The Securities and Exchange Board of India (“SEBI”) has notified the SEBI (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”) on 21 May, 2012, thus bringing various funds investing in Indian securities under a unified regulatory umbrella.
Earlier SEBI had introduced a concept paper to explain the regulation and the rational behind the same. Portions of the concept paper is quoted below:-
WHY COMPREHENSIVE REGULATION FOR PRIVATE POOLS OF CAPITAL/ALTERNATIVE INVESTMENT FUNDS IS REQUIRED?
1. SEBI (Venture Capital Funds) Regulations were framed by SEBI in 1996 to encourage funding of entrepreneurs’ early‐stage companies. However, it has been found over the years that VCFs are being used as a vehicle for many other funds such as:
(i) Private Equity (PE)
(ii) PIPE (Private Investment in Public Equity)
(iii) Real Estate
These funds were using the VCF route while not adhering to or being responsible for helping start-ups or early stage companies which was the original idea behind the formation of VCFs. Further, unregistered VCFs were operating without any investment restrictions. On the other hand, PEs & PIPEs which were actually not VCFs, were finding it difficult under the restrictive atmosphere of a VCF which operate in the unlisted market and are generally not allowed acced to the secondary market.
2.. There is a need to recognize Alternative Investment Funds (AIF) such as PE or VC etc., as a distinct asset class apart from promoter holdings, creditors and public investors.
Thus at one end of the spectrum, there will be Mutual Funds or CIS which are for retail investors with prudential regulation seeking to regulate all kinds of risks. On the other end there are private pools of capital of institutions or sophisticated investors who entrust pooled funds to a manager who himself needs to have own funds forming part of the corpus.
Accordingly, SEBI notified the AIF Regulations to govern unregulated entities and create a level playing ground for existing venture capital investors.
Applicability
AIF Regulations are applicable to all privately pooled investment vehicles (other than mutual funds, collective investment schemes, family trusts, ESOP Trusts, employee welfare trusts, holding companies, funds managed by securitization companies or asset reconstruction companies, other special purpose vehicles not established by fund managers including securitization trusts or any such pool of funds which is directly regulated by any other regulator in India).
The different categories of AIFs based on investment philosophy are as follows:
(a) Venture Capital Funds: These funds will primarily invest in unlisted securities of start ups, emerging or early stage venture capital undertakings mainly involved in new products, new services, technology or intellectual property rights based activities or a new business model.
(b) Hedge Funds: Hedge Funds will employ diverse or complex trading strategies and invests and trades in securities having diverse risks or complex products, including listed and unlisted derivatives.
(c) Private Equity (“PE”) Funds: PE funds will invest primarily in equity or equity linked instruments or partnership interests of investee companies.(d) Infrastructure Funds: These funds will primarily invest in unlisted securities or partnership interest or listed debt or securitized debt instruments of investee companies or special purpose vehicles engaged in or formed for, the purpose of operating or holding infrastructure projects.
(e) Debt Funds: These funds will primarily make investments in debt or debt securities of listed or unlisted investee companies.
(f) Small and medium enterprises (“SME”) Funds: These funds will invest primarily in unlisted securities of investee companies which are SMEs or securities of those SMEs which are listed or proposed to be listed on a SME exchange or SME segment of an exchange.
(g) Social Venture Funds: These funds will invest primarily in securities or units of social ventures and which satisfy social performance norms laid down by the fund and whose investors may agree to receive restricted or muted returns.
Categories
AIFs are broadly categorised as follows, for the purposes of its registration with SEBI:
Category I - Funds which invest in start-up or early stage ventures/ social ventures/ SMEs/ infrastructure/ other sectors or areas which the government or regulators consider as socially or economically desirable and shall include Venture Capital Funds, SME Funds, Social Venture Funds and Infrastructure Funds and such other AIF as may be specified. This category may be entitled to incentive or concessions from SEBI or other regulators. Such funds formed as a trust or a company will be construed as a ‘venture capital company’ or ‘venture capital fund’, as specified under Section 10 (23FB) of the Income Tax Act, 1961.
Category II – This is the residual category and is for those funds which cannot be classified either as Category I or III and which do not undertake leverage or borrowing, other than to meet day to day operational requirements and as permitted under these regulations. This category will include PE Funds or Debt Funds for which no specific incentives or concessions are given by the government or any other regulators.
Category III - Funds in this category would adopt diverse or complex trading strategies and may employ leverage (including through investment in listed/ unlisted derivatives). This category will include Hedge Funds or funds which trade with a view to make short term returns or such other funds which are open-ended and for which no specific incentives or concessions are given by the government or any other regulators.
AIFs shall seek registration in one of the categories mentioned above and in case of Category I AIF, in one of the subcategories thereof. An AIF which has been granted registration under a particular category cannot change its category subsequent to registration, except with the approval of SEBI.
Other features
- The fund may raise funds from any investor whether Indian, foreign or non-resident Indians by way of issue of units.
- Each scheme of the fund should have a minimum corpus of Rs. 20 crores and each investor should make a minimum investment of Rs. 1 crore. Provided that if the investor is either a director or employee of the fund or an employee or director of the manager of the fund, the minimum investment will be Rs. 25 lakhs.
- No scheme of the fund is permitted to have more than 1000 investors.
- The sponsor/manager of the fund should continue to have a minimum interest of the lower of 2.5% of the corpus or Rs. 5 crore other than through the waiver of his management fees. For category III funds, the sponsor/manager’s interest should continue to be the lower of 5% of the corpus or Rs. 10 crores.
- These funds are not permitted to raise funds through the stock exchange mechanism but may be listed on stock exchange, subject to a minimum tradable lot of Rs. 1 crore. Listing of AIF is permitted only after final close of the fund or the scheme.
- Category I and II funds cannot invest more than 25% of the investible funds in any one investee company whereas category III cannot invest more than 10% of the investible funds in any one investee company. Co-investment in an investee company by a Manager or Sponsor shall not be on terms more favourable than those offered to the AIF.
- AIFs will have Qualified Institutional Buyer (“QIB”) status as per SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009.
- While a Category III AIF may be either close-ended or open-ended, the other two categories of AIFs will have to be close-ended funds with a minimum tenure of 3 years. Tenure for the closeended funds can be extended for a maximum tenure of up to 2 years subject to the approval of twothirds of its unit holders by value.
Existing Funds
Existing VCFs will be permitted to continue and shall be governed by the VCF Regulations till such fund or scheme managed by the fund is wound up. VCFs will not be permitted to raise any fresh funds after notification of these regulations, as aforesaid, except for commitments already made by investors as on the date of the notification.
These VCFs may seek re-registration under AIF Regulations, subject to approval of two-thirds of their investors by value. Existing funds (falling within the definition of an AIF) not registered with SEBI may continue to operate for 6 months from the date of commencement of the AIF Regulations or if it has already made an application for registration under these regulations within those 6 months then till the disposal of its application (extendable up to 12 months in special cases with the permission of the Board).
These funds will not be allowed to float any new scheme without registration under the AIF Regulations. Schemes floated by such funds before coming into force of AIF Regulations, shall only be allowed to continue till maturity. Further existing funds that are currently not registered with SEBI but wish to seek registration under the AIF Regulations may apply to SEBI for exemption from the strict compliance with the AIF Regulations if they are not able to comply with all provisions of these regulations.
Comments
While the idea is laudable, SEBi appears to be suffering from its inherent problem of bad or at best unimaginitive draft of its regulations. Throughout the concept paper SEBI expounded the idea of making a clear demarkation between the so called 'HNI' or private investment and the smaller retail or public investment. But when it came to coding the regulation, unfortunately a lot was left unexplained.
The problem as pointed out by author Mr. Vinod Kothari is that AIF Regulations permit an AIF to be organised either as a company, a limited liability partnership (“LLP”), or a trust. In case of the SEBI (Venture Capital Funds) Regulations, 1996, the options of organising a fund as a company, trust or a body corporate were available. However, most venture capital funds were actually orgnaised as trusts.
The difficulty arises from a reading of the definition of an AIF, and is further compounded by the definition of “units”. Regulation 2(1)(b) of the AIF Regulations defines the term an AIF to mean, subject to the exceptions set out therein, any fund established or incorporated in India in the form of a trust or a company or an LLP or a body corporate which:
(a) is a privately pooled investment vehicle which collects funds from investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors; and
(b) is not covered under the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996, Securities and Exchange Board of India (Collective Investment Schemes) Regulations, 1999 or any other regulations of the Board to regulate fund management activities.
The AIF Regulations do not define the word “investor”. However, the definition of the term “unit” includes shares, and therefore, every shareholder becomes a unitholder, and by extension, an investor. If, therefore, every shareholder of a company is taken to be an investor, then every company, other than a listed public
company, irrespective of what business the company carries on, is a privately pooled vehicle which collects money from its sareholders to be used in a particular manner. The question that, therefore, arises, and in relation to which no clarification has been issued by SEBI, is whether all privately pooled capital, such as contribution of ownership capital to a company, would fall within the purview of the AIF Regulations.
If any application of funds by a company is taken to be covered by the expression “investing it in accordance with a defined investment policy”, then every company becomes an AIF. And if the expression “investing it in accordance with a defined investment policy” is taken to mean investments as commonly understood, then every investment company becomes an AIF. There are thousands of investment companies registered with the Reserve Bank of India (“RBI”) and yet other thousands which are not registered. Obviously, the idea of AIF Regulations could not have been to bring all such investment companies, currently under RBI’s non banking finance company regime, also under AIF Regulations. If the idea of the AIF Regulations was to include only such funds as companies gather and manage other than shareholders’ money, then that meaning is not at all clear from the extant definition of either AIF or units.
WHAT IS REGULATED?
SEBI intends to regulate a pooling vehicle which essentially pools capital from various investors and investing such capital in accordance with defined investment policy. The idea is to ensure benefit to the investors.
Who are investors? The Black’s Law Dictionary (9th Edition) defines an investor as a buyer of a security or other property who seeks to profit from it without exhausting the principal, i.e. a person who spends money with an expectation of earning profit. Under common parlance, investors are outsiders who are neither the owners of the pooling vehicle, nor are they the managers. Therefore, it makes good sense to have excluded owners and managers.
2.1 Meaning of investment
The Blacks’ Law Dictionary (9th Edition) defines investment to mean expenditure to acquire property or assets to produce revenue, a capital outlay. Furthermore, P Ramanatha Aiyar’s, The Law Lexicon, (3rd edition) has also similarly defined the term investment to signify the laying out of money in such a manner that it may produce a revenue, whether the particular method be a loan or the purchase of stocks, securities, or other property.
The term investment is defined in the Accounting Standard AS 13 as assets held by an enterprise for earning income by way of dividends, interest and rentals, for capital appreciation, or for other benefits to the investing enterprise and assets held as stock-in-trade are not investments.
It is true that behind every outlay of capital the ultimate purpose is to earning revenue. However, there is a difference in the intentions and purposes while outlaying capital (a) by way of an ownership capital and (b) solely with the purpose of earning profit.
To our understanding where two or more persons come together with a common objective and work together to pursue that common objective, it cannot be said to constitute an AIF. There is an element of control is present in an ownership interest.
2.2 Key determinants of an AIF
The key deciding factors, as set out in the definition, are:
(a) a privately pooled investment vehicle;
(b) collection of funds from investors;
(c) investment made in accordance with a well defined investment policy; and
(d) investments are made for the benefit of the investors.
Therefore, funds are collected from investors on a private placement basis which are invested in accordance with an investment policy is drawn with an idea to earn returns in form of dividends, etc., for the benefit of the investors.
In an ownership capital scenario, the primary benefit is attributable to the entity (the company or a LLP, for instance) and the purpose is the growth of such entity.
Furthermore, unlike an AIF, there are no third party funds involved.
In India, a company form of a fund is not very prevalent because of several constraining and restricting reasons. Some of those can be summarized as hereunder:
1. Separation of management and investment
As can be noted, a scheme or a fund contemplates management by an external manager and does not constitute an in-house management mechanism. Where the funds are privately pooled for a common purpose and managed in-house on the bases of a private arrangement, agreement or understanding, it cannot be construed as an AIF.
The intention of SEBI is clear: (a) to protect interests of the investors; and (b) ensure proper management of the capital of the investors. Where there is no public money involved, SEBI clearly cannot have any intent to monitor.
2. Difficulties with a company form of AIF
Despite the flexibility in organisational form that might have been SEBI’s objective in giving the choice of the organisational form, the company form is eminently unsuitable for an AIF. Reasons are several.
First, Category III AIFs may be open-ended. In case of companies, open-ended company would mean free buyback of shares of a company, which is not permissible under the Companies Act, 1956 where buyback of shares by a company is restricted.
Second, whether closed-ended or open-ended, most AIFs have a limited life span – in case of companies, thinking of taking the company to winding up will be an extremely protracted exercise.
Third, in addition to the above, there are entry and exit norms applicable under the FDI policy, which do not apply in case of LLPs and trusts.
Last, needless to mention the continuous compliance issues associated with a company.
Ideally companies should be completely excluded from the AIF regulations, or it should be clarified that in case of companies, only such part of investment corpus as is different from the share capital of the company is counted as size of the AIF. In case of LLPs, general partners are in the nature of owners/managers of the LLP, while limited partners are external investors. The AIF Regulations should be focused only on the limited partners’ investments.
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