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The Alternative Investment Funds regime in India: Regulating for Growth

The Alternative Investment Funds regime in India: Regulating for Growth

Alternative Investment Funds (AIFs) are a relatively new phenomenon in India, but they are already making their mark on the investment landscape as a viable alternative to traditional investments in mutual funds and portfolio management services. Recent regulatory changes are set to prepare the AIF industry for substantial continued growth over the years to come.

The Securities and Exchange Board of India (SEBI) introduced specific regulations for AIFs in 2012, which were intended to bring unregistered funds within the legal framework. An AIF is a fund which is incorporated in India in the form of a Trust, Company or LLP, and is a privately pooled vehicle which can collect funds from both Indian and foreign investors, and which invests these in line with a defined investment policy. Under the regulations, AIFs have been categorised into three classes:

  • Category I: These funds receive incentives from the government, SEBI or other regulating agencies. These include social venture funds, infrastructure funds, venture capital funds and SME funds.
  • Category II: These funds are allowed to invest anywhere in any combination, but cannot take debts, except for day-to-day operation purposes. These include private equity funds and debt funds.
  • Category III: Funds that make short-term investments and then sell, like hedge funds, come under this.

Recent figures from the SEBI reveal that the total commitments raised by AIFs have already increased more than five-fold, from US$ 3.16 billion in 2014 to over US$ 18.15 billion by September 2017, and that commitments raised by AIFs have grown consistently over this period.

In terms of future prospects, a report by Preqin Insight from November 2017 highlights that with US$ 43 billion in assets under management (AUM), the alternative assets industry in India is only one sixth of the size of the industry in China, with private equity and venture capital forming the largest pool, closely followed by infrastructure. With US$ 24 billion in unrealised gains and dry powder, it has more AUM than all other asset classes combined. The report also notes there are 221 Private Equity managers located in India, and that there have been 4534 venture capital financings in India since 2008.

So what are the recent changes to the regulatory landscape in India, to spur future growth in the AIF industry? A number of major reforms were introduced in 2017, further to the second report of the Alternative Investment Policy Advisory Committee (AIPAC), set up under the auspices of the SEBI. Leading law firm Khaitan & Co has highlighted that a number of these changes are likely to bring cheer to the investor community.

In terms of some of the most significant changes, firstly, Category III AIFs are now able to participate in all commodity derivatives products that are traded on commodity derivatives exchanges in India, thereby opening up the market to institutional investors. This is a welcome move which will make the markets more reliable, and which may lead the commodity derivatives market to be opened further for other institutional investors such as mutual funds and Foreign Portfolio Investors (FPIs).

Second, there will be a change regarding Category II AIFs and the current one-year lock in on share capital post-IPOs, so that Category II AIFs will be able to freely trade equity shares within the one year period right after the IPO. Once implemented, this would be extremely positive since a majority of companies at the pre-IPO stage across the world are backed by private equity (i.e. Category II AIFs). The relaxation of the lock-in period will therefore facilitate time-bound exits and allow more flexibility, raising greater capital for pre-IPO stage stocks.

In other changes, Khaitan & Co consider that changes to AIF listing guidelines are a great move towards developing a secondary market for such products which will strengthen the evolution of the AIF regime in India, while changes to the Income Tax Act 1981 will be welcomed by both Category I and Category II AIFs as it will allow them to avail of the capital gains tax exemption under Section 10(38) and are not subject to tax on long-term capital gains due to non-payment of STT at the time of acquisition of such listed shares, with the one downside being that Category III AIFs are not being treated favourably, which may be a disincentive for fund managers hoping to set up a Category III AIF in India.

Overall, the Alternative Funds industry in India is clearly on the rise, and I believe that the regulatory changes being implemented can go a long way towards putting the country on a firm footing with onshore structures catering to the growing demand of alternative investments within India as well as from overseas investors wanting exposure to Indian opportunities.

By Udit Gambhir,
Managing Director SGG Asia