Background: The need of AIF arises with the surge in venture capital investment. With the identification of the benefits of venture capital investments for the growth of specific sectors, the Government of India started introducing various regulations targeted at different forms of investment funds in India, such as mutual funds, collective investment schemes, etc. However, caught in the confusion of many regulations, the Venture Capital Fund (“VCF”) vehicle came to be used by many other funds such as private equity (“PE”), private investment in public equity, real estate, etc., thereby making it difficult to give targeted concessions to VCFs to promote startup or early stage companies. It is in this background that in 2012 the Securities and Exchange Board of India (“SEBI”) introduced the SEBI (Alternative Investment Funds) Regulations, 2012 (the “AIF Regulations”) and to recognise AIFs, such as PEs and VCFs, as a distinct asset class apart from promoter holdings, creditors and public investors.
WHAT IS AIF?
As the name suggests “Alternative” investment is the financial asset that falls into non- conventional investment categories and not into conventional categories like stocks, bonds, cash etc. These are mainly popular or held by institutional investors, high net worth individuals because of its complex nature, degree of risk and lack of regulations. Broadly, an alternative investment is an investment in assets different from cash, stocks, and bonds. Alternative investments can be investments in tangible assets such as precious metals or wine. In addition, they can be investments in financial assets such as private equity, distressed securities, and hedge funds. Thus, AIF includes Private equity, venture capital, hedge funds, managed futures, real estate, commodities, derivatives etc.
Recently, AIF got popular in India and are defined in Regulation 2(1) (b) of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012. It refers to any privately pooled investment fund, (whether from Indian or foreign sources), in the form of a trust or a company or a body corporate or a Limited Liability Partnership (LLP). Hence, in India, AIFs are private funds which are otherwise not coming under the jurisdiction of any regulatory agency in India.
Specific exclusions include family trusts, employee stock option trusts, employee welfare trusts or gratuity trusts, holding companies, special purpose vehicles not established by fund managers and regulated under a specific regulatory framework (eg. securitization trusts), and funds managed by registered securitisation or reconstruction companies.
Apart from the registration and compliance requirements under the AIF Regulations, each AIF also needs to be compliant with the applicable statutes, depending upon the chosen structure of trust, LLP or a company. For instance, a company or a LLP has to be registered with the Registrar of Companies and there needs to be 2 directors/designated partner, one of whom needs to be resident in India. Apart from these, there are also filing and audit requirements for a company and an LLP. As such, a trust is the more favoured structure amongst the existing AIFs in India, since the regulatory framework governing trust structures is minimal and allows the management independence with respect to formulating its own standard of governance.
Features of AIF
Almost all alternative investments come with the following features that distinguish them from traditional forms of investment:
1.Low correlation between traditional Investments
This may be extremely beneficial to potential investors because the low correlation provides opportunities for portfolio diversification.
2.Hard to determine value
Alternative investments are often inherently complicated when it comes to valuation. The valuation of an alternative investment may require specific knowledge, and some exotic investments, such as fine art,may show unpredictable demand patterns. In addition, they may be unique in their nature, which also complicates the valuation.
Generally, alternative investments possess relatively low liquidity, especially compared to traditional investments. The low liquidity can be explained by the absence of centralized markets and the low demand for some of the assets relative to traditional investments (think about works of contemporary art). In addition, some of the investments come with restrictions regarding exiting from the investment.>
4.High Purchasing Cost
Alternative investments are frequently associated with high purchasing costs. Some alternative investments such as hedge funds require a minimum investment amount, as well as a fee.
Classification of Alternative Investments
Alternative investments may be classified as tangible or intangible investments.
Tangible alternative investments include the following:
- Precious metals
- Fine art
Intangible alternative investments include:
- Hedge funds
- Private equity
- Venture capital
Registration of Alternative Investment Funds (AIFs)- India
As per Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 Alternative Investment Funds shall seek registration in one of the three categories
Category I: Mainly invests in start- ups, SME’s or any other sector which Govt. considers economically and socially viable. Includes venture capital funds, SME funds, social venture funds, infrastructure funds, angel funds, etc.
- Angel funds, which is of particular topical interest, means funds pooling investments from angel investors, having net worth of at least Rs. 10 Crores (if a body corporate); or net tangible assets of at least Rs. 2 Crores, excluding value of principal residence, and experience as a serial entrepreneur, or being a senior management professional with at least 10 years of experience (if individual).
Category II: These include Alternative Investment Funds such as private equity funds or debt funds for which no specific incentives or concessions are given by the government or any other Regulator. IFs, which do not fall in Category I or Category III and which do not undertake leverage or borrowing other than to meet day-to-day operational requirements.
Category III: Alternative Investment Funds AIFs, which employ diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives such as 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 Regulator.
Tenure and Listing of Alternative Investment Funds / Schemes
- Investors can be Indian, NRI or foreign. However, for angel funds, Investors should be angel investors only;
- Minimum corpus should be Rs. 20 Crores for each scheme and Rs. 10 Crores for angel funds;
- Minimum investment by each investor should be Rs. 1 Crore, or Rs. 25 Lakhs (in case of employees/directors/fund manager of AIF or angel investors), as applicable. There are however no minimum investment requirement on units of AIF issued to the employees of the manager for profit sharing;
- Maximum number of investors can be 1000 for each scheme and 49 in case of angel funds. However, the industry demand is to bring up the number to 200, in case of angel funds, in parity with the private placement provisions under the Companies Act, 2013;
- Category I and II AIFs can be close ended only, with a minimum tenure of three years, while Category III AIFs can be both open and close ended.
- The manager or sponsor shall have a continuing interest in the respective AIF, (a) of not less than 2.5% of the corpus (if Category I or II) and 5% of the corpus (if Category III), or (b) Rs. 5 Crores (for each scheme) and Rs. 50 Lakhs in case of angel funds; whichever is lower. This has to be brought in the form of investment in the respective AIF and such interest shall not be through the waiver of management fees. Management fees is generally fixed at a certain percentage of the corpus, annually, and/or carried interest, to provide further incentive to the manager.
- Units of close ended Alternative Investment Fund may be listed on stock exchange subject to a minimum tradable lot of one crore rupees. Such listing shall be permitted only after final close of the fund or scheme. However, listing on stock Exchanges is purely voluntary.
In addition to the above, the AIF Regulations prescribe general and specific investment conditions for each category AIF and SEBI can also specify additional requirements/criteria for all/specific AIFs. Upon contravention of any of the provisions of the AIF Regulations, including the minimum corpus requirement as stated above, the penalties are as provided under the SEBI (Intermediaries) Regulations, 2008, which include suspension or cancellation of certificate of registration, debarment, etc.
Interestingly, the above eligibility criteria and the registration requirements are applicable for AIFs defined and included under the AIF Regulations and therefore it becomes important to explore what an AIF is.
Extension of the tenure of the close ended Alternative Investment Fund may be permitted up to two years subject to approval of two-thirds of the unit holders by value of their investment in the Alternative Investment Fund. In the absence of consent of unit holders, the Alternative Investment Fund shall fully liquidate within one year following expiration of the fund tenure or extended tenure.
Maximum limit for Overseas Investment by AIF
Overseas investments by AIFs investments shall not exceed 25% of the investible funds of the scheme of the AIF subject to overall limit of USD 500 million (combined limit for AIFs and Venture Capital Funds registered under the SEBI (Venture Capital Funds) Regulations, 1996).
PASS THROUGH TAXATION OF AIF
Category I enjoys the tax benefits of pass-through status and the Finance Act, 2015, extended a pass-through status to Category II AIFs as a response to a long standing industry demand. What it essentially means is that income on an investment fund (defined as a Category I or Category II AIF), is exempted from tax and such income is chargeable to income-tax in the hands of the unit-holder in the same manner as if the investments made by the investment fund has been made directly by the unit-holder. It is specialized tax practice on handling the issues of liability of withholding tax on the fund; differential treatment of unit-holders basis their residential status and treaty advantages of non-resident unit-holders in certain cases; risk of income being considered as income from profits and gains of business or profession, etc.
Overall, the AIF Regulations have been a welcome change and have been quite successful in providing separate incentives and imposing separate obligations for the various categories and subcategories of AIFs.
Angel Funds do have restrictions on investment, amongst others, which makes it a little unattractive:
- in companies less than 3 years,
- less than turnover of Rs.25 crores,
- not promoted by an industrial group with more than Rs.300 crore turnover
- Not in companies related to Angels
- No exit within 3 years.
It is imperative that the regulators recognise the industry demands of implementation of overall global best practices, promoting on-shore fund management and unlocking domestic capital pool through sectoral and regulatory intervention, amongst other things, for enabling the continuing growth of AIFs.
For more information, how ASCENT as a Global Fund Administrator can help in Alternative Investment Funds.