In March 2015, the Securities and Exchange Board of India (“SEBI”) constituted the 21 member Alternative Investment Policy Advisory Committee (“AIF Committee”), under the chairmanship of Infosys founder Mr. Narayan Murthy, to advise on ways to encourage the development of alternative investment and start-up ecosystems in India. The AIF Committee was well represented by various stakeholders, including domestic venture capitalists like the Indian Venture Capital Association and Indian Angel Network, renowned private equity firms such as KKR & Co. and The Carlyle Group, corporations like Religare Enterprises and Piramal Group, tax advisors such as PricewaterhouseCoopers, as well as the SEBI, Reserve Bank of India, and Ministry of Finance.

This week, the AIF Committee submitted its first report, suggesting the revamp of the current regulatory regime on alternative investment funds (“AIFs”), recommending relaxations in the tax regime applicable to AIFs, encouraging pooling of domestic capital, and pushing for promoting onshore fund management. In this blog, I will focus on outlining the key recommendations made by the AIF Committee regarding the proposed amendments to/revamp of the Securities and Exchange Board of India (Alternative Investment Fund) Regulations, 2012 (“AIF Regulations”).

Regulation of fund managers

At present, apart from the AIF Regulations which regulate investment funds, the SEBI has also issued the Securities and Exchange Board of India (Investment Adviser) Regulations, 2013 (“IA Regulations”) and the Securities and Exchange Board of India (Portfolio Manager) Regulations, 1993 (“PortMan Regulations”) to regulate investment advisors and investment managers. While this regulatory regime has thus far focused primarily on encouraging transparent compliance practices by funds and protecting the interests of investors, the AIF Committee believes that it is the fund managers, and not the funds themselves, that must be regulated, as they are in control of investment decisions which could pose risks to the investors, securities market, and the economy.

Accordingly, the AIF Committee has recommended that the PortMan Regulations, IA Regulations, and AIF Regulations should be replaced with a ‘Securities and Exchange Board of India (Alternative Investment Fund Managers) Regulations’ (“Managers Regulations”). The proposed Managers Regulations would contain a general framework for fund raising and reporting, while allowing the SEBI to provide special incentives to certain funds, such as angel funds and social venture funds. As regards fund and investment managers, the Managers Regulations would mandate registration and impose minimum capitalization requirements based on their targeted customer-base.

Further, the Managers Regulations would classify investors into ‘accredited investor’ and ‘retail investor’ groups, wherein accredited investors who meet certain minimum income / asset / net-worth thresholds are exempted from several requirements that may apply to retail investors. Such categorization would give fund managers the flexibility to provide customized product offerings to institutional and accredited investors who have more sophisticated investment appetites, while at the same time protecting the interests of retail investors.

Sub-classification of Category III AIFs

Industry appetite for investing in listed securities is quite large, but is currently undertaken by institutional investors and high net-worth individuals directly, rather than through any organized fund platform. In the interest of creating such a formal fund structure under the AIF Regulations, the AIF Committee has recommended that Category III AIFs be further classified into 2 categories, based on their investment horizon, preferred instruments, and investment objectives.

At present, funds which employ diverse trading strategies and invest in listed securities, such as hedge funds, funds looking to make short-term returns, and open-ended funds, are permitted to be registered as Category III AIFs. The proposed sub-category A under Category III AIFs would comprise of funds which primarily invest in listed securities without employing leverage, except for the purposes of hedging, with long fund life of at least 3 years. Sub-category B funds, termed ‘Complex Trading Funds’, would be those funds that have complex trading strategies and employ leverage, through investment in listed or unlisted derivatives.

Further, Category III AIFs are currently prohibited from investing more than 10% of their corpus in 1 company. The AIF Committee has recommended that this static threshold be replaced with a dynamic one, where the restriction is a function of market value of the fund’s portfolio as on the date of an investment.

The recommendations of the AIF Committee are geared towards sustaining the continued growth of the AIF industry by incorporating global practices that recognize the fiduciary role of fund managers, the limitations on capacity and risk tolerance of investors, and diversity in investment objectives. We would have to wait and see whether any of these recommendations are implemented, and if so, in what form, by the SEBI.