The Securities and Exchange Board of India (Sebi) has recently notified much-awaited norms for regulating alternative investment funds (AIFs). In the sequence of events, Sebi in August 2011 had issued a concept paper and draft regulations on AIFs inviting public comments. Several comments were received by Sebi, post which the draft regulations were substantially modified and a high-level summary of the likely AIF regulations were notified vide a press release on April 2, 2012. After a long wait, the final AIF regulations were recently notified on May 21, 2012. The final regulations have provided the investment fund industry, which had been alarmed due to the rigorous and unrealistic norms proposed by the draft regulations, some reasons to cheer. The reasons to cheer include the new regulations seeking to offer some flexibility to the industry players to choose a preferred investment vehicle and, at the same time, proving to be beneficial for their investors putting money in such investment pools due to sound investor protection measures contained in the regulations.
Under the AIF Regulations, Sebi has created three categories of registrations. Category-I AIF consists of those funds that are likely to have positive effects on the economy as they invest in start-ups or early stage ventures or other socially/economically desirable sectors. The category consists of venture capital funds, SME funds and social funds. Category-I AIFs are subject to investment restrictions and, at the same time, would also avail the benefits of tax pass-through status, certain takeover and IPO lock-in norms, which other two categories would not have. Category-II AIFs consist of private equity funds, debt funds, for which no specific incentives/concessions are required (also not subject to investment restrictions of the likes of Category-I) and consist of residual category of funds that do not classify either as a Category-I or Category-III AIFs. Category-III AIFs are in the nature of domestic hedge fund structures, which could have leverage and can thus pose systemic risks. Accordingly, additional reporting and other regulatory burdens have been imposed on them.
In a nutshell, the key departure under the AIF regulations from the now repealed Sebi VCF regulations (which applied only to registered venture capital funds), is that registration as an AIF is broadly mandatory for all private pools of capital raising money from investors. Previously, registration as a VCF was optional and, if registered, the entity would have to comply with several investment restrictions but at the same time would also avail of benefits from tax, takeover and IPO lock-in perspectives. Compared to the earlier regime, the new regulations specify more compliances from the perspective of reporting, disclosure and conflict resolution by the sponsors/managers of the AIFs with a focus on protection of even savvy investors.
While the AIF regulations are good, there are some practical concerns that need to be addressed in order to ensure a robust regulatory regime. Some of them are identified below.
First, the new regulations do not seem to be leaving the choice of selecting the appropriate registration category to the applicant depending on whether or not the applicant is desirous of availing the concessions and subject itself to investment restrictions. Most of the applicants wanting to apply under Category-I would be unsure as to whether or not Sebi would consider their fund as having positive spillover effects on the economy and recognise their investee companies as start-ups or emerging ventures (failing which, the applicant may be required to apply under other category). This seems to be leaving discretionary powers with the regulator to decide upon the categorisation of the applicant. The contentious issue being: if the applicant is willing to comply with investment restrictions, then why can he not be allowed freedom in selecting Category-I, to avail regulatory/tax benefits? This otherwise takes the new regulations half a step back compared to the earlier Sebi VCF regulations, which left registration optional for investment funds and accorded regulatory/tax benefits to all those who were registered.
Second, even for funds registering as Category-II, what has been mandated is that such funds shall primarily invest in unlisted investee companies. What Sebi means by ?primarily? is unclear. Also, such restrictions may not be warranted for Category-II, as the entities registered under this category do not enjoy regulatory/tax benefits of Category-I AIFs.
Third, sponsors/managers will have to contribute not less than 2.5% of the corpus or R5 crore and stay invested throughout the term of the fund. The way ?corpus? is defined under the regulations in terms of the total capital commitment by the investors in the fund, it is unclear whether the sponsors/ managers would be able to take out the proportionate monies back while distributing capital to the investors post sale of investments. Sebi should clearly permit the sponsors/managers to maintain 2.5% stake proportionate to the actual money of the investors deployed in the fund and not proportionate to the total commitments made by the investors in the beginning.
Despite some ambiguities surrounding the regulations, Sebi has done an impressive job by taking into account suggestions/comments received from the stakeholders in the process of drafting the final regulations. With increasing uncertainty in international markets and diminishing foreign inflows, the new AIF regulations seem to be a step in the right direction for the onshore investment fund industry. As the saying goes, ?well begun is half done?. Let?s hope that the remaining half is good, too.
The authors are with Finsec Law Advisors
