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WHITE PAPER: ALTERNATIVE INVESTMENT FUNDS

BIRD’S EYE VIEW

As on March 31, 2016, 209 Alternative Investment Funds (AIF) have been registered with SEBI1 with

many more in the pipeline. The cumulative investments by the AIFs exhibited an escalation of about

29.97% , recording investments in excess of INR 18,200 Crore till the end of first quarter of 2016.2 The

AIF industry has been fast growing and with the recent amendment in exchange control regulations with

respect to AIF, it is expected to see a dramatic shift in the quantum of investments made by AIFs.

Formally, domestic pooling of investments was done in accordance with SEBI (Venture Capital Fund)

Regulations, 1996 (‘VCF Regulations’) by the VCFs. However, this regime had a lot of uncertainties and

regulatory oversight. Thus, in order to overshadow the lacuna and challenges that the erstwhile VCF

Regulations provided for, SEBI introduced SEBI (Alternative Investment Vehicle) Regulations, 2012 (AIF

Regulations) to govern all such kinds of domestic funds and to open up market for more complex

structures such as hedge funds.

Thus, with advent of AIF Regulations, VCF Regulations have been repealed. However, AIF Regulations

have a grandfathering provision wherein all the existing registered VCF continue under VCF Regulations

until wound up provided no new scheme shall be launched and there is no increase in targeted corpus

after May 21, 2012 or may seek re-registration as an AIF if approved by two-thirds of investors by value.

Diagrammatic representation of various Pooling Vehicles

1 http://www.sebi.gov.in/cms/sebi_data/attachdocs/1461124238814.pdf 2 http://economictimes.indiatimes.com/articleshow/52565797.cms?utm_source=contentofinterest&utm_medium=text&utm_campaign=cppst

Domestic Pooling Vehicles

AIF SEBI

(Alternate Investment

Trusts) Regulations,

2012 InVITs

SEBI (Infrastructure Investment

Trusts) Regulations,2

014

REITS SEBI (Real Estate Investment

Trusts) Regulations,

2012

CIS SEBI

(Collective Investment

Scheme) Regulations,

1999

MF SEBI (Mutual

Fund) Regulations,

1996

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REGULATORY FRAMEWORK

WHAT ARE ALTERNATIVE INVESTMENT FUNDS

AIF is a privately pooled investment vehicle that collects funds from investors, whether Indian or foreign,

for investing it in accordance with a defined investment policy for the benefit of its investors.

AIFs does not cover Funds covered under SEBI Mutual Fund Regulations and SEBI Collective Investment

Schemes Regulation, Family Trust, ESOP Trust, Employee Welfare Trusts, Holding Companies as per

Companies Act, or any pool which are directly regulated by any other Indian Regulator.

FORMS OF SETTING UP OF AN AIF

As per the AIF Regulations, an AIF may be established or incorporated either in the form of a trust or a

company or a limited liability partnership or a body corporate. Based on various considerations such as

foreign investments, tax, compliance one needs to decide the investment vehicle. Set out below is a

preliminary comparative analysis:

Parameter Trust Company LLP

Governing

Act

Indian Trust Act, 1882

Companies Act, 2013 or

erstwhile Companies Act,

1956 as applicable

Limited Liability

Partnership Act, 2008

Meaning

“Trust” as an obligation annexed to the ownership of property, and arising out of a confidence reposed in and accepted by the owner, or declared and accepted by him, for the benefit of another, or of another and the owner.

Company incorporated under the provisions of Companies Act, 2013 or under the erstwhile Companies Act, 1956.

An LLP is a hybrid form of

a corporate entity,

prescribing limited

liability for partners with

flexibility of governing

the rights and duties of

partners as per the LLP

agreement.

Managing

entities

Trustee Board of Directors Designated Partners

Regulatory

Compliances

Low High High

Winding Up Simple Complex Moderate

CATEGORIES OF AIF

AIFs shall seek registration under any one of the following categories:

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*Areas which govt. consider as socially or economically desirable and incentives are given ** Employs diverse or complex trading strategies. No specific incentives or concessions given Upfront selection at the time of filing application; Change permitted subject to SEBI’s approval

INVESTMENT CRITERIA:

There are certain general criteria prescribed under the AIF Regulations for investments in AIF for the AIF categories.

Parameters Category - I Category – II Category - III

Min. Fund Size 20 crores

Min. Capital Commitment

INR 1 crore INR 25 lakhs: minimum value of investment by employees or directors of the AIF or Manager

Investment in Associate Company

not permitted except with 75% of the investor approval by value

Min. Tenure Close ended AIF shall have minimum tenure of 3 (three) years.

Max. Number of Investors

1000 per scheme

Solicitation Only by way of PPM

Experience of the Manager

At least one key personnel of the Manager should have minimum experience of 5 years.

Condition for co-investment

not be on terms more favorable than for AIF/scheme

Change of control

Prior SEBI approval will be required for change in control of AIF, Sponsor or Manager

QIB Status AIFs have been accorded the status of QIB

Category I*

SME

Fund

s

Social

Venture

Fund

VCF

Fund

Infrastructu

re Fund Angel

Fund

AIF Categories

Category II (Residual Category)

Category III**

PE

Fund

Debt

Fund

Hedge

Fund

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Investment Shall not invest more than 25% of its corpus in one investee company.

Shall not invest more than 10% of its corpus in one investee company.

Investment Restrictions

Invest in units of Category I AIF and not in units of other funds of funds.

Invest in

Unlisted investee co.

Units of Category I & II AIF, except for units of other funds of funds.

Invest in

Units of Category I & II AIF, except for units of other funds of funds;

securities of listed or unlisted investee co.;

derivatives or complex or structured products.

Borrowings Not to borrow funds or leverage except to meet temporary funding requirements.

May leverage or borrow (subject to Investors’ consent & max limit specified by SEBI).

Sponsor Commitment

Continuing interest of the manager or sponsor amounting to 2.5% of the corpus or INR 5 Cr whichever is lower.

Continuing interest of the manager or sponsor amounting to 5% of the corpus or INR10 Cr whichever is lower.

Nominated Investor (NI)

Considered as NI under SEBI (ICDR) Regulations, 2009

Insider Trading Exempt from Regulation 3 and 3A of SEBI (Insider Trading) Regulations for investment in companies listed on SME Exchange or SME segment of an exchange after due diligence subject to: • Disclosure of any dealing in securities, within 2

days, to the stock exchanges where the company is listed; and

• 1 yr lock-in. These provisions are not applicable to Social Venture Funds or Infrastructure Funds

No Exemption

Valuation Valuation by an independent valuer at least once in every 6 months. Can be enhanced to one year, if approved by at least 75% of the investors in value terms

Disclose NAV at quarterly intervals for close ended fund & monthly intervals for open ended funds3.

Daily reporting of leverage to custodian

Not applicable Yes in prescribed format

In addition to the above conditions, following are certain specific investment criteria applicable to category I AIFs:

3 NAV Calculation to be independent from the fund management function

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Funds Conditions

Category I AIFs

Venture Capital

Funds

- Min. 2/3rd investment in unlisted equity linked instruments of VCUs4;

- Min. 2/3rd investment in listed or to be listed companies on SME exchange;

- Max.1/3rd investment in IPO subscription of VCU;

- Max 1/3rd investment in debt or debt instruments;

- Max. 1/3rd investment in preferential allotment (1 yr lock-in);

- Max 1/3rd investment in SPV of fund for facilitating investments

- Max 1/3rd investment in equity or equity-linked instruments of financially weak

company or listed sick companies

SME Funds Min 75% investment in unlisted securities of VCU or SMEs or companies listed or

proposed to be listed on SME exchange;

Social Venture

Funds

- Min 75% investment in unlisted securities of social ventures;

- Permitted to give and accept grants to social ventures;

- Permitted to accept muted returns

Infrastructure

Funds

- Min 75% investment in unlisted securities of VCU, co. or SPVs engaged in

infrastructure projects

- Invest in listed, securitized debt instruments or listed debt securities of

companies or SPV, engaged in infrastructure projects

WHO CAN INVEST IN AIFs:

With an objective to attract offshore and domestic investors the following categories of investors are

eligible to make investments in AIF subject to prescribed conditions.

4 Regulation 2(aa) of AIF regulations define VCU

Investors

NR

NRI

FPI

FVCI

Resident Companies (Insurance Co., Banks)

Resident Individuals

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FOREIGN INVESTMENTS IN AIFs

Non-Resident, RFPI and NRI: Schedule 11 of the Foreign Exchange Management (Transfer or Issue of

Security by a person resident outside India) Regulation, 2000 (‘FDI Regulations’) permit person resident

outside India (other than an individual who is citizen of or any other entity which is registered /

incorporated in Pakistan or Bangladesh) to invest in all the categories of AIF subject to the following

prescribed condition5:

(a) Pledge: Any person who is a non-resident and holds units of an AIF in accordance with the FDI

Regulations may pledge such units to secure credit facilities being extended to the non-resident

investor.

(b) Payment Channels: The payment for the units of an AIF acquired by a person registered /

incorporated outside India shall be made by an inward remittance through the normal banking

channel including by debit to an NRE or an FCNR account.

(c) Redemption: A person resident outside India who has acquired or purchased units may sell or

transfer in any manner or redeem the units as per regulations framed by SEBI or directions issued by

RBI. However, there are no guidelines so far that specifically prescribed for

investment/transfer/redemption of units.

(d) Instruments: A person resident outside India can invest in shares or convertible debentures or

warrants or units of AIFs.

(e) Specific Investment Restriction for FPIs: It is clarified that FPI shall not hold more than 25% stake in a

category III AIF.6

FVCI: Schedule 6 of the FDI Regulations permit SEBI registered FVCIs to invest in units of Category I AIF

(Cat–I AIF) or units of a scheme or of a fund set up by a Cat-I AIF subject to the terms and conditions as

may be laid down by the Reserve Bank. Further, no prior approval of RBI shall be required for

investments by SEBI registered FVCI in case of investments made under Schedule 6.

Downstream investment by AIF in Indian companies

Downstream investment by the AIF should not be regarded as foreign investment, i.e. should be treated

as domestic investment, provided that the Sponsor as well as the Fund Manager is regarded as Indian

Owned and Controlled under the FDI Regulations. Since ownership and control cannot be determined in

LLP under the FDI, LLP cannot act as sponsor or manager.

Cases Ownership & Control of

manager/sponsor

Nature of investors in

the fund

Downstream is foreign

investment

A Indian Domestic No

B Indian Foreign No

OFFSHORE INVESTMENTS BY AIFs7

5 RBI Notification no. FEMA 355/2015-RB dated November 16, 2015 6 SEBI Circular CIR/IMD/FPIC/39/2016 dated March 15, 2016

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AIFs are allowed to invest into securities of companies incorporated outside India with prior approval of

SEBI, subject to certain condition

Investment Limits: Investment is within the overall limit of USD 500 million (combined limit for AIFs

and Venture Capital Funds).

Investment Conditions:

- Invest in the companies which have an Indian connection, i.e. a company having a front office

overseas, while running back office operations in India;

- Invest in equity and equity linked instruments of Offshore Venture Capital Undertakings.

“Offshore Venture Capital Undertakings” means a foreign company whose shares are not listed

on any recognized stock exchange in India or abroad.

- Invest limit of 25% of the investible funds of the scheme of AIFs

Restriction: No investment by AIFs in Joint Venture/Wholly Owned Subsidiary as defined under

Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, 2004.

AIF REGISTRATION PROCEDURE

Set out below is a diagrammatic representation of the steps and timelines involved in seeking AIF

registration.

AIF STRUCTURE

7 SEBI circular CIR/IMD/DF/7/2015 dated October 1, 2015

Step 1 •Fill, number, sign and stamp application in Form A along with necessary documents

Step 2 •Submit application in Form A along with necessary documents to SEBI

Step 3 •Submit Bank draft of INR 1 lakh to SEBI payable at Mumbai along with Form A

Step 4 •Response from SEBI –generally within 21 days (subject to compliance of requirements)

Step 5 •Approval from SEBI

Step 6 •Payment of registration fees of INR 5 lakh by way of bank draft to SEBI payable at Mumbai

Step 7 •Grant of certificate by SEBI, with such conditions as deemed appropriate by SEBI

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Investment Agreement

Investment Management Agreement

Contribution Agreement

Investors

Trust Deed

Management Fees

There are various considerations that the fund manager considers whilst finalising fund structures. Some

of the considerations are: (a) Investor’s jurisdiction; (b) Tax implication on the fund; (c) marketing

restrictions; (d) cost of incorporation in various jurisdictions etc.

A typical fund structure that is adopted by fund manager wherein AIFs are registered as trust entity with

the Registrar of Trust. Further, with opening up of foreign investments in AIF, offshore investors can

directly invest in domestic AIF. However, based on tax consideration of investor’s jurisdiction to

contemplate whether pooling of offshore investments must take place at the AIF as well. Set out below

is a diagrammatic representation of the domestic structure.

LEGISLATIVE FRAMEWORK

Legal entity AIF: Depending upon the nature of entity, the relevant statute with respect to the entity

would be applicable.

Investment Advisers: SEBI (Investment Advisers) Regulations, 2013 regulates registration, general

obligations of the investment advisers8 who provide investment advise relating to investing in,

purchasing, selling or otherwise dealing in securities including financial planning.

Trust Taxation:

Category I & II AIF: Taxation of Category I AIF and Category II AIF shall be in accordance with the special

tax regime under new chapter XII (FB) of Income Tax Act which is applicable to such funds irrespective of

whether they are set up as trust, company or limited liability partnership. Set out below is the taxability

of the Category I and Category II AIFs:

8 means any person, who for consideration, is engaged in the business of providing investment advice to clients or other persons

or group of persons and includes any person who holds out himself as an investment adviser, by whatever name called.

Regulation 4 lists of persons who are exempted from seeking registration as Investment Adviser

Investment

Manager Trustee

Sponsor

Portfolio Companies Investment

Committee

AIF

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Sr.# Particulars Investment Fund Unit Holders

1. Income under the head of ‘profits and gains of business or profession’ of the investment fund

Taxable Exempt

2. Income, other than profits and gains of business or profession

Exempt Taxable

3. Any loss incurred by investment fund To be carried forward and set off

Not passed to investor

4. Withholding on income distributed to unit holder*

In case of income other than business income - Tax withholding @ 10% In case of business income - No tax withholding

* tax withholding rates for income distributed to non-resident investors would be considered based on

treaty provisions.

In order to avail tax pass through status characterization of income of AIF is critical which is to be

determined based on facts.

No Pass through for Category III: Category III AIFs do not have a specific tax code and hence are subject

to domestic tax law based on the AIFs legal status (i.e. company, trust, etc)

Safe Harbour laws:

In order to encourage fund management activity from India, Section 9A of the Act provides lays down

certain conditions wherein an offshore fund shall not be construed to have a business connection in

India or be considered as person resident in India merely because the fund manager, undertaking fund

management activities on its behalf, is situated in India. Benefits under the safe harbour provisions are

subject to compliance with certain conditions laid down in section 9A of the Act read with CBDT

notification dated March 15, 2016 (prescribing rules for application of section 9A of the Act).

Disclaimer: The contents of this document are intended for informational purposes only and are not in the nature of a legal opinion or advice. It provides general information and guidance as on date of preparation and does not express views or expert opinions of ARA LAW. They may not encompass all possible regulations and circumstances applicable to the subject matter and readers are encouraged to seek legal counsel prior to acting upon any of the information provided herein. ARA LAW will not be liable for any damages of any kind arising from the use of this document, including but not limited to direct, indirect, incidental, punitive and consequential damages. It is recommended that professional advice be sought based on the specific facts and circumstances. This White Paper does not substitute the need to refer to the original pronouncements.