By Jayant M. Thakur
Chartered Accountant
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SEBI has issued, on 1st August 2011, fairly comprehensive draft Regulations to regulate all private funds that invest in any type of securities whether registered outside India or in India and whether their investors are from outside India or within India. These Regulations thus are intended to be very broad and will cover all funds that are not specifically governed by existing Regulations on certain funds. The possible concern is that certain private investment vehicles may get covered unintended though the purpose is to cover only the funds that raise monies for investment, albeit privately. A more serious concern is that the funds are categorised and restrictions are put on each category on their investment pattern, etc.
One of the stated purposes is of course that such comprehensive Regulations covering all types of funds will help them being granted exemptions from other statutes. However, the detailed control over them as proposed seems disproportionate to the needs of the exemptions. The other benefit of registration and regulation stated is that such control and supervision of SEBI may increase the credibility of such funds in the eyes of the investors in such funds.
Alternative Investment Fund (‘AIF’) means funds other than which are governed by specific Regulations such mutual funds, Collective Investment Schemes, etc. Many of such AIF are specifically identified, such as private equity funds, real estate funds, private pooled investment vehicle (‘PIPE’), etc. But generally, it is an inclusive definition covering all such funds except those specifically excluded.
Importantly, new venture capital funds will be covered by the AIF Regulations. Existing venture capital funds shall continue to be governed by the present Regulations till they are wound up.
What is an AIF? Regulation 3 gives a primary definition stating that it (i) invests in securities markets, (ii) having domicile anywhere, whether in India or abroad and (iii) (a) collects its funds from institutional or high net worth investors in India or (b) the manager of such fund is in India. Some points are worth highlighting. The AIF should invest in securities markets. This of course is required since this gives jurisdiction to SEBI that is a securities regulation body. However, it is not clarified as to whether the investments would be within India or abroad and the better view seems to be that the investment can be anywhere. Strangely, the AIF may invest in assets other than securities too. For example, real estate funds are also covered though their investments may be wholly in real estate projects.
The other important aspect is that the fund could be based abroad or even have its investors abroad. However, it appears that some Indian link is necessary. It is not sufficient that the investment is made in India. Either the funds should be raised from India or the manager of such AIF should be in India. While an Indian link has been retained, this is an area to which many funds have a primary objection. It may be noted that the SEBI Regulations relating to foreign venture capital funds will continue to apply on such funds, though these Regulations are much tamer.
Another requirement is that the funds should be collected from institutional or high net worth investors. While the term institutional investors’ is not defined (though this term can be interpreted from other SEBI Regulations), the term HNI does not mean that the investor should have a high net worth — rather it is an entity or individual that invests at least Rs.1 crore in the AIF. The intention seems to be that the funds that accept investments by smaller retail investors should be covered by other Regulations such as the mutual fund regulations, while AIFs should be restricted to large or institutional investors subject to a different set of regulations.
All existing AIFs, whether registered or not, will be required to register themselves when the Regulations are notified. New AIF will not be able to start business without prior registration.
The AIF may be formed as a company, an LLP or as a Trust.
The minimum fund size is to be Rs.20 crore. Interestingly, at least 5% of such amount should be invested by the Sponsors, etc. and this minimum shall be locked in till the fund is fully wound up and all investors are paid off. Minimum investment size by investors has to be 0.1% of the Fund size or Rs.1 crore, whichever is higher.
Unlike corresponding laws abroad, under the proposed Regulations as the introductory note to the proposed Regulations itself suggests, there is no exemption based on minimum size. Thus, the Regulations abroad do not apply to AIF of a minimum size and above. But the proposed Regulations apply to all entities that carry on business of AIF. The minimum fund size works as a minimum entry barrier. No AIF can function below the minimum fund limit of Rs.20 crore. Thus, unlike the prevailing laws abroad, though they significantly form the basis of the proposed SEBI Regulations, there is mandatory registration for all AIFs and detailed regulation and control over them.
The number of investors if the fund is structured as a company or LLP is limited to fifty.
This number is obviously derived from the limit under the Companies Act, 1956, for private companies and for private placement. But this could be restrictive. This also seems to be inconsistent with the minimum investment size of 0.1% of the fund size. By this percentage, the maximum number of investors should be 1000. In fact, the introductory note to the draft Regulations states that the maximum number of investors shall be 1000, but the Regulations provide for a low number of fifty.
Another important policy aspect is that that every AIF shall have only one Scheme. Thus, a fresh Scheme would require a fresh AIF with fresh registration and a totally fresh process.
The minimum term of the AIF shall be five years. Again, this seems to be an arbitrary provision, interfering with what parties may contractually decide.
The AIF is prohibited from investing more than 25% of its fund in one investee company. This is yet another legislature-mandated arbitrary policy interfering with discretion of the fund even if the investors support it.
Another requirement that can create practical problems is that the manager, etc. cannot coinvest in any investee company and that the whole of the equity investment should be through the fund. However, it is often seen that a form of sweat equity is given, quite transparently, to the manager, etc. of a small portion of the amount invested in a company which helps the manager/ key employees to participate in the appreciation of the investment. This reduces the fund costs also since the fund can pay lesser cash remuneration and at the same time motivates the manager, etc. Such co-investment should have been permitted with a requirement that it is transparent.
For each of the categories of AIFs, detailed requirements have been laid down. How much minimum percentage shall be invested in certain types of industries, in what type of investment such investment shall be made, etc. are specified. The aim seems to be that each category should specialise in a particular type of investment. At the same time, investment in some industries are barred. Certain types of instruments are also restricted for investment. Take the example of the proposed framework for Venture Capital Funds. The total fund size shall not be more than Rs.250 crore. Investment is permitted only in companies at an early stage of their business life by way of seed capital or minority stake in new ventures using new technology or innovative business ideas. Investment is not permitted in any company promoted by any of the 500 top listed companies or their promoters. At least 2/3rd of the investments shall be in equity shares of unlisted companies.
For each of the categories of AIFs, detailed requirements have been laid down. How much minimum percentage shall be invested in certain types of industries, in what type of investment such invest-ment shall be made, etc. are specified. The aim seems to be that each category should specialise in a particular type of investment. At the same time, investment in some industries are barred. Certain types of instruments are also restricted for investment.
Take the example of the proposed framework for Venture Capital Funds. The total fund size shall not be more than Rs.250 crore. Investment is permitted only in companies at an early stage of their busi-ness life by way of seed capital or minority stake in new ventures using new technology or innovative business ideas. Investment is not permitted in any company promoted by any of the 500 top listed companies or their promoters. At least 2/3rd of the investments shall be in equity shares of unlisted companies. There are further restrictions regarding investments of the remaining 1/3rd. Investment in Share Warrants is not permitted.
Debt Funds need to invest at least 60% of its corpus in debts of unlisted companies and not more than 25% of which shall be in convertible For each of the categories of AIFs, detailed requirements have been laid down. How much minimum percentage shall be invested in certain types of industries, in what type of investment such investment shall be made, etc. are specified. The aim seems to be that each category should specialise in a particular type of investment. At the same time, investment in some industries are barred. Certain types of instruments are also restricted for investment.
There are similar quite rigid conditions on what should be the investment mix for various types of funds. Further, an AIF cannot change the nature/ category of its fund mid-way. Thus, a set of fairly rigid conditions apply to each AIF even though the funds are raised from large and knowledgeable investors and on a private-placement basis after due disclosure.
Unfortunately, there is no free category in which, even if agreed between the AIF and its investors, the AIF could invest in any type of securities in any mix/proportion it desires.
It is stated in the introductory note to the proposed Regulations that portfolio managers who pool their clients’ assets would also be required to be registered as an AIF. However, this is not part of the Regulations. Apparently, this provision will come through separately by an amendment to the Regulations relating to portfolio managers.
The AIF Regulations will also give relief from certain possibly unintended technical violations of law by some funds. For example, having access to inside information during diligence process by PIPE funds shall not be deemed to be violation of the SEBI Regulations prohibiting insider trading. However, an important condition is that the investment made pursuant to such diligence shall be locked in for five years.
An interesting category is of Social Venture Funds. These are for those types of investments where a useful social purpose, rather than merely profit, is the theme of the fund. The nature of such social purposes is left for the AIF to decide with the investors.
A glaring omission is of the so-called art funds where investments are made in paintings, antiques, etc. These have come under scrutiny in recent years for various reasons. It is not one of the specific categories of AIF under the Regulations. It is not totally clear whether they would be governed under the SEBI Regulations for Collective Investment Schemes (‘CIS’) or whether SEBI intends to cover them under these AIF Regulations. Earlier, SEBI had taken a view that these are governed under the SEBI CIS Regulations. However, there is a residuary category for registration and perhaps under such category, they may be required to be registered. However, the conditions of investment, etc. of such funds are not specified.
To conclude, the draft Regulations show the tendency to overregulate. Without any need, all funds, without a basic exemption are sought to be covered. The control over investment pattern is perhaps too restrictive and in some aspects even too minute. The Regulations instead could have provided an overseeing role for SEBI to ensure transparency as well as avoidance of systemic risks. That has not happened and one hopes that the final Regulations achieve these objectives instead of micro-regulating this sector.
