AIF Regulations 2012 The Long Arm of Law Gets Longer

The time has come for Indian funds to gear up for life in a new regulatory eco system with India's securities market regulator, the Securities and Exchange Board of India (SEBI), notifying the SEBI (Alternative Investment Funds) Regulations, 2012 ("Regulations") recently.

While its coming into force was announced by a press release dated May 21 of this year, a blueprint of the Regulations first came into public consciousness as far back as August of 2011. The blueprint outlined, among other things, the pressing need to replace the existing SEBI (Venture Capital Funds) Regulations, 1996 ("VCF Regulations") which, in failing to stay abreast of industry trends, had become 'outmoded' to use a mild term. Draft regulations were also attached to the blueprint in order to receive public comments and feedback. Although regulators in India often invite stakeholder comments as part of a ritualistic exercise, to SEBI's credit, the final Regulations indeed mended some of the chinks in the draft regulations, which were pointed out by market watchers. Thus, the Regulations in their present form reflect a synthesis of SEBI's original objectives of protecting retail investors, cushioning the market from systemic risks and facilitating the formulation of more focused and specific regulatory directions, on the one side; and stakeholder concerns on the other.

Wider Perimeter

The Regulations will henceforth govern the activities of 'Alternative Investment Funds,' (AIFs), meaning all privately-pooled investment vehicles established or incorporated in India in the form of either company, incorporated body, limited liability partnership or trust.

One of the primary reasons cited for floating the Regulations was to bring hitherto unregulated funds within the ambit of SEBI's supervision and thereby ensure systemic stability. Therefore, in defining AIFs, SEBI has prevented situations of regulatory overlap. Employee stock options trusts, mutual funds, collective investment schemes (all regulated by SEBI); funds managed by securitization and reconstruction companies registered with the Reserve Bank of India under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002; as well as any such pools of funds already being monitored by a regulator are notable examples of exclusions from the Regulations on such basis.

Different Strokes for Different Folks

The Regulations have broadly divided the pools into three different categories on the basis of certain characteristics. Category I includes funds which chiefly invest in start-ups, venture capital undertakings, small and medium enterprises (SMEs), social ventures (bodies promoting social welfare, including microfinance institutes and not-for-profit companies) and infrastructure or other sectors which the government or regulators deem to be beneficial to the economy. Category III comprises AIFs which employ complex trading strategies, such as hedge funds, which are permitted to undertake leverage. Category II funds are those which fall in neither of these categories and are prohibited from borrowing or undertaking leverage activity (e.g., private equity funds).

The above trifurcation addresses a long standing grievance against the VCF Regulations that the venture capital fund (VCF) structure was misused by various funds as an omnibus structure in order to avail of beneficial tax treatment and exemption from lock-in, irrespective of their primary investment strategy. Also, other permitted fund structures were relatively shrouded with regulatory ambiguity. Due to this one-size-fits-all approach, regulators could not extend special concessions to investment pools which focused on funding sectors which fuelled the economy, which has been solved by placing them on a different pedestal. Real estate, private equity and hedge funds would also benefit in the long run from this classification as regulatory policy can now be framed with a greater degree of specificity, keeping their needs in mind.

All Present and Accounted For

The Regulations make registration with SEBI mandatory, thus taking away from pooling vehicles, the option to operate and invest third party investor funds without registration. To obtain the certificate of registration from SEBI, applicants must fulfill the eligibility criteria and pass SEBI's scrutiny of their charter documents, competence and the investment team's experience. The fund sponsor (Sponsor) and fund manager (Manager) must also steer clear of the SEBI (Intermediaries) Regulations, 2008. The application must also provide details regarding the investment objectives and strategy, tenure of the fund (or scheme) and target investors thereby ensuring that the AIF would have to do a fair bit of spadework prior to being in a position to float a scheme.

SEBI has incorporated grandfathering provisions to facilitate the transition from the repealed VCF Regulations to the AIF regime. Accordingly, any fund which falls under the definition of AIF as per the Regulations is required to be registered with SEBI within a period of six months from the notification of the Regulations, which may be extended by a further six months at the discretion of SEBI. Prior to registration, existing AIFs are prohibited from raising funds (other than those already committed by investors) and from floating new schemes. Schemes existing at the time of notification of the Regulations would be governed in accordance with contractual terms or, in the event the fund is registered with SEBI, as per the VCF regulations, but these would not be permitted to be rolled over or extended.

High Stakes

One of the concerns aired by SEBI at the time of floating the concept paper was the fear that while fund vehicles were engaged in complex and predominantly high-risk-high-return strategies, they were accessible to retail investors who could be lured in by projected returns without fully appreciating the risks involved. To remedy this state of affairs, the Regulations have imposed a minimum contribution floor per investor of ' 1 crore within an overall minimum fund size of ' 20 crore.

Most funds aim to tap investors with an investible corpus ranging in the vicinity of ' 5 lakh to ' 25 lakh, which may be even lower as per the investment objective. This provision would significantly reduce the scope of investors who can be approached, limiting participation in India's AIF scene to high net worth individuals, corporates and institutional investors, all of whom are perceived as savvy investors. Another indicator would be a comparison with the VCF Regulations, which imposed a minimum contribution of ' 5 lakh per investor and a firm commitment from investors of ' 5 crore to the fund at the time of registration with SEBI. Notwithstanding the gap being narrowed after accounting for depreciation of money in real value terms, the minimum investment caps imposed by the Regulations remain a significant hike in terms of both market practice and the VCF Regulations.

In respect of minimum investment contribution, the Regulations further stipulate that the Manager or Sponsor of a fund is required to have a continuing interest in the AIF of the lesser of ' 5 crore or 2.5% of the initial AIF corpus.Therefore SEBI has introduced this criteria not only to limit the position of Manager to only experienced personnel enjoying the widespread confidence of the market and thereby access the funds required to cross the threshold but impose a minimum degree of 'skin in the game for managers', thereby tempering excess risk taking (in theory). One wonders if in this case it is the limits imposed which are excessive. In the absence of a Sponsor bearing the brunt of the burden of the minimum interest, the Manager would be hard pressed to comply with this provision.

Small Players Left out of the Party

The Regulations have a lot of positives in their favour. Part of the investor protection measures include the high premium put on transparency by the Regulations entailing a high level of information disclosure being required to be made to investors. The norms pertaining to investment valuation mandatorily being required to be made at regular intervals by an independent valuer are equally laudable. While these proactive measures taken by SEBI have been hailed in many quarters as a sign of the coming of age of the domestic securities market, questions still abound as regards certain other aspects of the Regulations.

While it is indeed important that investors understand the risks involved with particular investment, the sheer scale of the barrier may daunt even savvy investors who would be restricted due to the high threshold commitment levels. Crucially, SEBI has chosen to introduce the Regulations at a time when access to liquidity is extremely restricted, thereby eliminating the operation of small to medium ticket funds which could have played an important role in sectors such as start-up funding and real estate. By imposing a very high entrance threshold for investors, it does them a disservice in the name of investor protection by limiting their asset diversification.

The provisions for listing of AIFs, similarly, will seem like a mirage to most funds when read with the fine print which pegs the minimum lot size at ' 1 crore. The minimum lot size is a thinly-veiled affirmation of SEBI's dislike for funds raising money from comparatively smaller participants. There are also certain dodgy areas in the Regulations such as application of benefits of tax pass-through, which at present seem to extend only to Category I AIFs. It is hoped that as the market matures, its gatekeeper (SEBI) too will loosen up the rules of the game in the interest of growth. While the benefits of SEBI's exercise in eliminating regulatory vacuum for funds are manifold, more plaudits would have come its way had it not made the already unenviable task of fund raising even more back-breaking.

Disclaimer–the views expressed in this article are the personal views of the author and are purely informative in nature.