The idea of Indian domiciled hedge funds, though first mooted by the SEBI over a decade back, has not picked up steam yet. Even upon the AIF Regulations specifically permitting the formation of hedge funds, there were several missing pieces which held the sponsors from taking the plunge. The regime on hedge funds has since developed on a piecemeal basis with the operating and prudential norms governing them being notified by SEBI over the course of a year after the AIF Regulations came into force.

One of the larger concerns that remained unaddressed was with respect to the restriction on foreign investment in hedge funds. While the AIF Regulations had permitted for the same, the RBI or the FIPB had not come up with an enabling notification until recently when the RBI issued notification no. FEMA 355/2015-RB dated November 16, 2015 (“FDI Notification”) permitting FDI in all categories of AIFs. Prior to the FDI Notification, the FIPB was considering proposals for foreign investment in AIFs on a case by case basis and was reluctant in approving foreign investments in a Category III AIF – the category which encompasses hedge funds.

The FDI Notification permitted foreign investment in all categories of AIFs, including hedge funds, without the need of any approval. Further, any downstream investment by an AIF (even those having foreign investment) would be categorized as foreign investment only in case the sponsor or the investment manager of such AIF is not owned or controlled by Indian residents. The notification is indeed a big step towards making the regulatory environment more conducive for Indian hedge funds. However, the above relaxation may not ensure the participation of foreign capital unless certain issues in the hedge fund regime are adequately addressed.

Firstly, there are too many restrictions placed on Indian hedge funds with respect to their investments. For instance, the FDI Notification provides that hedge funds having foreign investment could invest in only such securities or instruments in which a registered foreign portfolio investor (“FPI”) can invest. This would mean that such a hedge fund would not be able to invest in commodity derivatives, which is an investment category much favored by hedge funds across the world. Also, the above limitation prescribed under the FDI Notification limits such hedge funds from entering into the sphere of private companies. While ordinarily hedge funds stay away from private companies due to the illiquidity issues, successful hedge funds dabbling in exciting start-ups, particularly in the tech sector, is not uncommon.

In addition, hedge funds are currently not permitted to invest outside India. The regulations only permit AIFs to invest in unlisted companies abroad, with specific approval from the SEBI and subject to several other restrictions. This greatly reduces the ability of the Indian funds to hedge the risk caused by their over exposure to Indian securities and to make investments based on international conditions.

The success of a hedge fund lies in its ability to take quick decisions and information motivated trading strategies. The investment restrictions enumerated above goes against the investment philosophy of hedge funds and could undermine their success.

Another predicament for a foreign investor is the denial of pass through status to hedge funds for taxation purpose. While all other categories of AIFs are treated as pass through vehicles with their income being taxed directly in the hands of the unitholders, Category III AIFs are not accorded such treatment due to which a hedge fund would have to pay capital gains tax in India prior to making any distribution. This affects the ability of a foreign investor in a hedge fund to manage its tax outgo by appropriate tax planning.

Yet another issue that has plagued the Indian hedge fund industry is the lack of legislative clarity or certainty. For instance, while the SEBI in the AIF Regulations identified that hedge funds could utilize “diverse or complex trading strategies” and may invest or trade in securities having “diverse risks or complex products including listed and unlisted derivatives”, until recently, the SEBI used to instruct Category III AIF applicants to declare that they would not invest in commodity or currency derivatives. Even more disconcerting is the fact that there was no official notification from the regulator in this regard and the applicants were faced with this predicament only at the time of registration with SEBI. It is imperative that the regulators clearly notify the instruments in which hedge funds could invest for the investors to take an informed decision.

The above issues coupled with other long standing issues such as restriction on leverage makes the Indian hedge funds an unattractive avenue for foreign investments; and we may continue to witness global hedge funds shying away from the space and operating in India through the FPI route.