The Securities and Exchange Board of India (SEBI) notified SEBI (Alternate Investment Funds) Regulations, 2012 (AIF Regulations) on 21 May 2012. The AIF Regulations repeal the SEBI (Venture Capital Funds) Regulations, 1996 (VCF Regulations). Discussed below are some of the salient features of the AIF Regulations:
As compared to the VCF Regulations, the AIF Regulations cast a much wider net to include private equity funds, real estate funds, hedge funds and also existing capital pools that were not required to be registered under the VCF Regulations. Now all kinds of pooled investment vehicles will be required to seek registration with SEBI under the AIF Regulations. However, mutual funds, collective investment schemes, family trusts, employee stock option plan trusts, employee welfare trusts, holding companies, funds managed by asset reconstruction companies, securitization trusts and other entities that are regulated by any other regulator in India have been exempt from registering again with SEBI under the AIF Regulations.
2 Applicability to existing funds registered under the VCF Regulations:
Existing VCFs would be regulated by the VCF Regulations until the funds themselves or the schemes being managed by them are wound up, but the VCFs would neither be able launch a new scheme nor increase the target corpus of the existing schemes or of the funds themselves. However, these VCFs can migrate to the AIF regulatory regime by re-registration under the AIF Regulations on obtaining approval of two-thirds of their investors. We anticipate that only those funds which are fully invested will choose to remain outside the AIF regulations.
The AIF Regulations have categorized funds into the following three categories:
(i) Category I AIF to include VCFs, small and medium enterprise funds, social venture funds, infrastructure funds and such others as may be specified.;
(ii) Category II AIFs to include those funds that are not classified as Category I or Category III and which do not undertake leverage or borrowing activities other than to meet day-to-day operational requirements and as permitted in the AIF Regulations.; and
(iii) Category III AIFs to include hedge funds that are considered to have negative externalities such as exacerbating systemic risk through leverage or complex trading strategies. In addition to this the three categories will differ based on the government incentives which could change over the life of a fund.
4 Management Interest:
Investment managers and/or sponsors are required to contribute 2.5% of the initial corpus or INR 50,000,000, whichever is lower, for Category I and Category II AIFs and 5% or INR 100,000,000 for Category III AIFs. Market practice for the manager’s ‘skin in the game’ is between 1% to 2% of the fund size and this requirement could prove to be a challenge for newer managers and should have been a matter best left to be agreed by the manager and the investors. In addition to this, employees or directors of the fund or of the manager will have to make minimum cash investment of INR 2,500,000 in the fund which may be a daunting task for social venture funds.
5 Corpus, Membership and Tenure of the AIF:
A minimum corpus of INR 200,000,000 and each investor having to invest a minimum of Indian Rupees 10,000,000 means that only institutions, high net worth individuals (HNIs) and family offices will have access to AIFs. By limiting investors in an AIF to one thousand, SEBI has sought to close the door on companies raising large sums through the private placement route without registration with SEBI. While Category I and Category II AIFs are required to be close-ended with a minimum tenure of three years, Category III AIFs may be either close-ended or open-ended. The term of an AIF may be extended for a period up to two years subject to approval of two-thirds of the investors. In any other case an AIF will be required to liquidate within one year of its term.
6 Listing of AIF units and regulation of investments:
SEBI has permitted units of close ended AIFs to be listed on stock exchanges after final closing, subject to the scheme being of a minimum tradable lot of INR 10,000,000. Investment by all categories of AIFs will be subject to the following conditions: (i) AIFs may invest in securities of companies incorporated outside India subject to such conditions or guidelines that may be stipulated or issued by the Reserve Bank of India and SEBI from time to time. (ii) Co-investment in an investee company by a manager or sponsor cannot be on terms more favourable than those offered to the AIF. (iii) AIFs cannot invest in associates except with the approval of 75% of investors. (iv) The un-invested portion of the corpus may be invested in liquid mutual funds or bank deposits or other liquid assets of higher quality such as treasury bills, collateral borrowing and lending obligations, commercial papers, certificates of deposits, etc. until the deployment of funds as per the investment objective. (vi) AIFs may act as a nominated investor i.e. as a qualified institutional buyer or private equity fund in accordance with SEBI (Issue of Capital and Disclosure Requirements) Regulations 2009.
Category I and Category II AIFs have not been permitted to invest more than 25% and Category III AIFs have not been permitted more than 10% of their investible funds in one investee company.
7 Other Compliance:
It is mandatory for an AIF to file a placement memorandum or an information memorandum along with the requisite fees at least 30 before launching a new scheme. Unlike the VCF Regulations, the AIF Regulations prescribe very detailed requirements that need to be provided in the private placement memorandum. AIFs are also required to provide financial information of portfolio companies and material risks along with an analysis of how these are managed by them to the investors on an annual basis.
8 Insider trading and AIFs:
An interesting aspect of the AIF Regulations is that it has created an exemption from Regulations 3 and 3A of SEBI (Prohibition of Insider Trading Regulations), 2009 (Insider Trading Regulations) for Category I and Category II AIFs for their investments in companies listed in Small and Medium Enterprises (SME) Exchanges or on the SME segment of a stock exchange provided that (i) the AIF conducts due diligence prior to such investment; (ii) discloses such investments within a period of two days of such investments to the stock exchange where the companies are listed; and (iii) the investment has been locked in for a period of one year from the date of such investment. This suggests that the Insider Trading Regulations apply to subscription of shares of listed companies, a principle that has been rejected by the Securities Appellate Tribunal. If indeed SEBI expects potential investors subscribing to shares of a listed company to comply with Insider Trading Regulations and not to be treated in the same way as companies listed on the SME Exchanges, there can be no PIPE investments. This will clearly require an amendment to the Insider Trading Regulations and this attempt merely sets out a regime for the SME segment which is still at a very nascent stage of development and could well have been extended to all AIF investments thereby codifying market practice.