Speculation over investor response to greater AIF regulation

Author: | Published: 1 Aug 2012
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In a move designed to tighten its control over alternative investment funds (AIFs), the Securities and Exchange Board of India (Sebi) drafted and proposed a set of guidelines entitled 'Regulation of Alternative Investment Funds' on August 2 2011. The aim was to extend the perimeter of regulation to unregulated funds, and ensure systemic stability, increase market efficiency and encourage the formation of new capital through a new regulatory regime. The Sebi approved and announced the guidelines at its board meeting on April 2 2012.

The AIF Regulations will be applicable to all pooled investment vehicles, except specifically notified vehicles such as mutual funds, CIS schemes, family trusts, ESOP trusts, employee welfare trusts or holding companies, which are already covered under regulations by other regulators.

To increase transparency in the alternative investment market, AIFs will now need to clearly delineate their investment purpose to the Sebi and stick with the investment intention at launch. Private equity, venture capital, private investment in public equity (Pipe), infrastructure funds, real estate funds and hedge funds will need to register under the AIF categories listed by the Sebi.

The funds are divided into three categories. The AIFs under Category I are funds that will have positive spillover effects on the economy and include venture capital funds, SME funds, social venture funds and infrastructure funds. These funds shall be closed-ended, shall not engage in leverage and shall follow investment restrictions as prescribed for each category. Certain incentives or concessions might be considered by the regulators.

Funds under Category II are funds that are given no specific incentives or concessions by the Government of India (GOI) or any regulator. They shall not undertake leverage other than to meet day-to-day operational requirements as permitted in the Regulations. They include private equity funds, debt funds, fund-of-funds and other funds not classified as Category I or Category III. These funds shall be closed-ended, shall not engage in leverage and have no other investment restrictions.

Category III includes hedge funds that are considered to have negative externalities such as exacerbating systemic risk through leverage or complex trading strategies. These funds can be open-ended or closed-ended and may engage in leverage subject to limits specified by the Sebi. According to the Sebi, These funds will be regulated 'through the issuance of directions regarding areas such as operational standards, conduct of business rules, prudential requirements, restrictions on redemption, and conflicts of interest'.

Alleviating concerns

AIF sponsors must contribute at least 2.5% of a fund's total corpus or Rs 50 million (US$912,000), whichever is lower. An AIF will be required to have a minimum corpus of Rs 200 million. A minimum contribution of Rs 10 million by each investor is required, with each fund allowed up to 1,000 investors. An AIF is not allowed to invest more than 25% of its capital into a single company.

The SEBI (Venture Capital Funds) Regulations, 1996 will be repealed. However, existing venture capital funds will continue to be regulated by the VCF Regulations until such funds are wound up. And existing funds that are not registered under the VCF Regulations and are not able to comply with all provisions of the AIF Regulations may seek Sebi exemption from strict compliance with the latter.

Following release of the draft guidelines in August 2011, there were concerns among investors on the fate of existing funds in the market. The final framework has cleared some of these earlier concerns.

The Sebi guidelines will impose the first systematic regulatory regime over private equity in India. While the Sebi's goal is to better control market risk and ensure greater accountability, some legal practitioners are worried that the regulations might be counterproductive to the performance of private equity. They are concerned that they might exert too many limits on how investors organise their funds.

Shantanu Surpure, managing attorney at Mumbai boutique law firm Sand Hill Counsel, was recently quoted in Asian Venture Capital Journal as saying that one of the attractions of investing in India is the range of sectors and investment styles that can be mixed and matched to make up a fund portfolio. "In some ways, there will be less flexibility going forward and it's unclear whether that will affect appetite for private equity investing," he says.

But others suggest that compliance with the new regulatory framework should not prove to be a deterrent of any kind. Talwar Thakore & Associates' partner Feroz Dubash says: "There have been concerns that the new regulations might complicate the investment process and might have an adverse effect on investor sentiment. However, greater regulation of alternative funds is a global trend and investors are likely to take that into account and cope with these tightened regulations."

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