WHITE PAPER: ALTERNATIVE INVESTMENT FUNDS

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1 WHITE PAPER: ALTERNATIVE INVESTMENT FUNDS BIRD S EYE VIEW As on March 31, 2016, 209 Alternative s (AIF) have been registered with SEBI 1 with many more in the pipeline. The cumulative investments by the AIFs exhibited an escalation of about 29.97%, recording investments in excess of INR 18,200 Crore till the end of first quarter of The AIF industry has been fast growing and with the recent amendment in exchange control regulations with respect to AIF, it is expected to see a dramatic shift in the quantum of investments made by AIFs. Formally, domestic pooling of investments was done in accordance with SEBI (Venture Capital ) Regulations, 1996 ( VCF Regulations ) by the VCFs. However, this regime had a lot of uncertainties and regulatory oversight. Thus, in order to overshadow the lacuna and challenges that the erstwhile VCF Regulations provided for, SEBI introduced SEBI (Alternative Vehicle) Regulations, 2012 (AIF Regulations) to govern all such kinds of domestic funds and to open up market for more complex structures such as hedge funds. Thus, with advent of AIF Regulations, VCF Regulations have been repealed. However, AIF Regulations have a grandfathering provision wherein all the existing registered VCF continue under VCF Regulations until wound up provided no new scheme shall be launched and there is no increase in targeted corpus after May 21, 2012 or may seek re-registration as an AIF if approved by two-thirds of investors by value. Diagrammatic representation of various Pooling Vehicles MF SEBI (Mutual ) Regulations, 1996 AIF SEBI (Alternate Trusts) Regulations, 2012 Domestic Pooling Vehicles InVITs SEBI (Infrastructur e Trusts) Regulations,2 014 CIS SEBI (Collective Scheme) Regulations, 1999 REITS SEBI (Real Estate Trusts) Regulations, ampaign=cppst 1

2 REGULATORY FRAMEWORK WHAT ARE ALTERNATIVE INVESTMENT FUNDS AIF is a privately pooled investment vehicle that collects funds from investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors. AIFs does not cover s covered under SEBI Mutual Regulations and SEBI Collective Schemes Regulation, Family Trust, ESOP Trust, Employee Welfare Trusts, Holding Companies as per Companies Act, or any pool which are directly regulated by any other Indian Regulator. FORMS OF SETTING UP OF AN AIF As per the AIF Regulations, an AIF may be established or incorporated either in the form of a trust or a company or a limited liability partnership or a body corporate. Based on various considerations such as foreign investments, tax, compliance one needs to decide the investment vehicle. Set out below is a preliminary comparative analysis: Parameter Trust Company LLP Governing Act Meaning Managing entities Regulatory Compliances Indian Trust Act, 1882 Companies Act, 2013 or erstwhile Companies Act, 1956 as applicable Trust as an obligation annexed to the ownership of property, and arising out of a confidence reposed in and accepted by the owner, or declared and accepted by him, for the benefit of another, or of another and the owner. Company incorporated under the provisions of Companies Act, 2013 or under the erstwhile Companies Act, Limited Liability Partnership Act, 2008 An LLP is a hybrid form of a corporate entity, prescribing limited liability for partners with flexibility of governing the rights and duties of partners as per the LLP agreement. Trustee Board of Directors Designated Partners Low High High Winding Up Simple Complex Moderate CATEGORIES OF AIF AIFs shall seek registration under any one of the following categories: 2

3 AIF Categories Category I* Category II (Residual Category) Category III** SME s Social Venture VCF Infrastructu re Angel PE Debt Hedge *Areas which govt. consider as socially or economically desirable and incentives are given ** Employs diverse or complex trading strategies. No specific incentives or concessions given Upfront selection at the time of filing application; Change permitted subject to SEBI s approval INVESTMENT CRITERIA: There are certain general criteria prescribed under the AIF Regulations for investments in AIF for the AIF categories. Parameters Category - I Category II Category - III Min. Size 20 crores Min. Capital Commitment in Associate Company Min. Tenure Max. Number of Investors Solicitation Experience of the Manager Condition for co-investment Change of control QIB Status INR 1 crore INR 25 lakhs: minimum value of investment by employees or directors of the AIF or Manager not permitted except with 75% of the investor approval by value Close ended AIF shall have minimum tenure of 3 (three) years per scheme Only by way of PPM At least one key personnel of the Manager should have minimum experience of 5 years. not be on terms more favorable than for AIF/scheme Prior SEBI approval will be required for change in control of AIF, Sponsor or Manager AIFs have been accorded the status of QIB 3

4 Restrictions Borrowings Sponsor Commitment Nominated Investor (NI) Insider Trading Valuation Daily reporting of leverage to custodian Shall not invest more than 25% of its corpus in one investee company. Invest in units of Category I AIF and not in units of other funds of funds. Invest in Unlisted investee co. Units of Category I & II AIF, except for units of other funds of funds. Not to borrow funds or leverage except to meet temporary funding requirements. Continuing interest of the manager or sponsor amounting to 2.5% of the corpus or INR 5 Cr whichever is lower. Considered as NI under SEBI (ICDR) Regulations, 2009 Exempt from Regulation 3 and 3A of SEBI (Insider Trading) Regulations for investment in companies listed on SME Exchange or SME segment of an exchange after due diligence subject to: Disclosure of any dealing in securities, within 2 days, to the stock exchanges where the company is listed; and 1 yr lock-in. These provisions are not applicable to Social Venture s or Infrastructure s Valuation by an independent valuer at least once in every 6 months. Can be enhanced to one year, if approved by at least 75% of the investors in value terms Not applicable Shall not invest more than 10% of its corpus in one investee company. Invest in Units of Category I & II AIF, except for units of other funds of funds; securities of listed or unlisted investee co.; derivatives or complex or structured products. May leverage or borrow (subject to Investors consent & max limit specified by SEBI). Continuing interest of the manager or sponsor amounting to 5% of the corpus or INR10 Cr whichever is lower. No Exemption Disclose NAV at quarterly intervals for close ended fund & monthly intervals for open ended funds 3. Yes in prescribed format In addition to the above conditions, following are certain specific investment criteria applicable to category I AIFs: 3 NAV Calculation to be independent from the fund management function 4

5 s Venture Capital s SME s Social Venture s Infrastructure s Category I AIFs Conditions - Min. 2/3rd investment in unlisted equity linked instruments of VCUs 4 ; - Min. 2/3rd investment in listed or to be listed companies on SME exchange; - Max.1/3rd investment in IPO subscription of VCU; - Max 1/3rd investment in debt or debt instruments; - Max. 1/3rd investment in preferential allotment (1 yr lock-in); - Max 1/3rd investment in SPV of fund for facilitating investments - Max 1/3rd investment in equity or equity-linked instruments of financially weak company or listed sick companies Min 75% investment in unlisted securities of VCU or SMEs or companies listed or proposed to be listed on SME exchange; - Min 75% investment in unlisted securities of social ventures; - Permitted to give and accept grants to social ventures; - Permitted to accept muted returns - Min 75% investment in unlisted securities of VCU, co. or SPVs engaged in infrastructure projects - Invest in listed, securitized debt instruments or listed debt securities of companies or SPV, engaged in infrastructure projects WHO CAN INVEST IN AIFs: With an objective to attract offshore and domestic investors the following categories of investors are eligible to make investments in AIF subject to prescribed conditions. NR Resident Individuals NRI Investors Resident Companies (Insurance Co., Banks) FPI FVCI 4 Regulation 2(aa) of AIF regulations define VCU 5

6 FOREIGN INVESTMENTS IN AIFs Non-Resident, RFPI and NRI: Schedule 11 of the Foreign Exchange Management (Transfer or Issue of Security by a person resident outside India) Regulation, 2000 ( FDI Regulations ) permit person resident outside India (other than an individual who is citizen of or any other entity which is registered / incorporated in Pakistan or Bangladesh) to invest in all the categories of AIF subject to the following prescribed condition 5 : (a) Pledge: Any person who is a non-resident and holds units of an AIF in accordance with the FDI Regulations may pledge such units to secure credit facilities being extended to the non-resident investor. (b) Payment Channels: The payment for the units of an AIF acquired by a person registered / incorporated outside India shall be made by an inward remittance through the normal banking channel including by debit to an NRE or an FCNR account. (c) Redemption: A person resident outside India who has acquired or purchased units may sell or transfer in any manner or redeem the units as per regulations framed by SEBI or directions issued by RBI. However, there are no guidelines so far that specifically prescribed for investment/transfer/redemption of units. (d) Instruments: A person resident outside India can invest in shares or convertible debentures or warrants or units of AIFs. (e) Specific Restriction for FPIs: It is clarified that FPI shall not hold more than 25% stake in a category III AIF. 6 FVCI: Schedule 6 of the FDI Regulations permit SEBI registered FVCIs to invest in units of Category I AIF (Cat I AIF) or units of a scheme or of a fund set up by a Cat-I AIF subject to the terms and conditions as may be laid down by the Reserve Bank. Further, no prior approval of RBI shall be required for investments by SEBI registered FVCI in case of investments made under Schedule 6. Downstream investment by AIF in Indian companies Downstream investment by the AIF should not be regarded as foreign investment, i.e. should be treated as domestic investment, provided that the Sponsor as well as the Manager is regarded as Indian Owned and Controlled under the FDI Regulations. Since ownership and control cannot be determined in LLP under the FDI, LLP cannot act as sponsor or manager. Cases Ownership & Control of manager/sponsor Nature of investors in the fund A Indian Domestic No B Indian Foreign No Downstream is foreign investment OFFSHORE INVESTMENTS BY AIFs 7 5 RBI Notification no. FEMA 355/2015-RB dated November 16, SEBI Circular CIR/IMD/FPIC/39/2016 dated March 15,

7 AIFs are allowed to invest into securities of companies incorporated outside India with prior approval of SEBI, subject to certain condition Limits: is within the overall limit of USD 500 million (combined limit for AIFs and Venture Capital s). Conditions: - Invest in the companies which have an Indian connection, i.e. a company having a front office overseas, while running back office operations in India; - Invest in equity and equity linked instruments of Offshore Venture Capital Undertakings. Offshore Venture Capital Undertakings means a foreign company whose shares are not listed on any recognized stock exchange in India or abroad. - Invest limit of 25% of the investible funds of the scheme of AIFs Restriction: No investment by AIFs in Joint Venture/Wholly Owned Subsidiary as defined under Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, AIF REGISTRATION PROCEDURE Set out below is a diagrammatic representation of the steps and timelines involved in seeking AIF registration. Step 1 Fill, number, sign and stamp application in Form A along with necessary documents Step 2 Submit application in Form A along with necessary documents to SEBI Step 3 Submit Bank draft of INR 1 lakh to SEBI payable at Mumbai along with Form A Step 4 Response from SEBI generally within 21 days (subject to compliance of requirements) Step 5 Approval from SEBI Step 6 Payment of registration fees of INR 5 lakh by way of bank draft to SEBI payable at Mumbai Step 7 Grant of certificate by SEBI, with such conditions as deemed appropriate by SEBI AIF STRUCTURE 7 SEBI circular CIR/IMD/DF/7/2015 dated October 1,

8 There are various considerations that the fund manager considers whilst finalising fund structures. Some of the considerations are: (a) Investor s jurisdiction; (b) Tax implication on the fund; (c) marketing restrictions; (d) cost of incorporation in various jurisdictions etc. A typical fund structure that is adopted by fund manager wherein AIFs are registered as trust entity with the Registrar of Trust. Further, with opening up of foreign investments in AIF, offshore investors can directly invest in domestic AIF. However, based on tax consideration of investor s jurisdiction to contemplate whether pooling of offshore investments must take place at the AIF as well. Set out below is a diagrammatic representation of the domestic structure. Investors Contribution Agreement Sponsor Manager Management Agreement Management Fees AIF Trust Deed Trustee Agreement Committee LEGISLATIVE FRAMEWORK Portfolio Companies Legal entity AIF: Depending upon the nature of entity, the relevant statute with respect to the entity would be applicable. Advisers: SEBI ( Advisers) Regulations, 2013 regulates registration, general obligations of the investment advisers 8 who provide investment advise relating to investing in, purchasing, selling or otherwise dealing in securities including financial planning. Trust Taxation: Category I & II AIF: Taxation of Category I AIF and Category II AIF shall be in accordance with the special tax regime under new chapter XII (FB) of Income Tax Act which is applicable to such funds irrespective of whether they are set up as trust, company or limited liability partnership. Set out below is the taxability of the Category I and Category II AIFs: 8 means any person, who for consideration, is engaged in the business of providing investment advice to clients or other persons or group of persons and includes any person who holds out himself as an investment adviser, by whatever name called. Regulation 4 lists of persons who are exempted from seeking registration as Adviser 8

9 Sr.# Particulars Unit Holders 1. Income under the head of profits and gains Taxable Exempt of business or profession of the investment fund 2. Income, other than profits and gains of Exempt Taxable business or profession 3. Any loss incurred by investment fund To be carried forward Not passed to investor and set off 4. Withholding on income distributed to unit holder* In case of income other than business income - Tax 10% In case of business income - No tax withholding * tax withholding rates for income distributed to non-resident investors would be considered based on treaty provisions. In order to avail tax pass through status characterization of income of AIF is critical which is to be determined based on facts. No Pass through for Category III: Category III AIFs do not have a specific tax code and hence are subject to domestic tax law based on the AIFs legal status (i.e. company, trust, etc) Safe Harbour laws: In order to encourage fund management activity from India, Section 9A of the Act provides lays down certain conditions wherein an offshore fund shall not be construed to have a business connection in India or be considered as person resident in India merely because the fund manager, undertaking fund management activities on its behalf, is situated in India. Benefits under the safe harbour provisions are subject to compliance with certain conditions laid down in section 9A of the Act read with CBDT notification dated March 15, 2016 (prescribing rules for application of section 9A of the Act). Disclaimer: The contents of this document are intended for informational purposes only and are not in the nature of a legal opinion or advice. It provides general information and guidance as on date of preparation and does not express views or expert opinions of ARA LAW. They may not encompass all possible regulations and circumstances applicable to the subject matter and readers are encouraged to seek legal counsel prior to acting upon any of the information provided herein. ARA LAW will not be liable for any damages of any kind arising from the use of this document, including but not limited to direct, indirect, incidental, punitive and consequential damages. It is recommended that professional advice be sought based on the specific facts and circumstances. This White Paper does not substitute the need to refer to the original pronouncements. 9