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 now 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, the 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 the data available from SEBI on 30 June 2020, in the eight years since the promulgation of the AIF Regulations, AIFs in India have raised funds worth USD25 billion, out of which USD21 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-end 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, fall in this category. Similar to Category I AIFs, Category II AIFs are also closed-end 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-end and for which no specific incentives or concessions are given by the government or any other regulator, fall in 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-end or closed-end 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 8 September 2020, 693 AIFs were registered with SEBI. Of these, 678 were registered as trusts, 13 as LLPs, and two 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 also 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 investors all material information necessary for the investors to take an informed decision on their investment in the AIF. This would include information such as:
To ensure that a minimum standard of disclosure is made to the investors, SEBI has mandated, with effect from 1 March 2020, a standard form of the PPM that all AIFs must follow, which provides a certain minimum level of information. An AIF is exempt from following the SEBI format for its PPM only if:
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).
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 commitment of all the investors in an AIF is termed 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 is 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. Subcategories 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 to provide 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 infrastructure 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".
In December 2019, SEBI introduced "stewardship responsibilities" for AIFs – to protect client wealth and to ensure greater responsibility towards their clients by enhancing monitoring of, and engagement with, their investee companies. To this effect, SEBI released a stewardship code that came into effect from 1 April 2020 – all categories of AIFs are required to follow the stewardship code in relation to their investments in listed equity investments (Stewardship Code). A similar stewardship code applies to mutual funds in the country.
Under the Stewardship Code, AIFs must engage with investee companies through discussions with management, or voting in shareholder/board meetings, on matters such as corporate governance, strategy, performance, and material environmental, social and governance opportunities etc.
The move towards such stewardship responsibilities and bench-marking activities (see 2.9 Rules Concerning Other Service Providers) reflects how SEBI is prioritising data collection, investor protection and transparency in the AIF industry.
As of June 2020, the collection of a nominal stamp duty (ie, a type of document tax) on the issue, sale and transfer of units of AIFs has also been mandated.
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 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 (often one and the same 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.
SEBI has also mandated an annual audit by an auditor or a legal professional to ensure the AIF's compliance with the SEBI format PPM. However, AIFs that do not have to follow the SEBI format PPM (see 2.2 Fund Structures) are not required to undertake the audit exercise for PPMs.
SEBI has also introduced the requirement for an industry benchmark for AIFs (except angel funds) to enable comparison of the AIF industry against other investment avenues and global investment opportunities, and to help investors assess the performance of the AIF industry. To this end, SEBI has made benchmarking of AIFs’ performance mandatory and has introduced a framework to facilitate the use of data collected by the benchmarking agencies. Such benchmarking is to be undertaken by those AIFs that have completed a year from the date of their first closing. Ongoing benchmarking exercises are being undertaken by credit-rating agencies.
Non-local service providers to AIFs are not subject to additional 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 an 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, eg, 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.
Domestic and Foreign Investors
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.
Press Note 3 (2020 Series)
Furthermore, the government recently issued Press Note 3 (2020 Series) dated 17 April 2020 to provide that an entity of a country that shares a land border with India or where the beneficial owner of an investment into India is situated in or is a citizen of any such country, such entity can invest only under the government approval route. This is mainly to curb opportunistic takeovers/acquisitions of Indian companies on account of the current COVID-19 pandemic. This recent rule issued by the government may adversely impact offshore investors seeking to invest in India if they fall within the purview of this restriction and adds to the timelines of such investments. Also, there is no clear regulatory prescription as to the meaning of beneficial ownership, as no specific threshold or definition has been prescribed under Press Note 3 (2020 Series).
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:
While the COVID-19 pandemic has affected the current economic situation, there seems to have been an increase in the establishment of special situations funds where a large part of the underlying assets are pre-identified, along with a preference for club-style funds or managed accounts rather than blind pool platforms. The pandemic has also triggered certain end-of-fund life transactions, such as structured secondaries and fund life extensions.
Onshore v Offshore
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.
The National Investment and Infrastructure Fund
The government, in its capacity as an anchor investor, has established a collaborative investment platform, namely the National Investment and Infrastructure Fund, for international and Indian investors looking for investment opportunities in infrastructure and other high-growth sectors of the country, which includes a fund of funds programme that is likely to emerge as a significant domestic LP.
Promotion of Start-ups and Micro and SMEs
Furthermore, the Small Industries Development Bank of India has been actively investing in various AIFs in order to promote and accelerate the growth of start-ups and micro, small and medium-sized enterprises in India.
There has also been a recent policy push towards onshore fund management. The Indian government has 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.
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 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 that is detected, is to be reported to SEBI by the trustee/sponsor as soon as possible.
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 last AIPAC report, issued in July 2018, made certain key recommendations, including the following:
Recently, SEBI has potentially been considering the introduction of a new category of AIFs that will be focused on buying stressed assets directly from banks and non-banking financial companies. The introduction of this new category of AIFs may pave the way for a departure from SEBI’s restriction preventing AIFs from providing loans.
AIF Regulations do not impose any restrictions on 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, since 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 the place where the 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 (often one and the same entity) 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 INR 200 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 in India. Investors typically include HNWIs, 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, certain prudential norms are 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 or 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 Reserve Bank of India (RBI) to file a form (Form InVi) to disclose the foreign investment.
AIFs that receive foreign investments 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.
The AIF Regulations do not require any disclosures to be made by 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 an AIF must withhold tax from distributions to its investors, applicable at:
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 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 for 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.
The Indian economy has been in the sweet spot for fundraising and investment activity for several years. The World Investment Report 2020 by the UN Conference on Trade and Development (UNCTAD) states that India was the ninth-largest recipient of foreign direct investment (FDI) in 2019, with USD51 billion of inflows during the year, an increase from USD42 billion of FDI received in 2018, when India ranked 12 among the top 20 host economies in the world. Furthermore, as per the India Private Equity Report 2020 by the Indian Private Equity & Venture Capital Association (IVCA) and Bain & Company, India’s share of the Asia-Pacific deal market was nearly 25% in 2019 (continuing to be the second largest deal market in the Asia-Pacific region), while China’s private equity market has retracted over the last year. As per the same report, the total private equity and venture capital investment value in India rose to USD45.1 billion in 2019, the highest in the last decade, primarily due to the number and average deal value of USD100 million-plus deals.
On the back of this performance, India, like the rest of the world, has been hit by the COVID-19 pandemic. Year 2020 has been marred by a slowdown and cautious investment activity. Due to a nationwide lockdown, economic activity was brought to a near standstill and the government and regulators rolled out several measures (fiscal and stimulus packages, including an initiative to prevent large-scale default on corporate loans through a moratorium on interest and principal payments,a restructuring scheme being introduced and the suspension of the Insolvency and Bankruptcy Code) to curtail the downward trajectory. According to the monthly private equity/venture capital roundup by the IVCA and Ernst & Young, investments in July 2020 were 51% lower than in July 2019 (USD4.1 billion in July 2020 v USD8.4 billion in July 2019). Nonetheless, fundraising depicted a healthy growth (USD2.2 billion in July 2020 compared to USD545 million in July 2019). A few recent examples of Asian fundraising are: Sequoia Capital raising USD1.4 billion for venture and growth capital investments in India and the South-East Asia region; Axel raising USD550 million for its sixth India-focused fund; Lightspeed Venture Partners raising USD275 million for its third India-focused fund; and KKR raising over USD11 billion in the first close of its fourth Asia-focused fund. To better equip itself for the economic aftermath of COVID-19, corporate India has been building its war chest through steady capital raise and attracting investments in strategic businesses, eg, Kotak Mahindra Bank raised approximately USD1 billion from institutional investors, and Reliance Jio raised more than USD4 billion from various investors, including KKR, Facebook, Google and General Atlantic.
While India continues to attract capital, the effect of the pandemic led to India’s gross domestic product (GDP) contracting by 23.9% in April to June 2020 in comparison to the same period in 2019. However, the Asian Development Bank has forecast a strong recovery for India's economy in FY2021–22 in its Asian Development Outlook (ADO) 2020 Update, with GDP predicted to grow by 8% as mobility and business activities resume more widely.
With this brief introduction to the current state of affairs, especially with COVID-19 playing havoc with economies across the globe, we will now discuss a few trends and developments from the Indian funds and investments scene.
InvITs and REITs: Taking Flight on the Back of Strong Performance
Business trusts have been prevalent in the West for several years, with the the first real estate investment trust (REIT) being launched in the United States in the 1960s. The Securities and Exchange Board of India (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 private placements of InvITs, including IndInfravit (CPPIB-backed), India Infrastructure Trust (Brookfield-backed), and Oriental InvIT (backed by a few institutional investors). On the REIT front, the Embassy Office Parks REIT became the first REIT in the country when it listed in April 2019, and this was followed by Mindspace REIT in July 2020. As per press reports, the REITs and InvITs have in general outperformed their respective sectoral indices, the S&P BSE Realty Index and the BSE India Infrastructure Index.
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 unit-holders. Additionally, REITs and InvITs (and their investors) are not subject to tax in India on dividend income earned from underlying investee companies.
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 on the back of the recent amendments to Indian tax law and SEBI InvIT Regulations. SEBI amended the InvIT Regulations to permit private, unlisted InvITs. And pursuant to representations, the government of India extended the concessional pass through the tax regime to unlisted InvITs as well. Thus, a private unlisted InvIT becomes an ideal vehicle for platform investment structures, as opposed to the traditional JV company structure which is riddled with limitations from an Indian legal and regulatory perspective.
In its 2019 report, analytics company CRISIL projected that InvIT issuances will grow five-fold to more than INR2 lakh crores (approximately USD28.57 billion) in the next two years, since long-term offtake contracts and strong counterparties provide revenue visibility. The stage is thus clearly set for further success stories for InvITs and REITs in India. On the back of the two successful REITs, expectations for REITs focusing on residential real estate and other housing/hospitality-related structures are on the rise. Sectors such as power transmission, roads, gas pipelines, telecoms infrastructure, renewable energy, ports and airports are expected to go the InvIT way.
Tax Exemption to Sovereign Wealth Funds and Pension Funds
As per Venture Intelligence data, sovereign wealth funds (SWFs) and pension funds have invested nearly USD5,366 million in infrastructure investments in India during the period 2015 to 2020 YTD, which constitutes approximately 56% of their total investments in India. Furthermore, World Bank data indicates that within the current institutional investor base of approximately USD140 trillion, pension funds constitute 28% of investment volume and SWFs constitute 6%.
Globally, countries like the United States, the United Kingdom, Australia, Singapore, the Philippines, and others offer some form of tax exemption on the income derived by SWFs and qualifying pension funds under their domestic laws. Taking its cue from such nations and in order to continue to attract the wallet share of pension funds and SWFs, the government of India introduced a special exemption regime in the Finance Budget 2020.
As per this special tax regime, notified SWFs and pension funds will enjoy a complete exemption from taxes on dividend, interest and long-term capital gains from debt or equity investments made by them in certain infrastructure sub-sectors. In order to qualify for the exemption, the investment must be made before 31 March 2024 and must be locked in for a period of three years. The infrastructure sub-sectors that qualify would be notified under the harmonised master list by the government of India from time to time.
This special tax exemption regime is also expected to give a fillip to investments in InvITs and alternative investment funds (AIFs), since income from investments by SWFs and pension funds made in InvITs and AIFs that invest in companies engaged in qualifying infrastructure activities, would also be exempt from tax in India.
Going the Alternatives Way: AIFs for Investment and Succession
AIFs have flourished through the advent of the SEBI (Alternative Investment Funds) Regulations, 2012 (AIF Regulations). From just 23 registered AIFs in December 2012, the AIF industry has seen tremendous growth, with close to 700 registered AIFs as of August 2020. According to SEBI, the value of the total funds raised as of 30 June 2020 was approximately USD25.9 billion.
AIFs also enjoy a special pass-through tax regime and a less restrictive regulatory regime, making them a flexible yet robust investment vehicle. The government of India (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, CPPIB, Ontario Teachers’, AustralianSuper, and other Indian financial institutions to its investor base. NIIF has become the largest infrastructure fund in India, with AUM of more than USD4 billion across three funds. The GoI has also launched the SWAMIH AIF to provide last-mile funding to stalled affordable and middle-income housing projects with AUM of approximately INR25,000 crore (USD3,571 million), with the GoI funding 40% of the AUM. The GoI has also announced a five-prong strategy to resolve NPLs, which includes an independent AIF to be set up for the purpose of taking over certain NPLs for resolution through funds raised from investors.
Government measures to address the COVID-19 crisis
With the COVID-19 pandemic leading to economic slowdown, corporates are reeling under the debt burden. As mentioned above, to prevent large-scale default on corporate loans the GoI has provided a moratorium on interest and principal payments, notified a new one-time restructuring package, and introduced a spate of amendments to the Insolvency and Bankruptcy Code (IBC) including, increasing the minimum debt size for protection under the IBC, imposing a standstill on the initiation of any new restructuring or insolvency proceedings under the IBC, as well as excluding any fresh loans (to tide over financial constraints caused by COVID-19) from the ambit of “debt” under the IBC.
AIFs as a solution
AIFs, being appropriately regulated and robust structures, are becoming strategic vehicles for acquiring distressed and stressed opportunities that are emerging from this economic crisis. The AIF structure also offers efficiency in terms of contribution of capital for both domestic and foreign investors, distribution of capital and returns, matters relating to investor protection, adoption of internally benchmarked corporate governance and ESG norms, organised liquidation etc. Thus, AIFs structured as debt funds, as well as structured for equity acquisitions, have distinct legal, regulatory and tax advantages in such situations.
AIFs are also becoming a preferred structure for family offices in India. Unlike the scenario in Switzerland and Singapore, India’s funds regime is still in its nascent stage and hence, does not provide specific family office management structures. AIFs fill this need by offering a professionally managed and duly regulated structure for planned investment and achieving the goals of succession for family and business holdings. With huge wealth creation in the last two decades in the hands of HNWIs and UHNWIs, AIFs dedicated to the goals of respective family offices have been set up and have become active investors in India as well as outside India, with a view to achieving portfolio and forex diversification objectives.
Family offices are also an important source of capital for domestic fundraising in India. The IVCA estimates that more than half the funds raised in rupee capital originate from HNWIs and family offices.
India's first IFSC
Lastly, India has also made its first international financial services centre (IFSC) operational. Gujarat International Finance Tec-City (GIFT City) 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, reducing dependence on offshore holding jurisdictions like Singapore, Mauritius and the Cayman Islands. 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 fundraising jurisdictions.
PPM Template and Performance Benchmarking for AIFs
In order to streamline disclosure standards in the growing AIF industry, SEBI has introduced significant amendments to the AIF Regulations.
To counter the possibility of mis-selling due to private placement memorandums (PPMs) being overly complex/having too little information for investors, SEBI has prescribed a template for the minimum requisite information to be provided in a standard format, along with an annual audit to ensure compliance with the terms of the PPM. However, this does not apply to AIFs into which every investor commits a minimum contribution of INR70 crores (USD10 million or equivalent) and such investors must all sign a waiver from such compliance.
SEBI has introduced mandatory performance benchmarking for AIFs and a framework for facilitating the use of data collected by benchmarking agencies to provide customised performance reports. Globally-used performance metrics will be applied to calculate returns in both INR and USD terms. The IVCA has appointed CRISIL as the benchmarking agency for this exercise. Previously, there was no information available in the public domain on returns earned by AIFs, and investors did not have an authentic medium on which to verify data on the performance of AIFs or to compare their performance against overall industry trends. Under the new framework, CRISIL will make category-level aggregate benchmarks publicly available. AIFs will also have to attach authentic benchmarking reports to any reports/material, which will provide existing and potential investors with a clear picture so they can compare the performance of AIFs against other investment avenues and global opportunities.
SEBI has also placed an obligation on AIFs to adopt a “stewardship code”, ie, to formulate a comprehensive policy on the discharge of their stewardship responsibilities, publicly disclose it, and review and update it periodically. The code also covers policy on the continuous monitoring of all aspects of investee companies, as well as policy on the identification and mitigation of conflicts of interest.
Raising the Wall to Shield Indian Companies from Hostile Takeovers
COVID-19 unleashed an unprecedented effect on world economies. Governments reacted with a protectionist wave, with each country taking measures to insulate itself from the damaging effects of the pandemic.
Japan decided to build an economy that is less dependent on China, so that Japan can mitigate supply chain disruptions caused by the current COVID-19 pandemic. To this end, Japan announced its emergency economic package on 7 April 2020, earmarking JPY240 billion (approximately USD2.2 billion) for fiscal 2020 to pay Japanese manufacturing firms to leave China and relocate production either in their home country or to diversify their production bases into South-East Asia. Australia, Italy, Spain and Germany announced amendments to their respective foreign investment laws to make acquisitions and takeovers by foreigners much more difficult. So did the European Union. The USA's Foreign Investment Risk Review Modernisation Act of 2018 (FIRRMA) had already increased the review of foreign investments under the Trump administration due to security and national interest concerns. India, too, wasn’t immune to this sentiment.
In April 2020, the GoI amended the foreign direct investment (FDI) policy with the stated objective of preventing "opportunistic takeovers/acquisitions of Indian companies due to the current COVID-19 pandemic”. The revised FDI policy stipulates for primary investments: a non-resident entity, being an entity of a country which shares a land border with India or where the beneficial owner of an investment in India is situated in or is a citizen of any such country, then such entity can invest in India only with prior government approval. The other conditions as applicable under the extant FDI policy (such as permissible and prohibited sectors/activities, pricing norms, eligible instruments etc) will continue to apply. For secondary investments: transfer of ownership in any existing or future FDI in an Indian entity, whether directly or indirectly, which results in the beneficial ownership falling into the hands of entities/citizens of the above-mentioned restricted countries, shall also require prior government approval.
The policy does not define “land border nations”. Geographically, India shares land borders with the following nations: Pakistan, Bangladesh, China, Nepal, Myanmar, Bhutan and Afghanistan. For the purposes of the FDI policy, China would include Hong Kong. Several challenges have emerged from the revised FDI policy since there are no de minimus exemption thresholds, and operational guidelines for seeking approval are yet to be notified. Hence, deal-making and fundraising have hit roadblocks navigating the revised FDI policy.
Key Amendments to Investment Advisers Regulations
Investment advisers are regulated by SEBI. The formal regime for investment advisers was introduced in India in 2013, through the SEBI (Investment Advisers) Regulations, 2013 (IA Regulations). The scope of the IA Regulations is very wide as the term "investment advice" essentially means any advice relating to investing in, purchasing, selling or otherwise dealing in securities or investment products, and advice on investment portfolios containing securities or investment products, and includes financial planning. Some of the general obligations of investment advisers (also applicable to stockbrokers, portfolio managers and merchant bankers, even though exempt from seeking registration, in the course of incidental advice being provided to their clients) are:
These obligations are very similar to those imposed on licensed financial advisers in other sophisticated jurisdictions, such as the United States, United Kingdom, Singapore and Hong Kong. The IA Regulations thus specify uniform standards across all the intermediaries/persons engaged in providing investment advisory services, irrespective of whether such activity is incidental to their primary activity or not, and also address the gaps or overlaps in legal or regulatory standards.
In July 2020, SEBI introduced certain significant amendments to the IA Regulations, which were made with a view to curbing mis-selling, overcharging, lack of transparency in the dealings of advisers, and other practices which are against investor interests. A couple of critical amendments that impact the manner in which investment advisory activities will be conducted in India are summarised below.
The amended IA Regulations bring to the fore a new concept of "persons associated with investment advice" which is defined to include any member, partner, officer, director, employee or any sales staff of an investment adviser who is engaged in providing investment advisory services to the clients of the investment adviser. Thus, all persons associated with investment advice (other than administrative and clerical staff) are now required to have the appropriate educational qualification and professional certification (accredited to the National Institute of Securities Markets, India), and not merely one or two persons in the office of an investment adviser, as was previously the case. This is a welcome change as it imposes an obligation for the investment adviser to ensure it employs persons with adequate experience and the sound technical knowledge to interface with the clients – thus ensuring that the representatives understand for themselves the investment product that they are recommending to the clients.
Furthermore, all investment advisers are compulsorily required to maintain records of their agreements with clients, and submit an annual audit report to SEBI on their compliance with the IA Regulations. In this context in the US, the SEC has mandated that investment advisers who advertise their track record/performance must maintain records of all account statements and worksheets to demonstrate the calculation of the performance of all managed accounts.
Segregation of advisory and distribution services
Another crucial change being introduced by SEBI is client level segregation of advisory and distribution services. A client cannot obtain both advisory and distribution services (including distribution of AIF units) from the investment adviser or its affiliates/group companies. The underlying concern addressed by this is conflict of interest and it is intended to curb mis-selling practices. The detailed compliance and monitoring processes are yet to be notified by SEBI. The amended IA Regulations do permit an investment adviser to provide execution services in relation to the implementation of advice. However, the amended IA Regulations prohibit investment advisers from receiving any consideration (whether as commission or referral fees, whether embedded or indirect or otherwise, by whatever name) directly or indirectly or through any of its affiliates/group companies. SEBI also proposes to notify a standard form of agreement to be executed between investment advisers and clients.
Foreign exchange control regulations
It is also important to remember the restrictions under foreign exchange control regulations in relation to investment advisory activities in India. Any foreign investor who wishes to invest in an entity engaged in investment advisory activities (Target Co) will need to seek prior government approval if the Target Co is not registered under the IA Regulations. For example, a Target Co that provides investment advice only to non-Indian clients is exempt from registration. Hence, any foreign investment in such an entity will be subject to prior government approval.
Offshore fund managers
Caution must also be exercised by offshore fund managers who wish to conduct marketing or pre-marketing meetings in India in order to assess the interest of Indian residents in offerings of offshore funds managed by them. The Indian legal and regulatory regime should be navigated with care with respect to each stage (engagement of intermediaries, conduct of meetings, offering related compliances, and funding of initial and subsequent drawdowns by Indian residents).
Several reports have predicted that India is well poised for stellar growth. Research entitled “Long-term macroeconomic forecasts – Key trends to 2050”, conducted by The Economist Intelligence Unit, revealed that India will become the world’s third-largest economy by 2050, overtaking the UK, Germany, Japan, France and Brazil. The growth trajectory has hit a snag due to the COVID-19 pandemic but the GoI has ensured that the legal, regulatory and tax framework is in place, and that fundraising and investments are progressing at a healthy pace. Hence, India is expected to emerge strong after the pandemic.