Alternative Investment Funds

Amendments to the Securities and Exchange Board of India (AIF) Regulations, 2012

Holding investments in dematerialised form and appointment of custodian

Securities and Exchange Board of India ("SEBI"), vide notification dated January 5, 2024, and circular dated January 12, 2024, introduced changes aimed at refining the regulatory framework governing Alternative Investment Funds ("AIFs"). The key provisions are as follows:

1. The SEBI (AIF) Regulations, 2012 ("AIF Regulations") are amended to provide that AIFs must hold their investments in dematerialised form. However, this does not apply to:

1. investments by AIFs in such type of instruments which are not eligible for dematerialisation;
2. investments held by a liquidation scheme of the AIFs that are not available in the dematerialised form; and
3. such other investments by AIFs and such other schemes of AIFs as may be specified by the SEBI.

SEBI further specified that investments made by an AIF on or after October 1, 2024, must be held in dematerialised form. This requirement does not apply to schemes of AIFs whose tenure ends on or before January 31, 2025, and schemes of AIFs which is in extended tenure as on the date of the circular. The investments made prior to October 1, 2024, are exempted from the requirement of being held in dematerialised form, except where: (a) the investee company of the AIF are mandated under applicable law to facilitate dematerialisation of its securities; and (b) the AIF, on its own, or along with other SEBI registered intermediaries/entities which are mandated to hold their investments in dematerialised form, exercises control over the investee company. These investments must be held in dematerialised form on or before January 31, 2025.

2. The AIF Regulations are amended to provide that the sponsor or manager of the AIF must appoint a custodian registered with SEBI for safekeeping of the securities of the AIF. The custodian for a scheme of an AIF must be appointed prior to the date of first investment of the scheme. Existing schemes of Category I and II AIFs having corpus less than or equal to INR 500,00,00,000 (Indian Rupees five hundred crore) and holding at least 1 (one) investment as on the date of this circular must appoint custodian on or before January 31, 2025. The custodian which is an associate of the sponsor or manager can act as a custodian for that AIF only when all the following conditions are met:

1. the sponsor or manager to have a net worth of at least INR 20,000 crore (Indian Rupees twenty thousand crore) at all points of time;
2. 50% or more of the directors of the custodian do not represent the interest of the sponsor or manager or their associates;
3. the custodian and the sponsor or manager of the AIF are not subsidiaries of each other and do not have common directors; and
4. the custodian and the manager of the AIF sign an undertaking that they will act independently of each other in their dealings of the schemes of the AIF.

In case of AIFs with custodians that are associates of their manager or sponsor, the managers of such AIFs must ensure compliance with above conditions on or before January 31, 2025.

AIF regulations amended to ensure investor protection

SEBI, vide notification dated April 25, 2024, issued the SEBI (AIFs) (Second Amendment) Regulations, 2024, amending the AIFs Regulations. The key provisions are as follows:

1. Category I AIFs and Category II AIFs can create encumbrance on equity of investee company, which is in the business of development, operation or management of projects in any of the infrastructure sub-sectors listed in the Harmonised Master List of Infrastructure issued by the Central Government, only for the purpose of borrowing by such investee company and subject to the prescribed conditions by SEBI;
2. AIFs, manager of the AIFs and key management personnel of the manager must exercise specific due diligence, with respect to their investors and investments, to prevent facilitation of circumvention of laws specified by SEBI;
3. the liquidation period for a scheme of an AIF that is expired or is expiring within 3 (three) months, can be granted an additional liquidation period, subject to certain conditions as specified by the SEBI;
4. AIFs cannot launch any new liquidation scheme after the notification of these amendments;
5. provisions relating to the dissolution period are inserted. The term 'dissolution period' is defined to mean the period following the expiry of the liquidation period of the scheme for the purpose of liquidating the unliquidated investments of the scheme of the AIF. The scheme entering into a dissolution period must file an information memorandum with SEBI through a merchant banker. The dissolution period of a scheme of an AIF must not be more than the original tenure of the scheme and must not be extended in any manner upon expiry of the dissolution period. The scheme of the AIF must not accept any fresh commitment from any investor and must not make any new investment during the dissolution period; and
6. the unliquidated investments of the AIF scheme that are not sold by the expiry of the dissolution period will be mandatorily distributed in-specie to the investors, as specified by the SEBI.

Foreign investment in AIFs

SEBI, vide circular dated January 11, 2024, revised the foreign investment provisions in the Master Circular for AIFs dated July 31, 2023 ("AIF Master Circular") to incorporate the revised thresholds for determining beneficial ownership. The Prevention of Money Laundering (Maintenance of Records) Rules, 2005 were amended last year revising the thresholds for determining beneficial ownership from 25% to 10% for companies and from 15% to 10% for trusts. Pursuant to the amendment, the manager of an AIF must ensure, at the time of on-boarding investors, that the investor, or its beneficial owner is not included in the sanctions list and is not a resident in the country identified in the public statement of Financial Action Task Force ("FATF") as:

1. a jurisdiction having a strategic anti-money laundering or combating the financing of terrorism deficiencies to which counter measures apply; or
2. a jurisdiction that is not made sufficient progress in addressing the deficiencies or is not committed to an action plan developed with the FATF to address the deficiencies.

Further, in case an investor, who has already been on-boarded to scheme of an AIF, does not meet the revised condition, the manager of the AIF must not drawdown any further capital contribution from such investor for making investment, until the investor meets the said condition.

Investments in AIFs by regulated entities

To address the concerns relating to investments by Regulated Entities ("REs") and to ensure uniformity in implementation among REs, the Reserve Bank of India ("RBI"), vide circular dated March 27, 2024, advised the following:

1. downstream investments referred to in paragraph 2(i) of the circular dated December 19, 2023 ("2023 Circular"), will exclude investments in equity shares of the debtor company of the RE, but will include all other investments, including investment in hybrid instruments;
2. provisioning in terms of paragraph 2(iii) of the 2023 Circular will be required only to the extent of investment by the RE in the AIF scheme which is further invested by the AIF in the debtor company, and not on the entire investment of the RE in the AIF scheme;
3. paragraph 3 of the 2023 Circular applies only to AIFs without downstream investment in debtor companies of the RE. If the RE invested in subordinated units of an AIF scheme with downstream exposure, it must comply with paragraph 2 of the 2023 Circular. Further, the proposed deduction from capital in the 2023 Circular will be equally distributed across Tier-1 and Tier-2 capital, and the reference to investment in subordinated units of the AIF Scheme includes all forms of subordinated exposures, including investment in the nature of sponsor units; and
4. investments by REs in AIFs through intermediaries such as fund of funds or Mutual Funds ("MFs") are not included in the scope of the 2023 Circular.

Changes in terms of private placement memorandum of AIFs

1. SEBI, vide circular dated April 29, 2024, eased the requirement of intimation of changes in the terms of AIFs through merchant bankers. Pursuant to the SEBI AIF Master Circular, intimation with respect to any change in the terms of Private Placement Memorandum ("PPM") of AIF was required to be submitted to SEBI through a merchant banker along with a due diligence certificate from the merchant banker. Certain changes in the terms of PPM, such as, changes made in the write-up on market opportunity/ Indian economy/industry outlook, track record of investment manager, risk factors, legal regulatory and tax consideration, do not need to be submitted through a merchant banker and can be filed directly with SEBI. Similarly, changes with respect to, information such as contact details (address, phone number etc.) of AIF, sponsor, manager, trustee or custodian, auditor, registrar and share transfer agents, legal advisor or tax advisor, size of the fund/scheme, information related to affiliates, commitment period, key investment team, key management personnel (except if the changes are due to change in control of manager and sponsor), advisory boards, expenses, disclosures, and other factual and routine updates need not be filed through a merchant banker.
2. Further, large value funds for accredited investors are exempted from the requirement of intimating any changes in the terms of PPM through a merchant banker. They can directly file any changes in the terms of PPM with SEBI, along with a duly signed and stamped undertaking by CEO of the manager of the AIF (or such other person with equivalent role/ position) and compliance officer of the manager of the AIF, in a pre-specified format.

Registration of AIFs

1. SEBI, vide notification dated May 10, 2024, issued a commencement notification for certain provisions of the SEBI (AIFs) (Second Amendment) Regulations, 2023. These amendments pertain to the eligibility criteria of AIFs for the purpose of the grant of certificate to an applicant. Accordingly, to meet the eligibility criteria, the key investment team of the manager of AIFs must have at least 1 (one) key personnel with relevant certification as specified by the SEBI.
2. Subsequently, SEBI, vide their circular dated May 13, 2024, issued the certification requirement for the key investment team of manager of AIF. The criteria to obtain the prescribed certification by at least 1 (one) key personnel of the key investment team of manager of AIF, is applicable to all the applications for registration of AIFs and launch of schemes by AIFs filed after May 10, 2024. Further, existing schemes of AIFs and schemes of AIFs whose applications for launch of schemes are pending with SEBI as on May 10, 2024, must comply with the requirement of obtaining the certification on or before May 9, 2025.

The ever-increasing regulatory oversight on AIFs

In addition to direct regulatory oversight on the AIFs itself, AIFs are also indirectly impacted by various other statutory and regulatory restrictions or conditions that are applicable to the underlying legal form of the AIF, the investors in the AIF or the investment portfolio of the AIFs. Some of the statutory and regulatory amendments affecting AIFs are discussed below.

1. Significant beneficial ownership and AIFs

Under the AIFs Regulations, an AIF can be established or incorporated in the form of a trust or a company or a Limited Liability Partnership ("LLP") or a body corporate.

After trusts, LLPs are the most preferred legal form for an AIF, since LLPs are more beneficial from a tax perspective and with lesser compliance requirements than a company.

However, LLPs are also being subjected to additional compliance requirements.

One compliance/disclosure requirement imposed on the LLPs is pursuant to the LLP (Third Amendment) Rules, 2023 and the LLP (Significant Beneficial Owners) Rules, 2023 ("SBO Rules"). As per the SBO Rules, the LLP is required to take necessary steps to find out if any individual qualifies as a 'Significant Beneficial Owner' ("SBO") in relation to the LLP. If such SBO are identified, then the LLP must cause such individual to make a declaration in Form No. LLP BEN-1.

As per one of the exemptions available under the SBO Rules, the aforesaid requirements will not apply to the extent the contribution in the LLP held by an investment vehicle registered with SEBI, such as an AIF. Thus, if an AIF is a partner in the LLP, the SBO Rules will not apply in respect of such AIF partner.

However, where the AIF is set up as an LLP, then the SBO Rules will apply in relation to such AIF.

Accordingly:

As per the explanation, if an individual does not hold any right or entitlement indirectly under sub-clauses (a), (b), (c) or (d) above, he will not be considered an SBO. The SBO Rules further define what would be considered as holding any right or entitlement 'directly' and what would be considered as holding any right or entitlement 'indirectly'.

As per the SBO Rules, if an individual (acting alone or together or through one or more persons or trust) is entitled to exercise or actually exercises, significant influence or control, in any manner other than through direct holdings alone, then such individual will be considered to be a SBO.

The term 'significant influence' is defined to mean "the power to participate, directly or indirectly, in the financial and operating policy decisions of the LLP but is not control or joint control of those policies." (emphasis added)

The SBO Rules mandate filing a declaration in Form No. LLP BEN-1 for individuals who become SBOs or change ownership. The AIF must also file a return in Form No. LLP BEN-2 within 30 (thirty) days of receipt of declaration in Form No. LLP BEN-1, along with prescribed fees. Additionally, the AIF must maintain a register of significant beneficial owners in Form No. LLP BEN-3, open for inspection during business hours.

It was not common for information of 1 (one) investor to be made accessible to other investors of the AIF.

Further, apart from the sponsors and managers of AIFs, the investors of the AIFs also undergo 'know your customer' verification. Given that AIFs are already regulated by SEBI, it is unclear whether applying the SBO Rules to AIFs was needed.

2. Evergreening and AIFs

The RBI's circular dated December 19, 2023, seeks to restrict evergreening of debt by banks/non-banking financial companies through investments in AIFs. While the intent behind this circular is well received, the implications seem far reaching.

3. Dematerialisation of units issued by AIFs

As per the aforementioned circulars, all existing and new investments in AIFs must be held in dematerialised form.

While demat of securities and units may not be a cumbersome process, opening of demat accounts by investors, especially by foreign investors or non-resident Indians can be time-consuming.

The process/implementation standards issued from time to time with respect to the Aggregate Escrow Demat Account and related matters should provide some relief and direction to the AIF industry.

4. Dematerialisation of investments held by AIFs

In its meeting held on November 25, 2023, SEBI required AIFs to hold their investments in dematerialised form. SEBI inter alia approved the following amendments to be made to the SEBI (AIFs) Regulations, 2012 (the amendments are still to be made):

5. Appointment of custodian

Previously, only Category I and II AIFs with a corpus of more than INR 500,00,00,000 (Indian Rupees five hundred crore) and Category III AIFs were required to appoint a custodian. However, in its meeting held on November 25, 2023, SEBI mandated that all AIFs must appoint a custodian. In this regard, SEBI permitted an associate of manager or sponsor of the AIF to act as a custodian, subject to conditions that are similar to those prescribed under the SEBI MFs Regulations, 1996 in relation to appointment of a related party of sponsor of a MF as its custodian.

Some of these measures are aimed at digitisation and strengthening investor protection, which are welcome. However, it is hoped that such measures do not add to the ever-increasing operational costs of the AIFs, which ultimately get passed on to the investors.

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