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General introduction to the regulatory framework

SEBI acts as the primary regulator for all funds and asset management or advisory activities in India, in accordance with the SEBI Act, 1992 (SEBI Act).

However, it is pertinent to note that the central government together with the Reserve Bank of India (RBI), India's central bank constituted under the RBI Act, 1934, regulates foreign investment and exchange control. While the SEBI, RBI and central government spheres are generally demarcated, the activity of a regulated entity may be overseen by multiple regulators if there is a cross-border element.

i AIFs

The AIF Regulations define an AIF as a privately pooled investment vehicle set up in India, which raises funds from investors and invests in accordance with a defined investment policy for the benefit of its investors.

The AIF Regulations exclude funds regulated under the CIS Regulations, the MF Regulations and any other regulations issued by Indian regulators. The scope of AIFs excludes, inter alia:

  1. holding companies;
  2. family trusts; and
  3. employee welfare/gratuity trusts.

While investors in an AIF could be domestic or foreign, each investor is required to commit a minimum of 10 million rupees, and an AIF is required to raise a minimum of 200 million rupees (with angel funds being allowed to have a minimum corpus of 50 million rupees) by way of commitment from its investors prior to commencing operations.

AIFs have been classified under the following three categories with the intention of distinguishing the investment criteria, as also providing an enabling framework for regulatory concessions, if any, which are or may be extended by the authorities:

  1. Category I AIF: Sub-categories include venture capital funds (including angel funds), 'SME' funds, social venture funds and infrastructure funds.
  2. Category II AIF: This category includes funds which do not specifically fall under Category I or Category III and which do not undertake leverage or borrowing other than to meet their day-to-day operational requirements. Private equity funds and debt funds typically fall under this category.
  3. Category III AIF: This category includes funds which employ diverse or complex trading strategies and may employ leverage, as well as listed focussed funds.

An AIF cannot have more than 1,000 investors (in the case of an angel fund, 200). Notably, no regulatory or government approvals are required for foreign investors to invest in AIFs.

The manager/sponsor are mandated to invest to provide some 'skin in the game'. This is set at the lesser of 50 million rupees (or 100 million rupees for Category III AIFs) or 2.5 per cent (or 5 per cent for Category III AIFs) of the corpus of the AIF. This is a continuing interest in the AIF and cannot be set off against management fees.

The AIF Regulations impose certain investment conditions on all AIFs, with additional conditions prescribed for each category or subcategory including in relation to minimum diversification, conflicted transactions and borrowing limitations.

AIFs are required to file reports with SEBI on a regular basis and also when there are material changes in information previously submitted to SEBI. The manager must prepare a compliance test report (CTR) – the CTR being an exhaustive reporting of compliances imposed by the AIF Regulations. Further, SEBI has recently (subject to limited exemptions) imposed a requirement to follow a prescribed format of the private placement memorandum (PPM) and the mandatory annual audit of the compliance of the PPM by an auditor or a legal professional.

The Indian government has also established an international financial services centre (IFSC) called Gujarat International Finance Tec-City (GIFT City). GIFT City serves as a special economic zone, which is deemed to be an offshore jurisdiction. GIFT City aims to incentivise offshore pooling structures to be brought within the geographical boundaries of India.

ii Mutual funds

Mutual funds in India are necessarily established as trusts. The MF Regulations set out the eligibility criteria, and also prescribe the rights and obligations of the sponsor, trustee, manager and custodian, including the contents of the trust deed and the management agreement. The MF Regulations also govern the economics, including payment of dividends, redemptions and valuation, and mandate norms and caps on fees, expenses and commissions payable to intermediaries.

Mutual funds typically cater to retail investors (with limited exceptions for private placement for specified types of schemes) by raising money from the public through the sale of the units of its schemes. Mutual funds being retail products, are highly regulated and the offer document is required to be detailed with extensive disclosures.

The MF Regulations place restrictions on the functioning and governance of the manager, requiring that at least 50 per cent of its directors be unconnected to the sponsor or the trustee.

Specific mutual fund strategies including real estate and infrastructure debt have specific conditions that they need to comply with, which are in addition to the general conditions.

iii REITs and INVITs

REITs and INVITs came into force on the same day with common objectives, and accordingly, and the regime have been fairly similar.

A public offer is required to be made for the units of the REIT or INVIT by way of an offer document, which is scrutinised by SEBI. This document typically sets forth extensive disclosures. REITs and INVITs are not permitted to have multiple classes of units or schemes.

INVITs also have the flexibility to privately place their units through a private placement memorandum scrutinised by SEBI, subject to certain conditions. Such a private placement is required to be aimed at institutional investors and bodies corporate only.

The units of the REIT (including where privately placed) mandatorily need to be listed on a stock exchange in India, with a reduced minimum trading lot of 50,000 rupees for REITs; for INVITs (the privately placed units need not be listed), the minimum trading lot for privately placed units is 10 million rupees; and otherwise, the minimum trading lot is 100,000 rupees. The REIT Regulations and INVIT Regulations prescribe the minimum offer size, the minimum public shareholding and the minimum number of investors.

Prior to the allotment of units, the sponsors are required to transfer (or so undertake) the underlying assets or their shareholding in the entity owning such assets, and the value of the assets should not be less than 5 billion rupees.

Both regulations specify minimum standards of net worth, qualifications and experience for, and rights and responsibilities of, sponsors, the manager and the trustee, and also the rights and responsibilities of the trust's valuers and auditors. Additionally, the INVIT Regulations require a project manager to be appointed, and also codify the responsibilities of such project managers who will undertake operations and management of the INVIT assets.

Further, not less than 50 per cent of the board of the managers of REITs or INVITs are required to be independent and cannot be on the governing board or manager of any other REIT or INVIT, as applicable.

The rights of unitholders have been codified in the regulations, including stipulating high standards of affirmative voting.

iv CISs

A CIS includes any scheme or arrangement under which investor contributions are pooled with a view to earning profits and in which the assets are managed on behalf of the investors. The CIS Regulations were notified in order to curb the growth of a number of unregulated private schemes in the 1990s. It is noteworthy that the CIS regime has not proven popular due to the connected restrictions; from 1999 to date, there has only been one registration.

v Portfolio managers

The PMS Regulations, amongst others, prescribe qualification, experience and capital adequacy conditions for registration as a portfolio manager. The PMS Regulations require that the minimum investment amount for an investor be 5 million rupees and that certain prescribed provisions be incorporated in the contract with the clients.

The discretionary portfolio managers are permitted to invest funds of their clients in the securities listed or traded on a recognised stock exchange, money market instruments, units of mutual funds and other securities prescribed by SEBI. The portfolio manager offering non-discretionary or advisory services are permitted to invest or provide advice for investment for up to 25 per cent of the assets under management of such clients in unlisted securities, in addition to the securities permitted for discretionary portfolio management.

vi IAs

The IA Regulations seek to regulate entities providing investment advice to clients and to protect investors from mis-selling.

The IA Regulations exempt other regulated entities or those who provide advice incidental to their main activity from the requirement to procure registration in addition to the exemption to persons solely advising foreign clients.

In order to protect retail investors, the IA Regulations stipulate capital adequacy norms and other eligibility criteria, including qualification and certification requirements that require designated persons to pass NISM (National Institute of Securities Market) examinations.

IAs are required to assess the suitability of advice being provided and, to this end, are required to undertake risk profiling of each client. As with investor protection regulations in India, the IA Regulations also have extensive provisions on activity segregation, disclosure and management of conflicts of interest. The IA Regulations mandate that an agreement be entered between IA and the client for ensuring greater transparency with reference to advisory activities.

vii RAs

SEBI issued the RA Regulations in order to register and regulate dissemination of research analysis and reports (and recommendations) relating to listed or to-be-listed securities, which apply to proxy advisers as well. It is pertinent to note that a person primarily responsible for, inter alia, making 'buy/sell/hold' recommendations would qualify as a research analyst.

Exemptions from registration as a research analyst has been provided to certain entities registered or regulated with SEBI. However, if such persons issue research reports to the public, they have to adhere to some obligations under the RA Regulations including on potential conflicts of interest, segregation of research activities and disclosures.

viii Offshore funds

All foreign investment in India is subject to the Foreign Exchange Management Act, 1999, its subordinate regulations (the FEMA Regulations) and circulars issued by the government and the RBI. These regulations govern various aspects of foreign investment including entry routes, sectoral restrictions and pricing guidelines. The government notified the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (the NDI Rules) on 17 October 2019, superseding the erstwhile Foreign Exchange Management (Transfer of Issue of Security by a Person Resident outside India) Regulations, 2017. The NDI Rules also govern foreign investment into Indian AIFs.

As discussed in Section I, an offshore fund seeking to make listed portfolio investments and investment in non-convertible debentures requires an FPI registration for which it must satisfy the prescribed eligibility criteria, including not being a resident of certain countries (such as those identified by the Financial Action Task Force as having deficient systems or not being signatories to the International Organization of Securities Commission's multilateral memorandum of understanding). It is however pertinent to note that Mauritius has recently been notified as a country whose entities may seek registration as a Category I FPI.

An FPI's or an FPI group's listed equity holding is required to be less than 10 per cent of the total equity on a fully diluted basis of the company.

Additional permissible investments include mutual funds and CISs, derivatives, and any debt securities or other instruments permitted by the RBI.

Offshore funds seeking to primarily invest in the unlisted space may choose to seek registration as an FVCI under the FVCI Regulations due to certain benefits accorded to FVCIs that are not available to FDI investors, which include free entry and exit pricing, exemptions from certain lock-in and public offer requirements, and a broad range of permissible instruments, including debt. This is, however, limited to 10 sectors, and investments outside of these sectors must be made under the FDI route or through one of the other routes discussed above.

FVCIs are, however, subject to certain investment conditions, including investing at least 66.67 per cent of their funds in unlisted equity or equity-linked instruments. FVCIs are permitted to invest in start-ups and are permitted to invest in 10 sectors.