The SEBI Alternative Investment Funds Regulations which were introduced in 2012, made a complete upheaval of the existing set of regulations relating to private funds in India, with respect to plugging the lacunae of the erstwhile SEBI (Venture Capital Fund) Regulations, 1996 (VCF Regulations), and also ensuring a minimal intervention approach, given the fact that unlike mutual funds, AIFs mostly dealt with the non-retail investor segment, primarily comprising sophisticated investors – HNIs and institutional investors – who are well informed and attuned to adopting higher risk-return strategies.

The year 2020 can well said to be a landmark year for AIFs on the regulatory front, with several noteworthy changes having been brought about by SEBI, India’s capital markets regulator. These regulatory changes are reflective of broader changes taking place in the AIF industry, given its unprecedented growth especially in the past decade: as of September 30, 2020, there were 693 AIFs overseeing over INR 4 trillion in investor commitments, as against 168 AIFs with INR 0.3 trillion in commitments as of September 30, 2015, reflecting an impressive ~15x growth during the interim period. Regulatory amendments in 2020 chiefly focused on ushering in a much needed transparency to the sector by standardising contents of offer documents and requiring compulsory performance reporting by AIFs; improving governance by mandating PPM audits and expanding responsibilities of the investment committee members; as well as operational changes such as collection of stamp duty on AIF units and further relaxations to operational aspects for IFSC-based AIFs. This article summarises key regulatory updates that took place during the calendar year 2020.

Improved Disclosure Standards by AIFs

The first set of the changes were brought about by SEBI vide circular dated February 06, 2020 titled “Disclosure Standards for Alternative Investment Funds” which covered three broad aspects, viz:

• Private Placement Memorandum (PPM) Standardization
• PPM Audit
• Benchmarking of AIFs

AIFs being privately pooled investment vehicles, the PPM becomes a cardinal document for prospective investors to make informed decisions. In the absence of a standardized format, contents of the PPM were left to the sole discretion of fund houses, resulting in considerable variation in the format of PPMs submitted with SEBI: while some had an overload of information that is not easily comprehensible, others did not divulge much, leading to a dearth of meaningful information available for investors to review. SEBI vide the circular stated supra, introduced a standard template for PPMs which is divided into two parts: (i) a minimum disclosure section which is mandatory, and (ii) a supplementary section for providing additional information as deemed necessary by the AIF, thereby providing much-needed flexibility to AIFs to provide the necessary information to investors, while meeting certain mandatory information standards.

Given the importance of the PPM, it becomes imperative that the covenants captured in the PPM are followed by the AIFs in true letter and spirit. Hitherto, funds would share the PPM with prospective investors at the time of investment and thereafter whenever there were non-material changes, a copy of these amendments was shared with investors; and when the proposed changes were material, prior investor consent was obtained before carrying out the said amendments. This was the only arrangement with investors vis-à-vis the PPM document per se. There was no mechanism to corroborate that the covenants of the PPM have been complied with by the AIF manager. SEBI, by mandating an independent audit of compliance with the terms of PPM has given investors a cushion of comfort, as well as enforcing a deserving layer of transparency and governance on AIF managers. This being the first year of audit, the general view on the process and efficacy of the PPM audit will be known and learnings and shortcomings therefrom can be addressed in forthcoming periods.

Despite significant growth, the Indian AIF industry has traditionally remained opaque with not much of disclosures being by AIFs regarding their performance or return on investments. SEBI in a major move to infuse transparency into AIF performance reporting, made it mandatory for performance benchmarking of AIFs from October 2020. Prior to such benchmarking becoming mandatory, it was common for fund houses to disclose their returns only to existing/prospective investors and that too, on standalone basis without drawing reference to any industry benchmark, simply because there was no comparable benchmark. As a result, AIFs adopted diverse and at times innovative benchmarks to compare their performance, leading to a dissimilarity in information available to investors for any meaningful comparison, as well as leaving an avenue for potential mis-selling of the fund to investors. Consequently, SEBI deemed it appropriate to develop an industry benchmark to compare the performance of AIF industry against other investment avenues, as also global investment opportunities. The performance benchmarking aims to facilitate dissemination of necessary information on industry performance so that investors are able to compare individual AIF’s performance with the overall industry performance or performance against a peer-group set of AIFs, thereby improving the overall disclosure standards of the Indian AIF industry.

Highlights of the Benchmarking framework are as follows:

• Keeping with the guidelines mentioned in the circular stated supra, the Indian Private Equity and Venture Capital Association (IVCA) appointed CRISIL as the benchmarking agency.
• CRISIL AIF Benchmarks represent the performance of the respective AIF categories at an aggregate level. They are presently available at a category level, i.e. Category I, II and III.  Sub-category level and sector-specific benchmarks are expected to be created going forward.
• Benchmarks are calculated both in rupee and US dollar terms and are available at a category level based on the vintage year of the fund. For returns in dollar terms, all cash flows, valuations and index values are converted to US dollar based on Reserve Bank of India’s reference rates for the respective dates. Returns for all three categories are on a post-expenses, pre-carry and pre-tax basis.
• Only those AIFs that have completed one year from the first close of the scheme as on the date for which the benchmarks are calculated were included for the benchmarking exercise.
• The first industry benchmark and AIF level performance versus Benchmark Reports were made available for the performance upto September 30, 2019. In the first stage, those AIFs launched after April 1, 2012, including existing schemes and those that have already matured and proceeds repaid to investors, schemes that have completed at least one year from the date of first close were factored.
• Performance Benchmarking shall be on a half-yearly basis, i.e., benchmarks will be published every six months as of September 30 and March 31. 
• In the PPM, as well as in any marketing, promotional or other material, where past performance of the AIF is mentioned, the performance versus benchmark report provided by the Benchmarking Agencies for such AIF/Scheme shall also be provided
• In any reporting to the existing investors, if performance of the AIF/Scheme is compared to any benchmark, a copy of the performance versus benchmark report provided by the Benchmarking Agency shall also be provided for such AIF/scheme.
• If any AIF seeks customized performance reports in a particular manner, the same may be generated by the Benchmarking Agencies, subject to mutually agreed terms and conditions.

Moving on to the next initiative, the Stewardship Code (the “Code”) which was introduced by SEBI in December 2019, was to come into effect from April 1, 2020, but on account of the COVID-19 pandemic, the Regulator had extended the timelines for compliance with the same. The Code, which is a globally accepted best practice, enunciates a set of good corporate governance practices aimed at strengthening investor protection. The code is applicable to AIFs with respect to their investments in listed equities, and inter alia prescribes active engagement with investee companies on various governance related matters including corporate governance, environmental, social and governance (ESG) matters. The implementation of the Code ushers in greater accountability on all institutional investors and by extending the applicability of the Code to the AIF Industry, the Regulator has left no stone unturned in ensuring that the interests of ultimate beneficiaries of the capital markets are well protected. Furthermore, participation of entities in the Stewardship Code reassures investors that their interests are of foremost importance.  

Collection of Stamp Duty on Issue, transfer and sale of units of AIFs

SEBI had vide circular dated June 30, 2020 prescribed modalities for collection of stamp duty on issue, transfer and sale of units of AIFs. Issuance of AIF units will attract a stamp duty of 0.005% of the value of units while transfer of units will attract a stamp duty of 0.015%. Redemption of units, being neither a transfer, issue nor a sale, is not liable to any duty.

The AIF Regulations prescribe a minimum capital contribution of INR 1 crore from each investor. The stamp duty levy on issuance/ transfer of AIF units puts an additional cost on the investors, reducing the net amount available for investment and, consequently impacting the return on capital. Stamp duty for AIF transactions in physical form (i.e., Statement of Account form) will be collected by the Registrar and Transfer Agent (RTA) acting as collecting agent and transaction in demat form will be collected by Stock Exchange/authorized Clearing Corporation or a Depository. AIFs who have not appointed RTAs were required toappoint an RTA to enable collection of stamp duty on issue, transfer and sale of units of AIFs in compliance with the applicable provisions of Indian Stamp Act, 1899 and Rules thereto.

Qualification of the Investment Team and responsibilities of Investment Committee members (Amendments to SEBI AIF Regulations; October 19, 2020):

One of the amendments brought about by the SEBI (Alternative Investment Funds) (Amendment) Regulations, 2020 is on the eligibility criteria for grant of AIF Registration. The Regulations previously required that the key investment team of the AIF Manager to have adequate professional experience and relevant professional qualification for being construed as eligible. While emphasis was laid on the quantum and type of experience, there was no specifications made on professional qualifications. The Amendment has now spelt out the streams that would qualify for ‘relevant professional qualification’.

The other amendment is a new addition to the General Obligations, Responsibility and Transparency of AIFs. The amendment seeks to hold the investment manager responsible for the investment decisions of the AIF. Further, the proviso to the sub regulation (6) of Regulations (20) permits the investment manager to constitute an investment committee to sub delegate the function of taking investment decisions. The amendment further seeks to pin the onus on the investment manager and members of the investment committee w.r.t the decisions taken and holding them accountable for ensuring that provisions of the Regulations and covenants of the PPM are complied with. The amendment also mandates that at least 75% investor approval (in terms of value of investment) be sought for reconstituting the investment committee with external members post onboarding of the investors.

Relaxations for IFSC-based AIFs

After SEBI’s decision last year to permit AIFs to operate from the International Finance Services Centre (IFSC), active discussions have been underway to provide regulatory headroom for local AIFs to explore and innovate fund structures, and make India a competent jurisdiction as compared to traditional offshore jurisdictions such as Singapore and Mauritius. This year witnessed two regulatory announcements aimed at improving the operational ease of functioning/compliance for AIFs in IFSC. Earlier this year, the Central Board of Direct Taxes exempted all non-residents and foreign companies from the mandatory requirement for obtaining a permanent account number (PAN) with respect to the AIF investments. Accordingly, non-resident investors making an investment in an ISFC-situated AIF need not obtain PAN if: (i) the non-resident does not earn any income from India, other than the income from the said AIF investment, (ii) the tax due on the said investment has been deducted at source by the AIF and remitted to the authorities, and (iii) the non-resident furnishes such information (contact details, declaration of residence, tax identification number at their country of residence, etc.) as prescribed by the Income Tax Rules.

In December 2020, the International Finance Services Centre Authority issued a pathbreaking circular making some significant relaxations to its operating guidelines for AIFs situated within IFSC. Accordingly, IFSC-domiciled AIFs:

• can borrow funds or engage in leveraging activities, so long as: (a) the maximum leverage and the methodology of calculation thereof is disclosed in the PPM, (b) investor consent is obtained, (c) the AIF has a comprehensive risk management framework in place, commensurate to its size, profile and complexity.
• are exempted from investment caps for investing in any single entity (maximum 25% of investible funds, for Category I and II AIFs; and 10% for Category III AIFs), so long as the AIF makes appropriate disclosures in the PPM and such investments are in line with the risk appetite of its investors
• co-invest in a portfolio company through a segregated portfolio by issuing a separate class of units, provided that the PPM makes appropriate disclosures regarding creation of the segregated portfolio, and such investments are not on more favorable terms than those offered to the common portfolio of the AIF
• Invest in another AIF registered in India, alongside other permissible investments.

Conclusion:

The regulatory ambit in the last few years may have well moved from a minimal intervention model to a more demanding framework, but one needs to keep in mind the larger picture. The regulatory changes in the AIF front has paved the way for building not only a strong core for the Industry but a robust model that can address and adapt to the dynamic needs of the capital markets in the years to come.

The contents of this article are intended merely as a general overview of the subject matter and is not to be construed as any form of legal advice or investment recommendation.

Source/ Citation:

1. SEBI Consultation Paper on Introduction of Performance Benchmarking and Standardization of Private Placement Memorandum for Alternative Investment Funds
2. SEBI Concept Paper on Proposed Alternative Investment Funds Regulation
3. SEBI Circular SEBI/HO/IMD/DF6/CIR/P/2020/24 dated February 05, 2020
4. SEBI Circular SEBI/ HO/IMD/DF6/CIR/P/2020/113 dated June 30, 2020
5. SEBI Circular CIR/CFD/CMD1/168/2019 dated December 24, 2019
6. SEBI (Alternative Investment Funds) (Amendment) Regulations, 2020
7. CRISIL AIF Benchmarking Reports of September 30, 2019
8. IFSCA Circular F. No. 81/IFSCA/AIFs/2020-21 dated December 9, 2020

Author

Nrithya Ganam, Pratik Kothari, Cyril Paul