By KT Chandy & Padmini Pai BH
Over the past decade, the Indian funds industry has witnessed remarkable growth, propelled by legislative support from the government to attract Indian managers. Alternative investment funds (AIFs) have emerged as pivotal players in this narrative, significantly empowering Indian fund managers to independently deploy substantial pools of capital raised globally. As of September 30, 2023, AIF investments soared to `3.5 trillion .
Securities and Exchange Board of India’s (Sebi’s) proactive efforts in nurturing and regulating AIFs has fostered an environment for growth and innovation in the industry. The government has acknowledged the potential of AIFs as catalysts for fundraising, both domestically and internationally. In the 2015 Budget speech, the finance minister permitted Foreign Direct Investment (FDI) in AIFs to enhance investments from various sources . This was followed by Reserve Bank of India’s (RBI) rules on FDI in AIFs.
Under the Foreign Exchange Management Act, 1999 (FEMA) rules, the classification of AIF investments as FDI or otherwise depends on the domicile and control of the manager/sponsor of the AIF. Under FEMA, if the manager /sponsor is owned and controlled by Indian residents, the AIF is considered as a resident AIF for FEMA purposes and can invest without any sectoral caps or restrictions. This classification remains applicable regardless of foreign Limited Partners (LP) in the AIF. This control-based approach aims to promote Indian managers and provide them with the flexibility to invest based on their strategies and risk assessment, irrespective of the composition of the investors. Clarity of the FDI regulations and Sebi’s continuous push to enhance AIF governance standards has created a top-class Indian manager pool with discretionary powers over the capital pooled in the AIF.
On January 19, 2024, Sebi issued a consultation paper on proposals to enhance trust in the AIF ecosystem. The regulator proposes to introduce obligations on AIFs, managers, and key management personnel (KMPs) to undertake specific due diligence to address circumvention of extant financial sector regulations by AIFs. The consultation paper envisages a framework under the regulations to monitor “circumventions”.
The proposal brings up three key questions: Should AIF regulations include this new requirement for due diligence by the manager? Do we need a framework and if yes, how can the framework be objective and robust? Lastly, extreme care must be exercised while finalising the framework.
Need for additional due diligence by fund manager
While Sebi’s proposal is well-intended, it risks introducing significant uncertainty into regulatory compliance processes. Assessing compliance with regulations is typically straightforward, but detecting “spirit” and circumvention is complex, highly subjective, and a binary answer almost impossible to get to. The proposal risks burdening fund managers with subjective assessments and a quasi-regulatory obligation which can impact the broader ecosystem including investors, investee companies, service providers etc.
For instance, the consultation paper refers to AIFs with a single investor and wonders whether such a structure facilitates circumvention of regulations. In practice, Indian AIFs frequently receive investments from foreign pooler funds. These pooler funds typically have multiple investors Formulating principles based on the assumption that a single investor indicates facilitation of circumvention might have unintended consequences and impact FDI flow into AIFs.
Framework: Oversimplification of complex issues?
Recognising the inherent subjectivity, the proposal aims to establish a guiding framework to identify instances of circumvention. While at a concept level, a framework does seem to be a good idea, its practical implementation requires careful consideration due to the diverse nature of the fund industry and its ever-changing dynamics. Creating a universally applicable, objective, and robust framework poses a significant challenge and risks oversimplifying complex situations and unconventional yet compliant structures. In this rapidly evolving and multifaceted industry, a “one size fits all” framework would likely sow more confusion than offer the intended clarity.
The framework, if created, should fundamentally align with Sebi and RBI regulations, which emphasise the pivotal role of the manager in AIFs. Requiring managers to consider factors beyond ownership and control, which demonstrate their discretionary powers, such as the presence of FDI, contradicts the control-based approach adopted by these regulations. Analysing factors like investor composition or investment sectors to detect potential circumvention would conflict with FEMA rules, rendering the control-based approach under FEMA redundant and can be viewed by investors and managers as a retroactive and detrimental step.
Again, the necessity for consultation is paramount. Finalising the framework demands extensive debate and solicitation of input not only from the fund community but also from relevant structural regulators. A framework constructed in isolation could significantly undermine the robust and expanding fund manager community.
The existing reporting frameworks are detailed and offer valuable insights to regulators for identifying cases that violate the regulations. Would an attempt to strengthen/enhance the existing reporting and compliances be more effective than new frameworks that could burden fund managers with onerous and possibly unclear obligations?
KT Chandy & Padmini Pai BH, respectively, tax partner & private tax co-leader, and tax director, EY India