their pooling vehicles as Venture Capitalist Funds (VCFs) with the SEBI.” It is interesting to note that certain benefits were conferred upon in case, the registration was obtained. Hence, fund managers based in India that sought to institute a significant fund management business in India, set up VCFs that were India domiciled. However, the VCFs regime had a lot of bottlenecks in it. The primary challenge constituted difficulty in raising foreign capital that mandated an approval from the Government of India, a state of dubiety with respect to the “taxability of income” in the possession of the investors in the VCF. There were also limitations set on the ability of a VCF to invest in listed securities and/or debt securities, as well as its ability to invest outside of India.
Alternate Investment Fund Regime (AIFs)
The challenges so faced in the VCFs, led to SEBI ultimately repealing the VCF Regulations. The SEBI (Alternative Investment Funds) Regulations, 2012 (AIF Regulations) have been authorised by the Securities and Exchange Board of India (‘SEBI). A Press release issued following its board meeting on April 2, 2012 (“Press Release”) intended to summarise some of the features of the AIF Regulations. SEBI had previously released a concept paper along with the draught AIF Regulations on August 1, 2011. An Alternative Investment Fund, or AIF, is a privately pooled investment vehicle developed or incorporated in India that collects funds from sophisticated investors, whether Indian or foreign, for investing in accordance with a defined investment policy for the benefit of its investors.
AIF does not include funds controlled by the SEBI (Mutual Funds) Regulations, 1996, the SEBI (Collective Investment Schemes) Regulations, 1999, or any other Board regulations governing fund management. In addition, the AIF Regulations exclude “family trusts” formed for the welfare of ‘relatives’ as defined under the Companies Act, 1956, “employee welfare trusts or gratuity trusts” established for the benefit of employees, “holding companies” as defined under Section 4 of the Companies Act, 1956, and the like from registering. The AIF Regulations’ road-map for the Indian fund industry is a significant deviation from the current regulatory framework. While it can seem to be daunting for the industry, it is admirable that many issues for which the industry has advocated seem to have been addressed adequately.
A Brief insight into the categorisation of AIFs
The AIF Regulations had identified three specific categories of AIFs as under:
- Category I AIF shall cover AIFs that will have a defined or specified investment strategy that primarily focus on AIFs in Category I have an established investment strategy that sets its focus on “Venture Capital Funds, SME Funds, Social Venture Funds, and Infrastructure Funds”, all of which, according to SEBI, has “positive spill over effects on the economy.” Such benefits and concessions would be available to AIFs who fall into this group. It is forbidden to engage in leverage in this category.
- Category II AIF is designed to encompass those AIFs which do not require any specific incentives and those that do not take any leverage or borrowing for anything besides the daily operational needs as has been allowed by the SEBI (Alternative Investment Funds) Regulations, 2012. Real estate funds, private equity funds (PE funds), distressed asset funds, and other forms of funds are all classified as Category II A.
- AIFs in Category III are those that focus on a wide range of “complex trading strategies”, including the use of leverage, such as by investments in listed and unlisted derivatives. AIFs which centred on employing diverse and complex trading strategies, including employing leverage, such as through the means of investment in listed and unlisted derivatives. AIFs that fall into this category, according to SEBI, are those that “exacerbating systemic danger.” Category III AIFs include hedge funds, PIPE Funds, and other types of funds.”
It is evident that jurisdictions around the world are competing for capital. In such circumstances, it is critical to establish a vibrant onshore fund platform that encourages the formation of domestic capital pools in order to maintain progress. The AIF Regulations represent a near-total transformation of how the onshore funds network will function.
Analysis of the Recent Circular and its effect on fund managers
The matter of sponsor commitment was infested with the issue of round tripping. Round-trip trading, also known as “round-tripping,” is the illegal practise of repeatedly buying and selling shares of the same security in order to deceive observers into thinking that the security is in higher demand than it is. Round-tripping can also obstruct technical analysis based on volume data by generating fake trading volume. This had a highly devastating effect on the alternative investment fund. It is expected that the new relaxation which has been introduced will bring forth a resolution to this issue. Additionally, it can be presumed that this will also reduce the set-up time for establishing of IFSC by fund managers to a great extent. Earlier, it took over 3-4 hours to in addition to the compliance of Indian GPs for managing the IFSC Alternative investment funds from offices outside the IFSC.
In accordance with the Reserve Bank’s latest observation in this regard, the purview of Overseas Direct Investment has been extended to include sponsoring from an Indian Party to an Alternative Investment Funds. As a result, an IP can use the automatic route to set an AIF in foreign jurisdictions, including IFSCs, as long as it follows Regulation 7 of the FEMA guidelines.
Outbound investments in the IFSC AIF are deemed to be outbound, and the RBI is yet to provide clear guidance on whether such sponsor investments require clearance. There were also concerns that the RBI might see AIFs focused entirely or partially on Indian investments as vehicles for ‘round tripping.’
The new direction has been treated as a welcome step by leading law firms as well as business think tanks.
The new automatic route will be available if the Indian firm meets certain criteria, including being regulated, having a three-year track record of profitability, and obtaining the appropriate regulatory approvals in India and abroad. For example, if an NBFC is sponsoring a fund, RBI must approve it, however if a PMS is sponsoring, SEBI must approve it.
It can be estimated that providing permission for this automated route shall ease up the process and act as an incentive for both Indian as well as foreign promoters to set up AIFs. This shall undoubtedly act as a booster for GIFT regime. However, it would be wrong to state that this new step is free from speculations of all kinds. It has been pointed out that this circular is limited in nature since it covers only the sponsor commitment up to regulatory commitment. Thus, there is a further clarification required in this regard.
 Supra Note 2