Alternative Investment Funds

INVESTMENT LAW

READING MATERIAL – NISHITH DESAI

ASSOCIATES’ PRIMER ON FUND OPERATIONS
 The VCPE Industry in India

Before the emergence of the VCPE industry in India, entrepreneurs largely depended
on private placements, public offerings and lending by financial institutions for
raising capital. However, these did not prove to be optimal means of raising funds.
Following the introduction of the VCF Regulations in 1996, the VCPE industry has
successfully filled the gap between capital requirements of fast- growing companies
and funding available from traditional sources such as banks, IPOs, etc. The VCPE
industry has also had a positive impact on various stakeholders –
 providing much needed risk capital and mentoring to entrepreneurs,
 improving the stability, depth and quality of companies in the capital markets, and
 offering risk-adjusted returns to investors.
The growth in VC funding in India can be attributed to various factors. Once the
Government of India started becoming more and more aware of the benefits of the
VC investments and the criticality for the growth of the different sectors such as
software technology and internet, favorable regulations were passed regarding the
ability of various financial institutions to invest in a VCF. Further, tax treatments for
VC Funds were liberalized and procedures were simplified.
 The VCPE Industry in India

Subsequently, in 2012, SEBI took steps to completely overhaul the

regulatory framework for domestic funds in India and introduced AIF
Regulations. Among the main reasons cited by SEBI to highlight its
rationale behind introducing the AIF Regulations are to
 recognize AIFs as a distinct asset class;
 promote start-ups and early stage companies;
 permit fund investment strategies in the secondary markets; and
 tie concessions and incentives to investment restrictions.
SEBI has adopted a practical grandfathering approach such that funds
that are already registered under the VCF Regulations would continue to
be governed by those regulations including for the purpose of raising
commitments up to its targeted corpus. However, existing venture capital
funds are not permitted to increase their targeted corpuses. Further, new
funds and existing funds that are not registered under any regime would
need to be registered under the AIF Regulations.
 Alternative Investment Funds

Subject to certain exceptions, the ambit of the AIF

Regulations is to regulate all forms of vehicles set up in
India for pooling of funds on a private placement basis.
An AIF means any fund established or incorporated in India
in the form of a trust or a company or a LLP or a body
corporate which:
 is a privately pooled investment vehicle which collects funds from
investors, whether Indian or foreign, for investing it in accordance with
a defined investment policy for the benefit of its investors; and
 is not covered under the Securities and Exchange Board of India
(Mutual Funds) Regulations, 1996, Securities and Exchange Board of
India (Collective Investment Schemes) Regulations, 1999 or any other
regulations of the Board to regulate fund management activities.
 Concepts

Corpus
 means the total amount of funds committed by investors to the AIF
by way of a written contract or any such document as on a particular
date
Debt fund
 means an AIF which invests primarily in debt or debt securities of
listed or unlisted investee companies according to the stated
objectives of the Fund
Hedge fund
 means an AIF which employs diverse or complex trading strategies
and invests and trades in securities having diverse risks or complex
products including listed and unlisted derivatives
 Concepts

Infrastructure fund
 means an AIF which invests primarily in unlisted securities or
partnership interest or listed debt or securitized debt
instruments of investee companies or special purpose vehicles
engaged in or formed for the purpose of operating, developing
or holding infrastructure projects
Private equity fund
 means an AIF which invests primarily in equity or equity
linked instruments or partnership interests of investee
companies according to the stated objective of the fund
 Concepts

Social venture
 means a trust, society or company or venture capital undertaking or limited
liability partnership formed with the purpose of promoting social welfare or
solving social problems or providing social benefits and includes,-
 (i)  public charitable trusts registered with the Charity Commissioner;
 (ii)  societies registered for charitable purposes or for promotion of science,
literature, or fine arts;
 (iii)  company registered under Section 25 of the Companies Act, 1956;
 (iv)  micro finance institutions
Social venture fund
 means an Alternative Investment Fund which invests primarily in securities or
units of social ventures and which satisfies social performance norms laid
down by the fund and whose investors may agree to receive restricted or muted
returns
 Concepts

Venture capital fund

 means an AIF which invests primarily in unlisted securities of start-ups, emerging
or early-stage venture capital undertakings mainly involved in new products, new
services, technology or intellectual property right based activities or a new
business model and shall include an angel fund
Venture capital undertaking
 means a domestic company:
 (i)  which is not listed on a recognised stock exchange in India at the time of making
investment; and
 (ii)  which is engaged in the business for providing services, production or manufacture
of article or things and does not include following activities or sectors:
 (1)  non-banking financial companies;

 (2)  gold financing;

 (3)  activities not permitted under industrial policy of Government of India;

 (4)  any other activity which may be specified by the Board in consultation with
Government of India from time to time
 Concepts

Sponsor
 means any person or persons who set up the AIF and includes
promoter in case of a company and designated partner in case
of a limited liability partnership
Manager
 means any person or entity who is appointed by the AIF to
manage its investments by whatever name called and may also
be same as the sponsor of the Fund
 Pooling Vehicles

The AIF Regulations contemplate the establishment

of funds in the form of
 a trust,
 a company,
 an LLP or
 a body corporate.
Trust
 Trust

Settlor
 The Settlor settles a trust with an initial settlement. Terms of the indenture of the
trust shall administer the functioning of the trust
Trustee
 The Trustee is in charge of the overall administration of the Trust and may be
entitled to a trusteeship fee. The Trustee may also appoint an investment manager,
who in turn manage the assets of the Trust and the schemes/ funds as may be
launched under such Trust from time to time. The Trustee is responsible for the
overall management of the Trust. In practice this responsibility is outsourced to
an investment manager pursuant to an investment management agreement.
Contributor
 The contributor is the investor to the Trust (the fund) and makes a capital
commitment under a contribution agreement
Market practice
 Almost all funds formed in India use this structure.
 Limited Liability Partnership

LLP
 The concept of LLP was recently introduced in India under the LLP Act. An LLP is a hybrid
form of a corporate entity, which combines features of an existing partnership firm and a
limited liability company (i.e. the benefits of limited liability for partners with flexibility to
organize internal management based on mutual agreement amongst the partners). The
functioning of an LLP is governed by the limited liability partnership agreement.
Partner
 A ‘partner’ represents an investor in the fund. A partner has an obligation to fund its
‘commitment’ to the fund and is entitled to distributions based on fund documents (being
the LLP Agreement in this case).
Designated Partner
 Although not expressly defined, this is understood to be the person responsible and liable in
respect of the compliances stipulated for the LLP.
Market practice
 Only a few funds are registered under this structure. The registrar of companies does not
favor providing approvals to investment LLPs.
 Company

Shareholders
Directors
Market practice
 There are no clear precedents for raising funds in a ‘company’
format in India.
 Categories of AIFs

Category 1
 Funds with strategies to invest in start-up or early stage ventures or social
ventures or SMEs or infrastructure or other sectors or areas which the
government or regulators consider as socially or economically desirable.
 These include:
 venture capital funds,
 SME funds,
 social venture funds,
 infrastructure funds and such other AIFs as may be specified.
 In September 2013, SEBI introduced ‘angel investment funds’ as a sub- class of
the venture capital fund sub-category.
 AIFs generally perceived to have positive spillover effects on the economy
and for which SEBI, the Government of India or other regulators may
consider providing incentives or concessions shall be classified as Category
I AIFs.
 Categories of AIFs

Category 2
 Funds which cannot be categorized as Category I AIFs or
Category III AIFs. These funds do not undertake leverage or
borrowing other than to meet day-to- day operational
requirements and as permitted in the AIF Regulations.
 AIFs such as private equity funds or debt funds for which no
specific incentives or concessions are given by the Government
of India or any other regulator are included in the Category II
AIF classification.
 Categories of AIFs

Category 3
 Funds which employ complex or diverse trading strategies and
may employ leverage including through investment in listed or
unlisted derivatives.
 AIFs such as hedge funds or funds which trade with a view to
make short-term returns or such other funds which are open
ended and for which no specific incentives or concessions are
given by the Government of India or any other regulator are
included in the Category III AIF classification.
 Restrictions for Category 1

Category I AIFs shall invest in investee companies or venture

capital undertakings or in special purpose vehicles or in limited
liability partnerships or in units of other AIFs specified in the
Regulations.
A Category I AIF of a particular sub-category may invest in the
units of the same sub-category of Category I AIFs. However, this
investment condition is subject to the further restriction that
Category I AIFs are not allowed to invest in the units of Fund of
Funds.
Category I AIFs shall not borrow funds directly or indirectly or
engage in leverage except for meeting temporary funding
requirements for more than thirty days, on not more than four
occasions in a year and not more than 10% of its investible funds.
 Restrictions for Category 1

Fund of funds
 An investment strategy of holding a portfolio of other
investment funds rather than investing directly in stocks,
bonds or other securities.
 This type of investing is often referred to as multi-manager
investment.
 Restrictions for Category 2

Category II AIFs shall invest primarily in unlisted investee

companies or in units of other AIFs as may be specified in
the placement memorandum;
Category II AIFs may invest in the units of Category I and
Category II AIFs. This is subject to the restriction that
Category II AIFs cannot invest in the units of Fund of
Funds;
Category II AIFs shall not borrow funds directly or indirectly
or engage in leverage except for meeting temporary funding
requirements for more than thirty days, on not more than
four occasions in a year and not more than 10% of its
investible funds
 Restrictions on Category 3

Category III AIFs may invest in securities of listed or unlisted

investee companies or derivatives or complex or structured
products;
Category III AIFs may invest in the units of Category I, Category II
and Category III AIFs. This is subject to the restriction that
Category III AIFs cannot invest in the units of Fund of Funds;
Category III AIFs may engage in leverage or borrow subject to
consent from investors in the fund and subject to a maximum limit
as may be specified by SEBI; and
Category III AIFs shall be regulated through issuance of directions
by SEBI regarding areas such as operational standards, conduct of
business rules, prudential requirements, restrictions on
redemption and conflict of interest.
 Key Themes

Continuing Interest
 The AIF Regulations require the sponsor or the manager of an AIF to contribute a certain amount
of capital to the fund. This portion is known as the continuing interest and will remain locked-in to
the fund until distributions have been made to all the other investors in the fund.
 For a Category I or Category II AIF, the sponsor or the manager is required to have a continuing
interest of 2.5% of the corpus of the fund or INR 5 crores whichever is lower and in the case of a
Category – III AIF, a continuing interest of 5% of the corpus or INR 10 crores whichever is lower.
 For the newly introduced angel investment funds, the AIF Regulations require the sponsor or the
manager to have a continuing interest of 2.5% of the corpus of the fund or INR 50 lakh whichever is
lower. Further, the sponsor or the manager (as the case may be) is required to disclose their
investment in an AIF to the investors of the AIF.
Minimum Corpus
 For any AIF, INR 20 crores
Minimum Investment
 At least INR 1 crore from each investor
 Unless such investor is an employee or a director of the AIF or an employee or director of the
manager of the AIF in which case the AIF can accept investments of a minimum value of INR 25
lakh
 Key Themes

Qualified Investors
 The AIF Regulations permit an AIF to raise funds from any investor whether Indian, foreign or non-
resident through the issue of units of the AIF.
 Accepting investments from non-resident investors requires approval from the FIPB.
Number of Investors
 For any AIF, capped at 1000
Tenure
 While Category I and Category II AIFs can only be close-ended funds, Category III AIFs can be open-ended.
The AIF Regulations prescribe the minimum tenure of three years for Category I and Category II AIFs.
 The tenure of any AIF can be extended only with the approval of two-thirds of the unit-holders by value of
their investment in the AIF.
Liquidity Facility
 In case any ‘material change’ (i.e., changes that SEBI believes to be significant enough to influence the
decision of the investor to continue to be invested in the AIF) to the placement memorandum is said to have
arisen in the event of (1) change in sponsor / manager, (2) change in control of sponsor / manager, (3)
change in fee structure which may result in higher fees being charged to the unit holders and (4) change in
fee structure or hurdle rate which may result in higher fees being charged to the unit holders, the existing
investors who do not wish to continue post the change shall be provided with an exit option and such
existing investors will be provided not less than one month for indicating their dissent.
 Taxation of AIFs

In response to a long-standing demand of the

investment funds industry in India, the Finance Act,
2015, extended tax pass-through status to AIFs that
are registered with SEBI as Category I AIFs or
Category II AIFs under the AIF Regulations.
Sec 115UB of Income Tax Act, 1961