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A primer on amendments made to AIF regulations

November 17, 2021
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SEBI

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This article is written by Nandeesh Nanda from Symbiosis Law School NOIDA. This article discusses the notice issued by SEBI for the reform in AIF regulations, dated 5 May 2021.

Introduction 

AIF or Alternative Investment Fund as the name suggests is an alternative to the conventional investment approach. It is different from stocks, debts, and similar securities.

The Alternative Investment Fund is a privately formed fund that has been created to let investors invest in pre-planned defined policies. These investors can be both Indian as well as foreign and it takes place through private participation. 

What are the AIF regulations

The notification of the SEBI (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”) on May 21, 2012, led to the approval and validation of alternate investment funds. AIF’s are regulated by SEBI ( Securities and Exchange Board of India) and such ventures must get themself registered. The collection of the funds can only occur on a private basis and not a public call such as for the issue of shares.  

AIFs are regulated as per the Regulation Act of SEBI, 2012. It is pertinent to be noted that although AIF seems similar to the lines of mutual funds they are not governed by SEBI (Mutual Funds) Regulations, 1996, SEBI (Collective Investment Schemes) Regulations, 1999, or any other regulations of the Board to regulate fund management activities.  

An AIF can take any legal form and can be incorporated as a company, a trust, an LLP ( Limited Liability Partnership), or even a body corporate. The trend reveals that most of the AIFs that are currently registered in SEBI have been established in the form of a trust. 

The maximum limit of investors that the Regulation Act allows is 1000 investors, however, if the AIF has been incorporated as a company, then the Companies Act 2013 comes into the picture and directs the provision of the members. Further, if the AIF is raising funds from its investor, then the AIF shall not accept an investment of less than one crore rupees. Also if the investors are employees or directors of the AIF, then the minimum limit is Rs.20 lakh . 

Now let us discuss the different categories of AIF and how applicants can enroll themselves under these categories. 

There are basically three categories of AIF and they are discussed as follows. 

Category I 

In accordance with Regulation 3(4), category I includes those AIFs that invest money of their  private investors in sprouting or early-stage ventures such as startups, or areas where regulators or the government seems economically or socially desirable. Certain sub-funds under category I are – Venture Capital funds, Angel funds, SME (small and medium-sized enterprises) funds, and infrastructure funds. Each sub-fund has its own minimum investment and a lock-in period. The lock-in period refers to the stipulated period within which the investments cannot be sold or redeemed. Some of these sub-funds carry a specific requirement that makes them differ from others such as 10 years of senior professional management role in case of angel funds, or 75% collective investment in the SME funds. 

Before explaining category II let’s skip to category III 

Category III 

Category III is considered to be an open-ended investment. It is a varied investment setup that invests in listed and unlisted derivatives. Derivatives simply put means shares, bonds, commodities, market indexes, currencies, and interest rates. They are less regulated and the government refrains from providing concessions or any incentives in these funds. These funds are mentioned in Regulation 3(4)(c).     

Various types of funds are registered under Category III and the most common ones are Hedge funds and PIPE (Private Investment in Public Equity) funds. Hedge funds are subjected to higher market volatility or variability and hence they produce high returns. Hedge funds are costly as the management team charges 19% of the investment as fees and also secures a stake in the profit up to 20%.  PIPE or Private Investment in Public Equity invests the funds into small and medium businesses. These investments are not secondary investments similar to shares and hence require less paperwork and less control. They are quick and include fewer formalities than an issue of share by a company. The fund managers tend to buy shares at a discounted price and help in the capital formation of the business. 

Category II 

Funds that do not fall in any of the above categories are termed category II funds. These funds don’t buy shares or borrowings, the funds are used to provide money for operational activities of other businesses such as real estate funds, private equity funds, funds for distressed assets, funds for funds, etc. They are mentioned in Regulation 3(4)(b).  

What are the amendments made to it  

Recently Alternate Investment Funds’ regulation has undergone a series of changes. SEBI (Alternative Investment Funds) (Second Amendment) Regulations, 2021 (Amendment Regulations) were released on 5 May 2021 which had led to some major changes and has allowed flexibility for the investors to be associated with multiple categories mentioned in the earlier part of the article, also a separate code of conduct has been formulated for better and professional functioning of the AIFs. There have been three major amendments after the notice of 5 May 2021 and they are as follows : 

  1. Flexible investments 
  2. Formal recognition of investment committee 

Introduction of a separate code of conduct Flexible investments   

According to the recent amendments, AIFs can freely make investments in other AIFs. Earlier , AIFs had to choose either to invest in an investee company or another AIF. This made them strictly adhere to the categories and be associated with them, however, this segmentation has been erased and instead of opting for one exclusively, AIFs can take both these courses of action. However, there should be proper disclosure under the Private Placement Memorandum (PPM) and with the consent of at least two-thirds of unit holders by the value of their investment in the AIF in terms of Regulation 9(2) of the AIF Regulations. Further, a list of information that needs to be broadcasted in the PPM has been mentioned, if the AIF invests in another AIF. The second development is inculcating Non-Banking financial companies (NBFC) into the scope of venture capital undertaking. The definition of venture capital undertaking, which is a category I investment, mentioned only companies providing goods or services or manufacturing. However, this definition has been broadened to include non-banking financial companies too. 

Formal Recognition of Investment Committee 

Investment committees have been duly active in aiding AIFs for their investment decisions and better functioning, SEBI acknowledged their existence by an amendment on October 19, 2020, however, the recent developments have turned out to be more empowering. 

The new amendment makes it mandatory to include the IC ( Investment Committee ) in the AIFs Placement Memorandum. Also earlier due to its ambiguous status, the investment committee and investment manager were kept on a similar pedestal, however, a separate structure has been created to hold the Investment committee accountable, providing it with more independence.

Further, if the members of the committee are externally recruited and are not mentioned in the Placement Memorandum, then the consent of 75% of investor members is required.

Introduction of a separate code of conduct  

These are given under Fourth Schedule, SEBI (Alternative Investment Funds) Regulations, 2012 [Regulation 20(1) and 20(9)]. Just like mutual funds, AIF is also now regulated by a code of conduct which is divided into various instructions that need to be followed by executives at all levels. The code is for various people that are either working in the AIF or simply associated with it. The code of conduct is drafted to address : 

(a) The AIF

(b) The manager and Key Management Personnel (KMP) of the manager and of the AIF

(c) The members of the IC, trustee/directors/designated partners of the AIF. 

Most of the code of conduct is similar to the one for mutual funds. An important exercise that the code of conduct promotes is transparency to the investors. According to the regulations, AIFs are required to frequently provide investors with crucial information, fund documents that have been promised as per the Private Placement Memorandum. The code of conduct also draws out the duties of Managers and Key Managerial Personnel (KMP); the code also tends to establish a system to resolve the conflict of interest among them. 

Impact of those amendments 

Collectively, such amendments were required to increase the credibility and reliability of AIFs as an investing vehicle.

A separate code of conduct adds professionalism and work ethic to the system. Also, it was a much-needed reform so as to keep mutual funds and AIF on a similar footing. The code of conduct also illuminates the relationship of the manager and Key Managerial Personnel. Further, it is mentioned in the Fourth Schedule of the AIF Regulations that KMP need not be a CEO, MD, CIO and can be a person with an equivalent role. Such reforms show the versatile functioning of the AIF and will bring a positive response from sophisticated investors by winning their confidence.

Conclusion 

AIF is an unexplored investment vehicle and with time SEBI has shifted its attention by reforming its Regulation Act and adhering to the advice given by various committees for better functioning of AIFs, one such being the Alternative Investment Policy Advisory Committee (AIPAC) under the chairmanship of Mr. Narayana Murthy in March 2015. Such active steps from SEBI keeps the investment arena a breeding ground for innovation. AIFs lacked viability due to a lack of code of conduct and the strict adherence to the existing categories that required a reform. It is still a long road and a cyclic submission of AIPAC reports (2015,2016,2017)  is a testimony to the fact that AIF is an emerging investment site.There has been a shift from conventional investment approaches and a genuine attempt from the government bodies to enhance the functioning of unconventional investment platforms builds an acceptance for such ventures.

References 

  1. https://www.mondaq.com/india/securities/1078404/amendments-to-the-aif-regulations-a-new-way-ahead
  2. https://www.google.co.in/amp/s/www.scconline.com/post/2021/06/28/amendment-to-sebi-alternative-investment-funds-regulations-2012/%3famp 
  3. https://www.sebi.gov.in/legal/regulations/jan-2021/securities-and-exchange-board-of-india-alternative-investment-funds-amendment-regulations-2021_48708.html 
  4. https://www.sebi.gov.in/sebi_data/attachdocs/1471519155273.pdf  
  5. https://www.wirc-icai.org/images/material/Regulatory-Framework-AIFs-India-10022018.pdf 

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