The need for Alternative Investment Funds (“AIFs”) in India was boosted with the surge in venture capital investments. 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.
Registration as AIF
The AIF Regulations make it mandatory to obtain certificate of registration from SEBI for enabling AIFs to operate under one of the following 3 categories:
- Category I – AIFs which invest in start-up or early stage ventures or social ventures or SMEs or infrastructure. 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 – AIFs, 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. Includes private equity funds or debt funds for which no specific incentives or concessions are given by the government or any other regulator.
- Category III – AIFs, which employ diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives. Includes hedge funds or funds, which trade for short term returns, or open ended funds, for which no specific incentives or concessions are given by the government or any other regulator.
The eligibility criteria/conditions are as follows:
- 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 AIFs may be listed on stock exchange, subject to a minimum tradable lot of Rs. 1 Crore and such listing of AIF is permitted only after final close of the fund or scheme.
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.
What is an AIF?
Any privately pooled investment vehicle, established or incorporated in India, in the form of a trust or a company or a limited liability partnership (“LLP”) or a body corporate, not covered under any other SEBI or sectoral regulations. Such privately pooled investment vehicle may collect funds from investors, whether Indian or foreign, for investing such funds in accordance with defined investment policies. [The question that poses itself in such case is whether the express exclusion of other organizational structures, such as a partnership firm, from the ambit of AIFs may be explored for pooling investments, especially in the growing context of accelerator and seed funding at very early stages. If so, would that entail a continuing risk for such pooling vehicles of being identified as AIFs at some point of time, thereby being liable for imposition of the same regulatory rigour for such smaller investment vehicles.]
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.
Pass-through Taxation of AIFs
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.
India has seen record jump in investments over the last few years and especially in 2015, with the number of angel and VCF investments rising to as many as 1,096 in 2015, up by 68% from 2014 [Source: www.vccircle.com]. It has also created a strong culture of investment in India and has enabled structuring of the life cycle of each and every stage of investment. Many angels have now moved up to creating a Category I funds.
However, 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. It is in this backdrop that the report dated 20 January 2016 of the Alternative Investment Policy Advisory Committee headed by Mr. Narayana Murthy becomes particularly relevant as the nation awaits the regulatory response to the same.
Author: Sohini Mandal is a Senior Associate at NovoJuris and specialises in private equity.