The much awaited AIF regulations governing registration and regulation of domestic pools of capital raised for investments into the Indian burgeoning equity and debt market have finally been notified in the Official Gazette of India. A study of the new regulations highlights certain issues which may need to be appraised by existing funds as well as those contemplated to be set up by various fund houses in the near future:
1. Distinction between venture capital and private equity: The PE / VC industry has always been fraught with the question regarding the distinction between private equity and venture capital. Venture capital is generally understood as early stage capital as compared to private equity capital provided to mid size companies which are getting dressed for an exit. Till now, the distinction between VC and PE, at least in the Indian context was more theoretical than practical, since most Funds were opportunistic and set up with a blurred focus of VC / PE investment. Recently, India also saw a surge of Growth Funds being set up, the main focus of these Funds being to provide risk capital to companies in their expansion stage, and which are experiencing rapid revenue growth. It would be difficult to characterize such investments as VC or PE investments.
The AIF Regulations have defined a VC Fund to mean a Fund which invests primarily in unlisted securities of start ups, emerging to early stage venture capital undertakings mainly involved in new products, new service, technology or intellectual property right based activities or a new business model. PE Fund on the other hand has been defined to mean a Fund which invests primarily in equity or equity linked instruments or partnership interests of investee companies according to the stated objective of the fund. This distinction is germane simply due to the fact that a VC Fund is registered as a Category I AIF, while a PE Fund would fall within the purview of Category II. The newly segregated focus of VC and PE investment could result in the following issues for consideration:
a. Category I Funds are eligible for certain benefits which have till recently been available to all Funds registered with SEBI under the erstwhile SEBI (VCF) Regulations. These include, exemption from lock in at the time the investee company lists on the stock exchange, provided these shares have been held for a period of at least one year, exemption from triggering open offer under the SEBI Takeover Code where shares in the target are purchased by promoters from Category I Funds, availability of pass through status under section 10(23FB) of the Income Tax Act, 1961, etc. From a tax perspective, PE Funds may still be able to achieve a single level of taxation under separate provisions of the Income Tax Act, 1961, and thus may not be very worried about not achieving a tax pass through specifically provided to VC Funds.
b. Further, a foreign venture capital fund (FVCI) may be able to invest directly into Indian securities or only into a Category I AIF (VC Fund) going forward. Thus, unified structures may be a thing of the past for PE funds, whereas Category I VC Funds may still be able to implement such structures. This may result in Category II PE Funds following a parallel structure whereby the domestic PE Fund would co-invest alongwith the FVCI entity set up in an offshore jurisdiction.
c. A VC Fund under the new regime is subject to certain restrictions, which include investment restrictions (investment of at least 66% of the corpus in equity or equity linked instruments), adherence to the negative list, etc. A PE Fund may however not be subject to such restrictions and could albeit now invest even in debt instruments or in NBFCs. In the earlier regime, Funds which could not meet the restrictions under the VCF Regulations, were set up as unregistered ‘Private Equity Funds’ or a ‘Debt Funds’ which ultimately invested across various sectors and stages of investment. These Funds will now benefit from the new regime by being able to register themselves with SEBI and also consequently provide comfort to institutional investors who prefer to invest only in regulated Funds.
d. A related complexity could arise for those Funds which do not follow a strict VC/PE approach. The AIF Regulations provide for registration only under one Category, and hence these Funds may have to decide their investment strategy, or set up two schemes under one Fund umbrella with two separate registrations with SEBI. The investment criteria (viz. number of investors, GP commitment, minimum investor commitment, etc) will apply to each scheme separately in such a case. While SEBI may permit switching between different categories with specific approval, multi stage investment strategic Funds may still need to set up separate schemes.
2. Increased GP Burden: The AIF Regulations require the Manager to make a GP Commitment of at least 2.5% of the corpus of the Fund, or INR 5 crores, whichever is lower. The industry norm of offsetting the GP Commitment from the management fees is also not permitted. However, the removal of the erstwhile requirement in the draft AIF Regulations for the Manager to buy out the investments at the time of winding down the AIF, is a welcome move. The key investment team of the Manager should also have adequate experience, with at least one key personnel having not less than 5 years of fund management experience, alongwith relevant professional qualifications. Practically, SEBI has always considered relevant experience of Fund Managers while granting approvals under the erstwhile VCF Regulations. These conditions may not be very onerous, and may be quite easily met by most Fund houses, nevertheless, may need to be kept in mind.
The AIF Regulations bring along with them a heavy burden on the Fund Manager to make detailed reporting to the Investors. Venture capital is a high risk investment meant only for sophisticated Investors. Till now, the Manager was not saddled with any mandatory reporting responsibilities to the Investors. The Manager will now have to make detailed reports to its Investors specifically with respect to financial, risk management, operation, portfolio and transactional information regarding fund investments. Valuation of investments will be required to be done at least once every six months, and a description of the valuation and methodology adopted, will need to be provided to the Investors. Also novel is the requirement to set up a dispute resolution procedure through arbitration or any other mechanism. The Manager will also be required to maintain internal records describing inter alia rationale for investments made and investment strategies followed. A custodian will be required to be appointed if the fund corpus exceeds INR 500 crores. Such increased compliances will increase the organizational expense, which may go on to reduce the return to the Investors.
3. Investor Power Augmented: The AIF Regulations also seek to empower Investors by giving them certain rights in the Fund. For instance, in a Category II Fund, leveraging will be permitted only with consent of the Investors. Further, any material alteration in the Fund strategy will require consent of at least 2/3 in value of Investors, change in the frequency of reporting from once in six months to once a year will require approval of at least 75% in value of Investors, and so will an investment in associate entities. 75% in value of the Investors will also have the power to wind up the Fund, and also determine in specie distribution of the assets of the Fund. While the latter authority always resided with Investors by virtue of the VCF Regulations, the other types of rights (as well as the deciding percentage of Investors) were typically decided by Fund Managers based on the commercial negotiations between the Manager and the Investors. These may now be governed by the threshold provided in the AIF Regulations.
4. Existing funds: Henceforth, all Funds operating in India will need to be registered with SEBI. Existing unregistered Funds will be permitted to operate for a period of six months within which they will be required to make an application to SEBI. Otherwise, they will be required to wind up. Further, fresh money would not be permitted to be raised other than commitments already made during this period of six months. Once registered, these Funds will be required to operate within the ambit of the AIF Regulations, though SEBI may grant special exemptions in select cases. Thus, these Funds will have to follow the strict compliance procedures laid down by SEBI. Existing Funds registered with SEBI under the VCF Regulations are however grandfathered till end of their tenure with a restriction on increasing targeted corpus / launching new schemes. However, these VCFs also have an option to re-register as AIFs subject to Investor approval. While most VCFs may prefer to be governed by the erstwhile VCF Regulations, re-registering as a Category II AIF could be beneficial since these AIFs may not need to adhere to the investment restrictions applicable to VCFs and would also be able to invest in sectors like NBFCs and gold financing. Thus, existing VCFs may need to evaluate such benefits vis-à-vis the cost of giving up VCF benefits.
5. Carry trusts: The term AIF has been defined generically to mean any Fund established in the form of a privately pooled investment vehicle which collects funds from Investors. However, employee welfare trusts set up for the benefit of employees are specifically excluded from the purview of the AIF regime. This means that any trusts or pooling vehicles set up to incentivize employees will not be required to register with SEBI. Traditionally, Fund structures have set up carry trusts for providing a share in the carried interest to their employees. Employees have an opportunity to earn a disproportionate return on their investments, part of which would be their share in the carried interest. With these new Regulations, combined with the advent of the General Anti Avoidance Rule (GAAR), there may be more uncertainty on taxation of returns from carry trusts.
On the whole, the new AIF Regulations are a step in the right direction. They will increase Investor confidence and monitor funds which till now have been unregulated. On the flip side, Fund Managers may need to chalk out their investment strategy and plans well in advance in order to determine the right category for registration, since the Regulations may not give them enough flexibility to change the registration at a later date.
(Shefali Goradia is the partner and Parul Jain is the director at BMR Advisors.)