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AIFs Allowed To Invest Overseas! Half Baked Reform?

Published on Wed, Dec 17,2014 | 09:30, Updated at Wed, Dec 17 at 09:35Source : 

AIFs Allowed To Invest Overseas! Half Baked Reform?

By: Sandeep Parekh, Founder, & Shashank Prabhakar, Senior Associate, Finsec Law Advisors

The Reserve Bank of India has issued a Circular dated December 9, 2014, permitting SEBI registered alternative investment funds ("AIFs") to invest overseas, in accordance its Circular No. 49 dated April 30, 2007 and Circular No. 50, dated May 4, 2007 (the 2007 Circulars). The RBI, by its 2007 Circulars had allowed domestic venture capital funds, registered with SEBI under the SEBI VCF Regulations, 1996, to invest only in equity and equity-linked instruments of off-shore venture capital undertakings, subject to an overall limit of US$ 500 million for all VCFs collectively. Registered VCFs interested in investing in equity and equity linked instruments of off-shore VCUs were required to obtain prior approval of the SEBI, but no prior approval of the RBI was required. The 2007 Circulars stipulated that SEBI would provide limits to individual VCFs investing in off-shore VCUs.

The 2007 Circulars followed the amendment made to Regulation 12 (b) of the SEBI VCF Regulations, which introduced Regulation 12(ba) allowing VCFs to invest in securities of foreign companies, subject to such conditions or guidelines laid down by SEBI or RBI, from time to time. Subsequently, Regulation 39 of the SEBI AIF Regulations, 2012 has repealed the SEBI VCF Regulations. New VCFs are now required to be registered with SEBI as “Category I Alternative Investment Fund – Venture Capital Fund,” under the AIF Regulations. The SEBI has carried through Regulation 12 (ba) of the erstwhile VCF Regulations in Regulation 15(a) of the AIF Regulations. Needless to state, investment by AIFs in off-shore VCUs would also be subject to other investment conditions laid down under Regulation 16 of the AIF Regulations.

Prior to the issuance of the Circular, there was no provision in the Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, 2004 (FEMA ODI Regulations) and its circulars, which specifically enabled AIFs to invest in instruments or securities issued by overseas entities. In that sense, the Circular has now fully enabled AIFs to invest overseas without any further amendments required to be carried out to the AIF Regulations.

However, the investment opportunities made available to registered AIFs through the Circular are quite narrow in scope given that the 2007 Circulars only allow investments in equity and equity-linked instruments of off-shore VCUs. Regulation 2(aa) of the AIF Regulations defines a VCU only from the perspective of a domestic company. The AIF Regulations do not shed any light on what would constitute an “overseas VCU” or as to whether the parameters would be any different from what has been specified in the definition under the AIF Regulations. It has to be kept in mind that the 2007 Circulars were issued specifically to domestic VCFs, registered with SEBI, under the erstwhile VCF Regulations. The AIF Regulations now cover not just VCFs but other investment funds, social sector funds, infrastructure funds, private equity funds, hedge funds, etc. The rationale for limiting investment opportunities for such AIFs only to equity and equity linked instruments of off-shore VCUs is not clear and the Circular also does not provide any reasons for such a limitation. The only explanation of such a restriction for domestic pools is that the requirements were copy pasted from the old provisions. While it may be justifiable to restrict a VCF to invest only in off-shore VCUs, there is no reason why a private equity fund or hedge fund registered in India should not be allowed to invest in instruments issued by off-shore funds or other off-shore entities.

Further, given the range of funds that the Circular applies to, the overall limit of US$500 million appears to be too small. As of today, there are more than 100 AIFs registered with SEBI. Theoretically, if all the 100 AIFs would want to invest in off-shore entities, it would potentially leave them each with room to invest less than US$ 5 million. Additionally, the requirement of having to obtain prior approval from SEBI could potentially be time consuming and a dampner. There is no requirement for the AIFs to obtain prior approval for their investments in onshore entities in the AIF Regulations. The FEMA ODI Regulations allow Indian entities to invest under both automatic and approval routes. Entities investing overseas under the approval route are required to obtain prior approval of the RBI. It is quite strange that the RBI has allocated the responsibility of granting prior approval to SEBI in what is essentially a foreign exchange transaction, which falls within the exclusive domain of the RBI under the Foreign Exchange Management Act. The Circular also does not stipulate any parameters for SEBI to follow while granting approval.

All these factors add up to making it seem like the Circular is unattractive and very conservative in its approach. One hopes that the RBI would be willing to consider these factors and make the required changes to the Circular.


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