AIF Regime - What's Next?

Published on Mon, Apr 16,2012 | 15:59, Updated at Mon, Apr 16 at 16:24Source : Moneycontrol.com

By: Tejesh Chitlangi, Finsec Law Advisors

The Securities and Exchange Board of India (SEBI), in its recent meeting has approved the proposal to frame SEBI (Alternative Investment Funds) Regulations, 2012 (AIF Regulations). SEBI in a press release issued post its meeting has provided for some of the salient features of the AIF Regulations, which are likely to be notified soon.

SEBI had earlier in August 2011 issued a concept paper and draft regulations on AIFs inviting public comments. A summary of the key features of the final AIF Regulations as stated in the press release has provided some relief and positive cues to the investment fund industry which was startled with the stringent set of norms proposed vide the earlier draft regulations. In light of a large number of industry representations/public comments criticizing the earlier proposed norms, SEBI seems to have taken those into account while approving the proposal to frame the AIF Regulations which are still under drafting but a big picture summary is available vide the press release.

Having said that, one still needs to wait for the final AIF Regulations to see if some of the hitches still remain unaddressed. This piece seeks to find out some of those possible concerns, a few practical problems which may arise due to the proposals which have already been approved (as reflected in the press release) and the way forward.

Before proceeding to the issues under contention, it would be useful to first quickly summarize the AIF categorization and registration norms under the new regime. The key departure from the existing SEBI Venture Capital Funds Regulations (VCF Regulations), which applies only to venture capital funds registered under it, is that registration as an AIF has now been made mandatory for all the entities raising funds for the purpose of making investments. The previous position was that one could register as a venture capital fund and subject itself to VCF Regulations, if one wanted benefits (from perspective of tax pass through status, certain takeover, IPO norms and of course the investor comfort of investing in a SEBI regulated entity) - thus making it seem that such registration was optional. The new AIF Regulations as per the press release will provide for three categories of AIFs. Category I AIF shall consist of those funds which require incentives/concessions from the regulators/Government as have an overall positive effect on the Indian economy (consist of Venture Capital Funds, SME Funds, Social Venture Funds and Infrastructure Funds) and at the same time will be subject to investment restrictions similar to those applicable on the existing venture capital funds under the VCF Regulations. Category II AIFs shall consist of private equity funds, debt funds, fund of funds and such other funds that do not require any specific incentives/concessions and forms a residual category of funds which do not classify either as a Category I or Category III AIF. Category III AIFs shall be more in the nature of domestic hedge fund structures which intend to use complex strategies or leverage which may pose a systemic risk and accordingly prudential norms and operational standards shall be prescribed for their operations.

Now coming on to the issues, First - the earlier proposed 9 categories of AIFs bothered the industry and the aforesaid 3 categories of registration at first glance seem to be reasonable. However, it still needs to be seen whether the new AIF Regulations completely leave the choice of selecting the appropriate category on the applicant (depending on whether or not such applicant is desirous of availing the concessions/incentives and subject itself to investment restrictions) or does SEBI has some say in prescribing the appropriate category to which the applicant belongs depending upon its investment objectives, strategy etc.

Second, nothing has been talked in the press release about one of the draconian provisions proposed in the draft regulations on AIFs regarding prohibition on in-specie distribution i.e. at the end of the tenure of the scheme if any investments remain un-liquidated; they being required to be taken up by the manager/sponsor of the AIF. Also, nothing has been mentioned in the press release about the earlier proposed mandatory requirement for investment managers/advisors of the AIFs to seek separate registration under a new regime governing them. Preferably, no separate additional registration for the managers/advisors should be prescribed as in any event they will have to qualify and fulfill the minimum qualifications as laid down by SEBI under AIF Regulations and will have to act within the set parameters while managing AIFs. Additional regulatory registration and oversight may be cumbersome and one needs to wait for the final AIF regulations to see what lies ahead.

Third, the press release states that SEBI will connect with the Government with an insistence to provide a tax pass through status for all the AIFs. However, whether or not the same will be available for Category II and Category III AIFs is to be examined. This is because only Category I AIFs would be entitled to incentives/concessions provided by the regulators/government but not the remaining two categories.

Fourth, it has been stated in the press release that the existing registered VCFs shall continue to be governed by the VCF Regulations (notwithstanding its proposed repeal from the date of notification of AIF Regulations) till the existing scheme/s is/are wound up. However, they cannot raise any fresh funds post the notification of the AIF Regulations except commitments already made by their investors. This seems to be a bit harsh as an existing VCF which has achieved only a first closing of say a quarter or half of its proposed fund size (fund size being informed to SEBI while making application for registration as a VCF) should ideally not be required to suddenly stop taking in new investors. Otherwise all the existing registered VCFs who have not yet achieved their remaining closings will have to shelve out their plans and set up a new entity to take new investors and raise the remaining targeted funds by registering it as an AIF (which will lead to a cumbersome exercise of running two parallel funds regulated under 2 separate regimes which otherwise could have been done in a single entity) or in the alternative, re-register as an AIF with the consent of 66.67% of their investors by value (which will again be a practical hardship as migration from one set of regulations to the other will require making of a fresh application, making requisite changes in their documentation, governance norms etc.). Preferably, SEBI should have allowed the existing VCFs to achieve their targeted fund raise in the scheme already launched under the VCF Regulations and continue to be governed by it. Let's see if the final AIF Regulations take care of this aspect.

Fifth, the press release states that the AIF Regulations will provide a mechanism for avoidance of conflict of interest. From a practical perspective, SEBI while drafting the new regulations should ensure that while providing the mechanism for 'avoidance of conflict' it does not end up removing the flexibility in operations or providing the norms which are too cumbersome to comply with. In today's world, conflict of interest is inevitable in any business activity and the same cannot be avoided but at the best can only be mitigated by prescribing disclosures and putting certain governance standards in place.

Some of the above uncertainties will only get clear once the final piece of AIF Regulations is notified. However, one should appreciate that the decisions taken by SEBI as summarized in the press release are reasonable compared to those originally proposed. For instance, the sponsor/manager contribution of 5% as proposed earlier has been reduced to 2.5% of the initial corpus or lower of 5 crore, which is a welcome move. Another good move by SEBI is to allow multiple schemes in an AIF which was earlier proposed to be prohibited. The new set of AIF Regulations, a glimpse of which can be seen in the press release, at least seem to be taking into account the fact that it's not SEBI's job to micromanage the investors.

On a final note, SEBI while notifying the new AIF Regulations should take into account the inconsistencies and uncertainties, some of which are highlighted above in this piece so that the Indian investment fund industry may breathe easy. As the devil lies in the details which are yet to be notified, so till then the wait and watch continues. With the likes of GAAR and retrospective tax amendment threatening to reduce the foreign inflows, the Indian economy's reliance on the onshore investment fund industry is going to increase more than ever and SEBI can finally play the hero here!!