This article has been written by Ms. Drishti Rawat, a second-year student at National Law University, Delhi.
Abstract
Alternative Investment Funds (AIFs) in India are regulated by the Securities and Exchange Board of India (SEBI) under the SEBI (Alternative Investment Funds) Regulations, 2012. This regulation provides the overall framework for registration, investments, disclosures and operations of privately pooled investment funds in India. The article provides an overview of the regulatory landscape for AIFs highlighting the key provisions, compliance requirements, consequences of non-compliance, and recent trends.
The article discusses the different registration categories for AIFs based on their investment strategy and eligibility norms prescribed by SEBI. It outlines the primary investment restrictions about concentration, leverage, valuation etc. along with stipulations for mandatory appointments of fund managers, custodians and minimum investment size. Key compliance requirements are examined including filing of placement memorandum, reporting norms, payment of fees and intimation of changes to SEBI.
Introduction
The Securities and Exchange Board of India (SEBI) is the regulatory authority for securities markets in India. Established in 1988, SEBI was given statutory powers in 1992 through the SEBI Act, to protect investor interests and promote the development of the securities market.
Over the years, SEBI has introduced various regulations and guidelines for different market participants. One such key regulation is for Alternative Investment Funds (AIFs) which came into effect in 2012. AIFs refer to privately pooled investment funds that collect funds from sophisticated investors, whether Indian or foreign, for investing according to a defined investment policy. The SEBI (Alternative Investment Funds) Regulations, 2012 provide a framework within which AIFs can operate.
AIFs provide an additional avenue for channelling funds to sectors like infrastructure, real estate, start-ups, SMEs etc. beyond traditional routes like banks, capital markets etc. By regulating AIFs, SEBI aims to encourage the mobilisation of funds for productive purposes while protecting investor interests. The regulations lay down guidelines on eligibility, investments, disclosures, reporting and other operational aspects for the three categories of AIFs. With a growing economy and investment avenues, AIFs have gained prominence over the last decade. However, appropriate regulations balancing flexibility and accountability are vital for the sustainable growth of AIFs.
Registration Requirements
All Alternative Investment Funds (AIFs) are required to register with the Securities and Exchange Board of India (SEBI) before raising any funds from investors, as per Regulation 3 of the SEBI (Alternative Investment Funds) Regulations, 2012.
The application for registration must be made through a Merchant Banker registered with SEBI. The manager, sponsor or designated partners must have a sound track record and minimum 5 years experience in related activities like advising or managing pools of capital or securities.
The sponsor or manager is required to have a continuing interest in the AIF of not less than 2.5% of the initial corpus or Rs.50 lakhs, whichever is lower. This ensures the sponsor remains invested in the fund’s performance.
AIFs are categorized into 3 categories based on investment strategy – Category I (Venture Capital, SME Funds, Social Impact Funds etc.), Category II (Real Estate Funds, Private Equity Funds, etc.) and Category III (Hedge Funds, Complex Trading Strategies). Each category has specific eligibility criteria pertaining to investment style, leverage permitted, investor qualifications etc. The application must specify the category and sub-category for which registration is sought.
SEBI may grant registration after scrutiny of application, due diligence of sponsors’ track record, review of placement memorandum, trust deed, investment management agreement etc. Registration is generally granted within 90-120 days, subject to fulfillment of all requirements. The certificate of registration is valid for perpetuity unless suspended or cancelled by SEBI.
Investment Conditions and Restrictions
Registered Alternative Investment Funds (AIFs) can only invest in those securities or assets that are permitted under the regulations specific to their category. This aims to align investments with an AIF’s stated investment strategy and risk profile.
Category I AIFs like venture capital or angel funds can invest primarily in equity or equity-linked instruments of startups, early-stage ventures and SMEs. They cannot invest in listed securities or engage in lending activity.
Category II AIFs like private equity funds are allowed to invest in listed or unlisted instruments, debt securities, securitized debt of companies, derivatives and units of other AIFs. They cannot engage in proprietary trading or lending.
Category III AIFs pursuing complex trading strategies can engage in leverage, derivatives trading and short selling. But they cannot invest in securities of unlisted companies.
Investment conditions also include limits such as:
Category I and II AIFs cannot invest over 25% of investible funds in one investee company.
AIFs cannot provide loans or make investment against borrowed capital in excess of 2X their net asset value.
Minimum investment amount by an investor is ₹1 crore.
To avoid conflicts of interest, AIF regulations prohibit any distribution linkages between sponsors/managers and investee companies. The sponsor or manager cannot hold over 25% in an investee company.
The investment restrictions aim to ensure capital is deployed as per stated strategy, excessive risk-taking is avoided and potential conflicts of interest are minimized. This protects investors’ interests.
Disclosure and Transparency Norms
To ensure transparency in their functioning, SEBI’s AIF regulations mandate detailed disclosure and reporting requirements.
AIFs have to provide quarterly reports to investors including the following details:
- Investments made during the quarter
- Value of each investment
- Cash holding at the end of quarter
- Net Asset Value (NAV) per unit
- Contribution made by sponsors/managers and investors separately.
Any changes in terms of the placement memorandum, fund management team, or change in control of sponsor/manager need to be intimated to investors.
Category III AIFs using complex trading strategies must disclose valuation methodologies and investment management policies to investors. Fees and expenses charged to the AIF are to be disclosed periodically.
AIFs have to submit regular reports to SEBI including annual audit reports, quarterly activity reports, and compliance test certificates from the auditor. This enables SEBI to monitor systemic risks.
By mandating disclosures at multiple levels, the regulations aim to maintain high levels of transparency on how AIFs operate and manage investors’ funds. This reassures investors and improves governance standards.
Governance Standards
SEBI’s AIF regulations stipulate certain governance standards to be followed:
Every AIF must appoint a custodian to hold securities and funds on behalf of investors. The custodian ensures proper handling of transactions, cash flows and assets.
AIFs must implement policies on valuation, conflicts of interest, liquidity management, etc. Robust internal controls and checks and balances should be in place.
The AIF manager/sponsor owes a fiduciary responsibility towards investors. Any conflicts of interest must be recognized and mitigated through appropriate policies and procedures.
The manager is responsible for all legal, regulatory and contractual obligations of the AIF. It must exercise due diligence and caution while appointing third party agencies like lawyers, auditors, fund accountants etc.
By mandating good governance through custodians, policies, fiduciary duties and due diligence, SEBI aims to ensure that AIFs function responsibly keeping investor interests paramount. This enhances the professionalism and maturity of the industry.
Penalties for Non-Compliance
To enforce compliance, SEBI can take strict penal action against AIFs and their managers for violations:
- SEBI can suspend or cancel the registration of an AIF for failure to comply with regulations. It can prohibit an AIF from launching new schemes.
- Monetary penalties can be imposed on the AIF, its managers, partners and key management personnel for regulatory non-compliance. Penalties can range from Rs.1 lakh to Rs.1 crore.
- SEBI can initiate prosecution through the courts in cases of serious violations. This can result in imprisonment for up to 10 years.
- SEBI can direct the AIF to refund any fees or consideration collected from investors if found non-compliant. It can forbid an AIF from representing any association with SEBI.
By defining clear penalties, SEBI aims to deter non-compliance. This enhances the credibility of AIF regulations and prevents potential misuse by funds.
Recent Trends
Over the years, SEBI has refined regulations to support AIF growth while protecting investors:
- Relaxations have been granted for angel funds and VC funds to attract early-stage investments. Investment limits in startup companies have been raised.
- The concept of ‘innovators growth platform’ was introduced by SEBI for easier listing norms and fundraising by startups.
- AIFs can now invest at least 25% of their corpus in overseas investments to expand opportunities.
- SEBI allowed mutual funds to invest in AIFs, opening up a new class of investors. Disclosure norms were simplified based on AIF category.
- The minimum investment amount for investors in AIFs was reduced from ₹1 crore to ₹70 lakhs to widen the investor base.
Such progressive changes have aimed at balancing investor protection with growth of AIFs as an asset class. SEBI has adopted a consultative approach with industry participants on new initiatives.
Conclusion
SEBI’s regulations for Alternative Investment Funds have clearly defined the essential requirements for regulatory compliance. AIFs must register with SEBI and can only invest in permitted securities as per their category. Strict investment restrictions and disclosure norms have been mandated. High governance standards, fiduciary duties and due diligence requirements create greater transparency and accountability. Non-compliance can attract severe penalties from SEBI.
Robust regulation plays a vital role in providing credibility and maturity to India’s alternative investment industry. It balances strong investor safeguards with supporting the growth of AIFs as an asset class. Responsible AIF managers who proactively adhere to SEBI guidelines can build immense trust and confidence among investors.
Going forward, SEBI is expected to continue refining regulations in consultation with stakeholders. With appropriate regulatory checks and balances, AIFs have the potential to play an important role in channeling institutional capital towards India’s innovative companies and infrastructure needs. However, investor protection will remain the foremost priority.
References
- Alternative Investments and its Regulation, Suresh Padmalatha, Taxmann, ISBN 978-93-5156-512-7, 1st Edition, 2018
- Investment Fund Regulations, R.K. Gupta, Bloomsbury, ISBN 978-93-86643-79-9, 1st Edition, 2020
- This article was originally published on the Majmudar & Partners website. The link for the same is herein: https://www.majmudarindia.com/insights/resources/finance/aifs-20-key-changes-in-indias-regulatory-regime-for-investment-funds
- This article was originally published on the Vahura website. The link for the same is herein: https://www.vaahura.com/guidelines-for-investments-by-alternative-investment-funds-in-india
- This article was originally published on the ARA LAW website. The link for the same is herein: https://www.aralaw.com/newsletter/update-on-sebi-alternative-investment-funds-amendment-regulations-2022
- This article was originally published on the India Corp Law website. The link for the same is herein: https://indiacorplaw.in/2020/02/sebi-consults-on-liberalization-of-investment-norms-for-aifs.html
- This article was originally published on the Ikigai Law website. The link for the same is herein: https://www.ikigailaw.com/sebis-consultation-paper-on-aif-regulations-the-pasta-sauce-test/
- This article was originally published on the VCC Circle website. The link for the same is herein: https://www.vccircle.com/sebi-eases-access-to-domestic-capital-for-aifs/
- This article was originally published on the Singhania & Partners website. The link for the same is herein: https://singhania.in/latest-updates/regulatory-updates/sebi-issues-circular-on-investment-by-category-i-aifs-in-units-of-aifs/
- This article was originally published on the Scriboard website. The link for the same is herein: https://www.scriboard.com/blog/can-mutual-funds-invest-in-aifs/
- This report was originally published on the CRISIL website. The link for the same is herein: https://www.crisil.com/content/dam/crisil/our-analysis/reports/Research/documents/2019/october/capital-markets-flash-report_alternative-investment-funds.pdf