Over the last few years, alternative investment has grown to be an attractive source of funding for Indian businesses. The increasing flow of alternative funds feeds start-ups, private companies, entrepreneurs and others, who may not always qualify for traditional capital sourcing. Whereas traditional sources of finance, such as banks, have a limited risk appetite, alternative investment provides enterprises with stable long-term "patient" capital.
While India previously regulated venture capital funds (VCFs), it has recently cast a much broader net seeking to cover other types of alternative funds, including private equity, infrastructure, debt, social venture and hedge funds. Alternative investment funds (AIFs) in India are governed by the Indian securities regulator, Securities and Exchange Board of India (SEBI), under the SEBI (Alternative Investment Funds) Regulations, 2012 (AIF Regulations).
In brief, the AIF Regulations define an AIF as a privately pooled investment vehicle set up in India, which raises funds from investors and invests in accordance with a defined investment policy for the benefit of its investors. The AIF Regulations mandate that an AIF should have a sponsor and a manager, although the manager of an AIF may also act as the sponsor. The AIF Regulations also mandate that the manager or sponsor of the AIF should make a sponsor investment, ie, have "skin in the game" (which cannot be set-off against the management fee).
The AIF Regulations exclude funds regulated under the SEBI (Collective Investment Schemes) Regulations, 1999; the SEBI (Mutual Funds) Regulations, 1996; and any other regulations issued by Indian regulators that regulate activities to do with pooling of capital or fund management.
The scope of AIFs, under the AIF Regulations, excludes:
While investors in an AIF could be domestic or foreign, each investor is required to commit (ie, undertake to contribute to the fund by way of legally binding document) a minimum amount of capital, and an AIF is required to raise a minimum amount of commitment from its investors prior to commencing operations (for further details, see 2.3 Regulatory Regime).
As per data available from SEBI on 30 June 2019, in the seven years since the promulgation of the AIF Regulations, AIFs in India have raised funds worth USD21 billion, out of which USD17 billion have been invested. With the growing appetite of sophisticated investors in India, these numbers are only expected to rise.
AIFs have been classified under three categories with the intention of distinguishing the investment criteria and providing a framework for regulatory concessions under other laws, depending on the category.
A change in category is only permitted if an AIF has not made any investments and if the AIF has accepted commitments it will permit investors to withdraw with a fee refund if applicable.
The following are the three categories of AIFs:
Category I AIFs
This category includes funds which invest in start-ups, early-stage ventures, social ventures, small and medium enterprises (SMEs), infrastructure or other sectors which the government or regulators consider socially or economically desirable. VCFs (including angel funds), SME funds, social venture funds, and infrastructure funds have been categorised as sub-categories of Category I AIFs. These AIFs face stricter regulation, but also, arguably, enjoy certain benefits. These AIFs are closed-ended and must have a minimum tenure of three years.
Category II AIFs
This category includes funds which do not specifically fall under Category I or Category III and do not undertake leverage or borrowing other than to meet their day-to-day operational requirements. Hence, Category II is the residual category of AIFs (see Category III AIFs, below).
Private equity funds (ie, funds investing primarily in equity or equity-linked instruments or partnership interests) and debt funds (ie, funds investing primarily in debt or debt securities) for which, typically, no specific incentives or concessions are given by the government/any regulator, typically fall under this category. Similar to Category I AIFs, Category II AIFs are also closed-ended and must have a minimum tenure of three years.
Category III AIFs
This category includes funds which employ diverse or complex trading strategies and may employ leverage. Hedge funds, funds which trade with a view to making short-term returns, and other funds which are open-ended and for which no specific incentives or concessions are given by the government or any other regulator, fall under this category. This category is perceived to be for high-risk, high-reward investments. AIFs seeking to invest primarily in listed markets are also bundled in this category, even if their strategy is long hold. Category III AIFs can be open-ended or closed-ended and have no minimum tenure.
The AIF Regulations permit an AIF to be formed as a trust, company, or a limited liability partnership (LLP), in India. Out of these three structures, there is stark preference among Indian managers to structure AIFs as trusts. As of 14 November 2019, 620 AIFs were registered with SEBI. Of these, 604 are registered as trusts, 13 as LLPs, and three as companies.
The clear preference for trusts as a viable AIF structure stems primarily from two distinct reasons:
Such contribution agreement and investment management agreement are not required to be made public.
It is important to note that under Indian law, a trust does not have a separate legal personality. The legal ownership of the trust lies with the trustee(s), and the investors are beneficiaries who have a beneficial interest in the trust.
An AIF formed as a trust will require a trustee. Typically, third-party professional trusteeship service providers are appointed as the trustees of AIFs. An AIF formed as a trust will require a "settlor" to settle the trust. This can be the investment manager/sponsor or any Indian-resident individual. Generally, there are no ongoing liabilities for a settlor.
AIFs in India require the following documents:
A trust deed is required for the settlement of the AIF as a trust (and for related matters such as appointment of the trustee and granting the trust requisite powers). In the case of an LLP, the constitutional document is an LLP agreement, and in the case of a company it is the memorandum of association, articles of association and any shareholders’ agreement. Constitutional documents are required to be filed with SEBI.
SEBI requires an AIF to raise funds through a private placement memorandum/offering memorandum (privately placed) or PPM. This is required to be filed with SEBI.
An AIF can raise funds only by way of issuing a PPM to the investors on a private placement basis, ie, units of an AIF cannot be issued to the public at large. A PPM must disclose to the investor all material information necessary for the investor to take an informed decision on their investment in the AIF. This would include information such as:
It is expected that SEBI will imminently declare a standard form for a PPM specifying the heads that must be covered therein.
An investment management agreement between the trustee/LLP/company and the investment manager, governs delegation terms by the former to the investment manager for the management and administration of the AIF.
In the case of an AIF formed as a trust, a contribution/subscription agreement between each investor, the trustee (on behalf of the AIF) and the investment manager, usually provides the substantive terms of the AIF. In the case of an LLP, this is drafted as an LLP agreement, and in the case of a company, as a shareholders’ agreement (and a subscription agreement).
See 2.1 Types of Alternative Funds.
The AIF Regulations permit domestic and foreign investors to invest in AIFs by way of subscription to units of the AIF. An AIF cannot have more than 1,000 investors, and in the case of an angel fund, no more than 200 investors. Notably, no regulatory or government approvals are required for foreign investors to invest in AIFs.
The total commitments of all the investors in an AIF is termed as its “corpus”. The AIF's “investible funds”, ie, funds which it could invest into portfolio entities, are arrived at after subtracting the estimated fund expenses for administration and management from the corpus. Each scheme of an AIF must have a minimum corpus of INR200 million (with angel funds being allowed to have a minimum corpus of INR50 million).
An investor must commit a minimum of INR10 million to an AIF, as per the AIF Regulations. This limit has been reduced to INR2.5 million for employees/directors of the AIF or the investment manager, and for investors investing in angel funds.
The manager/sponsor are mandated to invest to provide some "skin in the game". For Category I and II AIFs, this is set at the lesser of INR50 million or 2.5% of the corpus of the AIF, and for Category III AIFs this is set at the lesser of INR100 million or 5% of the corpus of the AIF. This is a continuing interest in the AIF and cannot be set off against management fees.
Key Diversification/Investment Limits
Category I and II AIFs cannot invest more than 25%, and Category III AIFs cannot invest more than 10%, of their investible funds in a single portfolio entity. Importantly, AIFs are required to adhere to the aforesaid investment diversification limit at all times, ie, at the time of each investment.
Category I and II AIFs are required to invest primarily in unlisted portfolio entities. "Primarily", in this context, is meant to indicate that the majority of the investments of a Category I or II AIF must be in unlisted securities. Sub-categories of Category I AIFs also have to comply with certain further investment restrictions.
Category I AIFs registered as VCFs must invest at least two thirds of their investible funds in unlisted equity shares/equity-linked instruments of a venture capital undertaking; or companies listed/proposed to be listed on an SME exchange/SME segment of an exchange. For this purpose, a venture capital undertaking is defined as a domestic company, which is not listed on a recognised Indian stock exchange and which is engaged by the business for providing services, production or manufacture of articles/things, and which does not include non-banking financial companies, gold financing, or any activities not permitted under the industrial policy of the Indian government.
Furthermore, VCFs cannot invest more than one third of their investible funds into subscriptions to initial public offers of a venture capital undertaking, or debt/debt instrument of venture capital undertakings, in which such VCF has already made investment; preferential allotment of equity/equity-linked instruments of a listed company, subject to a one-year lock-in period; or equity/equity-linked instruments of a listed financially weak/sick company.
Category I AIFs registered as SME funds must invest at least three quarters of their investible funds in unlisted securities/partnership interests of venture capital undertakings or investee companies, that are SMEs/companies listed or proposed to be listed on an SME exchange or the SME segment of an exchange.
Category I AIFs registered as social venture funds must invest at least three quarters of their investible funds in unlisted securities/partnership interests of social ventures and may accept grants for the same.
Category I AIFs registered as SME funds must invest at least three quarters of their investible funds in unlisted securities/partnership interests of venture capital undertakings or investee companies, or SPVs, that are engaged in/formed for the purpose of operating, developing or holding infrastructure projects.
Category III AIFs may invest in securities of listed or unlisted investee companies or derivatives or complex/structured products.
Category I AIFs are permitted to invest in the units of Category I AIFs; Category II AIFs are permitted to invest in Category I and Category II AIFs; and Category III AIFs are permitted to invest in the units of Category I or Category II AIFs. However, in each case, an AIF cannot invest in the units of a fund of funds.
There are restrictions on AIFs making overseas investments. In addition to prior approval from SEBI, the aggregate overseas investments of an AIF are limited to 25% of its investible funds. An AIF applying to SEBI is required to demonstrate that its overseas investment is unlisted and has an "Indian connection".
AIFs also serve as an attractive mode of investment because there are no restrictions on the repatriation of cash to its investors (including offshore investors).
AIFs cannot grant loans simpliciter; however, they can subscribe to debt instruments such as non-convertible debentures and/or optionally convertible debentures.
Furthermore, Category I and II AIFs are also limited in their power to raise loans. Category I and II AIFs cannot leverage or borrow, except to meet day-to-day needs for a period no longer than 30 days, for not more than 10% of their investible funds (see 2.3 Regulatory Regime) and not more than four times a year.
Category III AIFs, however, can leverage and borrow. Such leverage and borrowing can be undertaken with the consent of the investors and is also subject to a maximum cap as may be prescribed by SEBI, provided that such AIFs shall disclose information regarding:
The current leverage limit on Category III AIFs, as prescribed by SEBI, is twice the net asset value of the AIF.
AIFs can make investments only by way of subscribing to securities. Cryptocurrencies are currently not considered as securities under Indian law and therefore AIFs cannot invest in cryptocurrencies. It is also not possible for an AIF to hold hard assets and therefore, necessarily, investments are typically made in securities of companies or in LLPs.
AIFs are required to register with SEBI by way of filing an application form in a prescribed format. The SEBI application form should be accompanied by:
Certain undertakings and declarations, including on disciplinary history, are also required to be submitted to SEBI.
Applications are submitted to SEBI online. As per the AIF Regulations, SEBI is required to approve or reject the application within 30 days. However, SEBI has the power to request additional information. While each case is different, most applications are processed by SEBI within two months.
All AIFs are required to have a manager entity and a sponsor entity.
An investment manager provides investment management services to the AIF. The AIF Regulations require that the manager should be an entity incorporated in India. An AIF is also required to have at least one sponsor (which needs to be named as such to SEBI). The sponsor may be an Indian entity or an offshore entity. The sponsor could also be any person(s) that sets up the AIF. In the case of an AIF organised as a company, this includes a promoter, and for an LLP, it includes a designated partner.
If the manager and sponsor of an AIF are ultimately owned and controlled by resident Indian citizens and such persons are in control of the AIF to the general exclusion of others(an “IOCC AIF”), then investments by the AIF are treated as domestic investments, ie, no restrictions or conditionalities related to foreign direct investment (FDI) will apply, such as sectoral restrictions, impermissibility of certain instruments and pricing guidelines.
Furthermore, the members of the key investment team of an investment manager must have adequate experience and also meet certain qualifications. At least one member of the key investment team must have not less than five years' experience in advising and managing pools of capital, or in fund/asset/wealth/portfolio management, or in the business of buying, selling and dealing with securities, or other financial assets, and has the relevant professional qualification for the same.
While not specific to AIFs, it is relevant to note that:
AIFs and the manager are permitted to appoint third-party service providers for certain functions. These typically include auditing, custody, valuation and compliance functions. SEBI does not permit delegation of core functions.
Category I and Category II AIFs are required to appoint a SEBI-registered custodian if the corpus of such AIF is more than INR5 billion. A Category III AIF must appoint a SEBI-registered custodian irrespective of its size. An AIF is required to provide its investors with a valuation of its assets conducted by an independent valuer on a six-monthly basis (or annually, if 75% of the investors by value of their investment in the AIF agree to such annual valuation). Regulations also impose a mandatory audit requirement.
Non-local service providers to AIFs are not subject to incremental requirements.
Indian income tax laws accord “tax pass-through” status to SEBI-regulated Category I and II AIFs established or incorporated in India. Category III AIFs are not accorded such benefits; however, Category III AIFs set up as trusts may potentially follow general principles of trust taxation and other provisions of Indian tax laws to achieve tax transparency.
The statutory “tax pass-through” status (for Category I and II AIFs) has been granted in respect of all income (other than income chargeable under the heading "Profits and gains of business or profession" earned by such AIF). If income earned by an AIF is not characterised as “business income”, it is taxable in the hands of the investors of that AIF, in the same manner as if it were the income accruing to, or received by, such investors had they invested the money themselves. The income received by such AIFs is deemed to be of the same type and in the same proportion as if it had been received by investors.
If the income of the AIF is characterised as “business income” received or accruing or arising to the AIF, such income is taxable at the maximum marginal rate applicable to the AIF.
The taxation of offshore investors is governed by the provisions of the Indian Income Tax Act, 1961 (IT Act), read with the provisions of the double taxation avoidance agreements (DTAAs) between India and the country of residence of such offshore investor. The provisions of the IT Act would apply to the extent that they are more beneficial than the provisions of the DTAAs.
Investors in AIFs generally qualify for benefits under the DTAAs, subject to customary substance and other requirements.
The use of subsidiaries for investment purposes is not usual, primarily due to potential tax leakage in cash extraction from the subsidiary. Therefore, AIFs using a subsidiary structure tend to have specific commercial considerations that override or offset such issues, for example, infrastructure AIFs may use a subsidiary structure for value creation in a platform.
While the sponsor of an AIF may be an Indian or offshore entity, Indian entities generally act as sponsors in AIFs. This is also partly because the manager of an AIF has to be an Indian entity, and the manager and sponsor are often the same entity.
Under Indian law, AIFs are permitted to raise capital from domestic and foreign investors. Notably, no regulatory or government approvals are required to raise capital from foreign investors. AIFs are permitted to make distributions freely to foreign investors, ie, there are no foreign exchange investment and exchange control restrictions applicable to repatriation of money to foreign investors by means of AIFs, such as pricing guidelines. While a number of development finance and multilateral institutions participate directly in AIFs, it is fairly usual for a fund structure to offer a feeder vehicle offshore such as in Mauritius, Singapore, the Cayman Islands or Luxembourg, and a large number of AIFs seem to have raised capital from North America and Europe.
Investors in AIFs are also required to satisfy the customary "know your client" (KYC) checks.
Investments by AIFs are usually targeted at Indian entities. Offshore investments by AIFs are subject to restrictions under the AIF Regulations and Indian exchange control regulations. The key conditions are:
There has been a recent policy push towards onshore fund management. The Indian government has also established an International Finance Services Centre (IFSC) called Gujarat International Finance Tec-City (GIFT City). GIFT City serves as a special economic zone, which is deemed to be an offshore jurisdiction. GIFT City aims to incentivise feeders, traditionally set up outside India, to set up their feeders within the geographical boundaries of India.
Furthermore, there have been a slew of funds set up for stressed-asset investing, along with a preference for club-style platforms and managed accounts.
There have also been a number of end-of-fund life transactions, such as structured secondaries and fund life extensions.
In light of the liberalised investment and tax regime for AIFs, and predictability over the past few years, a number of offshore investors have started considering direct participation in the onshore pool, rather than investing via an offshore feeder.
AIFs are required to provide SEBI with regular reports. Category I and II AIFs are required to submit such reports on a quarterly basis, while Category III AIFs that undertake leverage are required to submit reports on a monthly basis.
Category I and Category II AIFs are required to provide annual reports to investors containing financial information about their investee companies and material risks to their investors within 180 days from the end of the relevant year. Category III AIFs are required to provide these reports to investors on a quarterly basis within 60 days of the end of the quarter. Additionally, AIFs, irrespective of category, are required to disclose certain information to their investors from a corporate governance and transparency standpoint including conflicts of interest, risk management, disciplinary history, valuations, and any significant change in the key investment team.
Notably, the manager of an AIF is required to prepare a compliance test report (on compliance with the AIF Regulations) in a prescribed format and submit it to the trustee/sponsor of the AIF within 30 days of the end of every financial year. Any violation observed is to be reported to SEBI as soon as possible, by the trustee/sponsor.
A major change expected is a standard format for PPMs that will be prescribed by SEBI. A draft version of this format is already under discussion with various stakeholders. A standard form PPM is expected to reduce regulatory timelines by facilitating quicker review by SEBI of AIF registration applications (as the PPM forms part of such application).
Over the past few years, a special committee set up to advise on matters relating to alternative investment, the Alternative Investment Policy Advisory Committee (AIPAC), has submitted reports on various policy reforms required to strengthen the alternative investment framework in the country.
The latest AIPAC report, issued in July 2018, made certain key recommendations, including the following:
AIF Regulations do not impose any restrictions as to the legal structure of managers. Fund managers are usually set up as companies or as LLPs, with the latter gaining more traction in the last few years, as LLPs are potentially more tax-efficient in certain cases. Each structure comes with its attendant considerations, for example, establishing and running a company in India has higher compliance requirements than establishing and running an LLP, but LLP law provides greater government investigative powers.
Accordingly, managers may choose either structure, and the reasons for doing so tend generally to be driven by commercial considerations, rather than legal or regulatory considerations.
A fund manager is not required to be registered with SEBI to carry out its activities as the investment manager of an AIF. However, it could be argued that fund managers are regulated by SEBI under the AIF Regulations to the extent that they act as investment managers to an AIF, particularly given their participation in the regulatory approval process, ongoing regulatory compliance requirements and duties under the regulations.
As part of the regulations, SEBI has prescribed some minimum standards of compliance and transparency, and also retains inspection rights over investment managers/sponsors (with attendant disciplinary powers). SEBI has also specifically imposed a fiduciary obligation on managers.
Other than direct taxes applicable to the management fee received by the managers of AIFs for providing investment and management services, GST at a rate of 18% is applicable on the management fee. There are no specific taxation principles, under direct or indirect tax laws, that apply to managers.
The IT Act provides that a foreign company is treated as tax resident in India if its place of effective management (POEM) is in India that year. POEM is defined to mean a place where key management and commercial decisions, necessary for conducting the business of an entity as a whole, are made.
POEM focuses on “substance over form” and provides that the place where the management decisions are taken is more important than the place where the implementation of the decisions takes place. However, an exception to the POEM concept is carved out for companies having turnover or gross receipts equal to or less than INR500 million in a financial year.
While typical permanent establishment rules also apply, POEM is greater in scope and relevance.
In addition to the management fee paid to the manager for providing investment management services, "carried interest" is typically paid for the profit share. Under Indian tax laws, carried interest, if received as a performance fee, is taxable in a similar way to the management fee. However, there are certain tax-efficient structures that managers/sponsors may adopt that seek classification of carried interest as a return on investment.
While there are no regulatory restrictions on managers outsourcing their functions or business operations, managers are not permitted to outsource their core business activities or functions such as investment-related activities. However, it is important to note that the ultimate responsibility for compliance with the AIF Regulations and the fund documents lies with the manager.
There are no minimum capitalisation norms applicable to managers. However, it is mandatory that the key investment team of the manager has adequate experience, with at least one key personnel having not less than five years’ experience advising or managing pools of capital.
Additionally, the manager and the sponsor of the fund are required to have the necessary infrastructure and manpower to undertake their activities. The manager and sponsor must also qualify as “fit and proper persons” under SEBI (Intermediaries) Regulations, 2008. The criteria for such qualification include evaluation of:
The sponsor of an AIF has to invest a minimum amount as sponsor commitment (see 2.3 Regulatory Regime). Furthermore, the minimum corpus of an AIF must be INR200 million.
The scheme of the AIF Regulations suggests that foreign entities cannot act as managers to AIFs. Foreign entities may, however, provide non-binding investment advice to AIFs/managers by way of establishing a subsidiary in India and registering with SEBI as an investment adviser under SEBI regulations governing investment advisers.
Both domestic and foreign investors may invest in AIFs and investors typically include HNIs, family offices, pension and insurance funds, institutional investors and banks. The flow of capital from development finance and multilateral institutions seems to have been steady over the past few years. Sovereign or quasi-sovereign wealth funds have also been active investors.
Certain domestic investors, such as banks, insurance companies and pension companies, are governed by their respective regulations and the relevant regulator has prescribed certain limitations on investments by these domestic investors. For example, banks cannot invest more than 10% of the unit capital of a Category I or II AIF and cannot invest in a Category III AIF. Similarly, while pension companies and insurance companies may invest in Category I and II AIFs, there are certain prudential norms prescribed by the relevant pension and insurance regulators on investments by these companies.
AIFs can be marketed by way of private placement through issuance of a PPM, to any person/entity in or outside India, subject to a limit that they cannot have more than 1,000 investors. At present, there are no specific rules defining the scope of private placement. Managers must seek legal advice in this regard.
Under the (Indian) Companies Act, 2013, any offer or invitation to subscribe to shares made by an Indian company to more than 200 persons in the aggregate financial year is considered as a public offer. This applies to AIFs set up as companies.
Furthermore, as mentioned above, no scheme of an AIF can have more than 1,000 investors.
See 4.2 Marketing of Alternative Funds.
See 4.1 Types of Investor in Alternative Funds.
AIFs that receive foreign investments from persons resident outside India are required by the RBI to file a form (Form InVi) to disclose foreign investment.
Such AIFs and/or AIFs that have made overseas investments, are required to submit a report on their foreign liabilities and assets (FLA Reporting) by 15 July of every year. This has been streamlined by the RBI and can be done on a web-based online reporting portal.
AIF Regulations do not require any disclosures to be made by the investors. However, all investors investing in an AIF must comply with KYC norms.
Investors in India are taxed based on their legal structures and different tax rates are applicable to corporations, partnerships and individuals.
AIFs in India have been accorded a statutory tax pass-through status for all streams of income other than business income, ie, investors in an AIF are taxed as if they have invested directly in portfolio companies. See 2.11 Tax Regime. The only requirement is that AIFs must withhold tax from the distributions to its investors, applicable at the rate of 10% on all income (other than business income) payable to resident investors and at rates in force (ie, the rates specified in the income tax law for the relevant year or rates specified in the applicableDTAA entered into between India and the country of residence of such non-resident) as applicable on all income (other than business income) payable to non-resident investors.
As part of various ongoing tax and regulatory developments around the globe, eg, information exchange laws such as the Foreign Account Tax Compliance Act (FATCA) and the Common Reporting Standard (CRS), there are now additional investor and counterparty account-related due diligence requirements for financial institutions. With the intention of increasing tax transparency and the automatic exchange of financial account information for tax purposes, the government of India recently signed the following agreements:
To give effect to these agreements, the Indian tax authorities have instituted rules which require Indian financial institutions to seek additional personal, tax and beneficial owner information and certain certifications and documentation from all investors. In relevant cases, information will have to be reported to the tax authorities/appointed agencies.
AIFs are considered to be financial institutions for these purposes and, therefore, investors in AIFs are required to comply with the request of the AIFs to furnish such information, documentation and declarations as and when deemed necessary by the AIFs. FATCA and CRS provisions are relevant not only at the on-boarding stage of investors but also throughout the life cycle of investment with AIFs. Investors are therefore required to intimate to the AIFs/managers, any change in their status with respect to any FATCA or CRS-related information/documentation provided by them previously, including any declarations provided in respect of the residency of the investors for tax purposes.
India has come a long way from the brink of default in 1991, and the last 28 years have seen several changes in the legal and regulatory environment to attract foreign investment. Research entitled “Long-term macroeconomic forecasts – Key trends to 2050”, conducted by The Economist Intelligence Unit, revealed that India will become the world’s 3rd largest economy by 2050, overtaking the UK, Germany, Japan, France and Brazil.
It is therefore no surprise that the alternative assets industry has also been witnessing steady growth. The Securities and Exchange Board of India (SEBI) introduced the revamped alternative investment funds (AIFs) regulations in 2012, and registrations surged from 23 AIFs in December 2012 to 629 AIFs in December 2019. However, with approx. USD43 billion assets under management (AUM), the alternative assets industry in India is only a sixth of the industry in China!
On the other hand, deal activity has been frenzied. As per the IVCA-EY Report, the year-to-date (January-August) PE/VC investments in India rose to an all-time high of USD36.7 billion, riding mainly on large investments in the infrastructure sector that accounted for 35% of all PE/VC investments during the year. The total Indian PE/VC investment could potentially be in the range of USD48 billion to USD50 billion by the end of 2019. In 2019, year-to-date PE/VC exits total USD8.1 billion vs USD8.5 billion for the same period last year (excluding the mega USD16 billion Walmart-Flipkart deal).
While India continues to attract capital, GDP growth slowed down to 4.5% in July-September 2019, making it the slowest quarter in more than six years. The fall in private consumption and the liquidity crunch could be attributed to several factors, such as disruption due to a strong dose of economic reforms introduced in quick succession (demonetisation, black money law and goods and services tax (GST)), structural ailments of non-performing loans (NPL), rushed implementation of the Bankruptcy Code, and a spate of corporate frauds. However, the World Economic Outlook has projected India to grow at the fastest rate among the G-20 countries in 2019-20.
Factoring in the above backdrop, the following structural and investment trends make India a compelling investment destination.
InvITs and REITs: The Flavour of the Season
Business trusts have been prevalent in the West for several years. SEBI introduced the regulatory framework for Infrastructure Investment Trusts (InvITs) and Real Estate Investment Trusts (REITs) in 2014. The pace picked up in 2017, after SEBI had progressively ironed out the hurdles under the InvIT Regulations, leading to a couple of public offerings of InvITs (IRB InvIT Fund and Indiagrid Trust) followed by a couple of private placements of InvITs (IndInfravit (CPPIB-backed) and India Infrastructure Trust (Brookfield-backed)). On the REIT front, the Embassy Office Parks REIT became the first REIT in the country when it listed in April 2019.
The InvIT route has progressively become the preferred route to monetise assets, and there is no better proof than the Government of India (GoI) giving its nod to the National Highways Authority of India (NHAI) to set up an InvIT to monetise completed national highway projects. It is believed that the funds unlocked by NHAI will be ploughed back into Bharatmala Pariyojana, the GoI's flagship highway development programme for the development of 24,800 km of roads for a total investment of INR5.35 lakh crores (approx. USD76.428 billion).
In terms of taxation, a REIT/InvIT is a tax-transparent entity, and any income earned by it from its portfolio is taxable directly in the hands of the unitholders. Additionally, the dividend distribution tax of approx. 20% (applicable to Indian companies at the time of the distribution of dividends) is not applicable to dividend distributions made by REITs and InvITs to unitholders, subject to the fulfilment of certain conditions.
Thus, InvITs are also emerging as tax-efficient structures for acquiring and operating large infrastructure assets, so white label InvITs (ie, InvITs backed by investors who propose to acquire third party assets, as opposed to developers creating InvITs to offload their own assets) are expected to mushroom.
SEBI continues to improve the InvIT/REIT regulations to deepen the hybrid securities market, with recent amendments including widening the scope for participation by retail/small investors in InvITs and REITs by decreasing the minimum subscription thresholds to INR50,000 and INR100,000 respectively, providing clarity on the preferential issue and institutional placement of units by listed REITs and InvITs as per the new guidelines, introducing a new category of “unlisted private InvITs” and permitting leverage of up to 70% of InvIT assets, subject to conditions. The Reserve Bank of India (RBI) is also playing its role to ensure the flow of liquidity into InvITs by recently announcing the regulatory framework for banks to lend to InvITs.
The stage is clearly set for further success stories for InvITs and REITs in India. Sectors such as power transmission, roads, gas pipelines, telecom infrastructure, renewable energy, ports and airports are expected to go the InvIT way. In its 2019 report, Crisil projected that InvIT issuances will grow five-fold to more than INR2 lakh crores (approx. USD28.57 billion) in the next two years, since long-term offtake contracts and strong counterparties provide revenue visibility.
Going the Alternate Way: AIFs in India
AIFs have flourished through the advent of the SEBI (Alternative Investment Funds) Regulations, 2012 (AIF Regulations), leading to a 60% rise in capital growth by AIFs in the past year. AIFs also enjoy a special pass-through tax regime and a less restrictive regulatory regime, making them a flexible yet robust investment vehicle. The GoI has taken a shine to the AIF regime. The National Investment and Infrastructure Fund (NIIF) is India’s first strategic investment fund (SIF) and was set up as an AIF with the GoI as the anchor 49% investor, adding ADIA, Temasek, AustralianSuper, Ontario Teachers’, CPPIB and other Indian financial institutions to its investor base. The NIIF Master Fund has become the largest infrastructure fund in India, with AUM of more than USD1.8 billion and a co-investment pool of USD2.5 billion. The GoI has announced two more AIF structures. The first is to provide last-mile funding to stalled affordable and middle-income housing projects, and is expected to start with an AUM of INR25,000 crore (USD3,571 million), with the GoI funding 40% of the AUM. The second proposed AIF is part of the GoI’s five-prong strategy to resolve NPLs. The independent AIF to be set up for this purpose will take over certain NPLs for resolution through funds raised from investors.
India has also operationalised its first international financial services centre (IFSC), Gujarat International Finance Tec-City (GIFT), which has been ranked third in the latest edition of Global Financial Centres Index (GFCI 22). AIFs/pooling vehicles can now be set up in GIFT City, and dependence on offshore holding jurisdictions like Singapore, Mauritius or the Cayman Islands can be reduced. Various tax and regulatory concessions have been conferred on entities operating in GIFT City, and only time will tell whether the funds industry will embrace GIFT City as the new normal for fund-raising jurisdictions.
Overhaul of the 2014 FPI Regime
In early 2018, SEBI set up a working group under the Chairmanship of Mr H.R. Khan, Deputy Governor (Retired) of the RBI, to advise on redrafting and simplifying the regulations relating to foreign portfolio investors. Based on the recommendations contained in the working group’s final report, submitted in September 2018, SEBI notified the new SEBI (Foreign Portfolio Investors) Regulations 2019 (New FPI Regulations), overhauling the earlier regulations issued in 2014. The highlight of the New FPI Regulations is the easing of operational constraints and compliance requirements for funds registered as foreign portfolio investors (FPIs). SEBI has now switched to a new approach to regulatory flexibility, by consolidating only core principles in the New FPI Regulations and setting out other aspects of procedure and implementation in the Operational Guidelines for Foreign Portfolio Investors, Designated Depository Participants and Eligible Foreign Investors (Operational Guidelines), which shall be subject to modification based on industry trends and topical requirements.
Under the New FPI Regulations, the number of categories of FPIs has been reduced from three to two, and the underlying eligibility criteria for each category of FPIs have been modified. To simplify and expedite the registration process, SEBI has turned away from the earlier broad-based eligibility criteria for institutional FPIs. Non-resident Indians/overseas citizens of India can now be FPI applicants. SEBI has also moved towards permitting FPIs to operate through the "multiple investment managers" structures, and appointing multiple custodians corresponding to each investment manager. In furtherance of the drastic steps taken by SEBI to reduce the share of Offshore Derivative Instruments, or p-notes in the Indian markets (from 50% of assets under management in 2007 to less than 2% currently), the Operational Guidelines demand a separate registration for FPIs that wish to invest in such p-notes.
IBC-led M&A and PE Funds Becoming the New Promoters
The Insolvency and Bankruptcy Code, 2016 (IBC) has introduced more attractive dimensions to the distressed M&A space in India. Despite the legal/regulatory challenges of the insolvency process under the IBC, foreign and domestic players are extremely optimistic about the turnaround potential of several distressed companies. While strategic investors seem to have the edge at present, private equity funds are also actively exploring various structures to fund distressed M&A (eg, through platform deals, asset reconstruction companies, AIFs, etc). Since its inception in 2016, more than 900 companies have been referred to the National Company Law Tribunal for insolvency resolution, out of which proceedings worth approx. USD42.5 billion have already been resolved.
In the private equity investment space, investors often seek majority control in Indian companies, as it allows them to facilitate their exit from the investment. Global investment firm KKR invested more than USD1.2 billion to acquire majority stakes in Analjit Singh’s health care assets (in Max India), as well as a 60% controlling stake in Chennai-based Ramky Enviro Engineers. Other control deals in the private equity space that confirm the trend include AION Partners’ acquisition (with JSW) of 74.3% in stressed asset Monett Ispat for INR24 billion, and Advent International’s acquisition of a majority stake in PET manufacturer Manjushree Technopak and Bharat Serums.
Fatal "Mutual" Attraction
In the wake of mutual funds being hit with defaults on debt securities held in corporate bonds, asset management companies took up the discussion with SEBI to permit mutual funds to be a part of the insolvency resolution process under the IBC of defaulting borrower companies. After much deliberation, SEBI has allowed such participation, subject to several conditions (including a pre-condition of segregating the portfolio pursuant to a credit event leading to a downgrade of the credit rating). In a recent ruling, a put-option holder (PE fund) was considered to be a “financial creditor” under the IBC on the basis that the amount had been raised for economic gain and had the commercial effect of borrowing, given that the terms of the transaction included not only the purchase of shares but also the date by which the amount was to be repaid. Put-option PE funds, home owners and mutual funds having a seat at the table of the committee of creditors, along with traditional public and private sector banks, makes for a very eclectic mix of financial creditors in the resolution saga.
Tax: No More a King’s Ransom
Recent amendments have been brought in, pursuant to industry demands, in relation to the "angel" tax, a tax payable on excess premium received by a private company on the issuance of its shares to Indian residents. While the earlier exemption from the angel tax extended only to shares issued to a venture capital fund, the Union Budget of July 2019 extended the exemption to PE funds and Category II AIFs as well.
A stumbling block in the progress of funds came through the Union Budget of July 2019, which proposed to increase the “surcharge”, a tax levied over and above regular income tax, for certain entities in the high-income bracket, such as trusts. Since most AIFs and offshore funds receiving income from India are set up as trusts, the following increased rates of surcharge would have applied to such AIFs and funds, unless they were organised as companies, firms (LLPs/partnership firms) or co-operative societies:
Facing industry protests over the increased tax burden, the enhanced surcharge was rolled back completely for registered FPIs, and also for certain kinds of capital gains income from sales of securities. For example, while the above surcharge rates continue to apply to capital gains from the sale of derivatives, debt instruments and similar instruments, they do not apply to capital gains from the sale of equity shares, units of InvITs, REITs and equity-oriented funds.
Another significant aspect of the recently announced tax incentives is the benefit accruing to funds that operate in India's first International Financial Service Centre (IFSC), which was commissioned at GIFT City, Ahmedabad. The Union Budget extended a 100% tax holiday to entities located in an IFSC for any consecutive period of ten years during the first 15 years of the entity's registration. A complete capital gains tax exemption has also been granted in relation to bonds, global depository receipts, masala bonds and derivatives of a Category III AIF if the AIFs are located in an IFSC and the bonds, derivatives, etc, are traded on a stock exchange located in the IFSC, provided the income is derived solely from convertible foreign exchange and all unitholders are non-residents. Furthermore, mutual funds located in an IFSC have been exempted from distribution tax on income distributed to unit holders where such income is derived from transactions made on a recognised stock exchange located in an IFSC.
No power on earth can stop an idea whose time has come
India continues to enjoy the "sweet spot" for investment options among global investors, whether they are sovereign funds, pension plans, superfunds, endowments or multilateral development banks. Over the last couple of years, India has witnessed several new investors making their entry and allocations to India, witnessing a healthy trend. Sectors such as financial services, consumer product and retail, healthcare, logistics and transportation, e-commerce and internet, industrial goods, manufacturing, agri-business, education and infrastructure will continue to attract capital.