The Securities and Exchange Board of India (SEBI) has issued a circular1 dated 1 October 2015 relaxing guidelines on overseas investment and providing certain other important clarifications for SEBI registered domestic funds (the Guidelines). The Guidelines permit domestic funds registered with SEBI, either as alternative investment vehicles (AIFs) under the SEBI (Alternative Investment Funds) Regulations, 2012 (the AIF Regulations), or as venture capital funds (VCFs) under the SEBI (Venture Capital Funds) Regulations, 1996 (the VCF Regulations), to invest up to 25% of their investible funds in offshore unlisted companies which have an Indian connection. The Guidelines also provide certain important clarifications for AIFs, especially on the operation and conduct of AIF managers and sponsors.
Please refer below for a detailed analysis of the Guidelines.
Overseas Investment by VCFs
The Reserve Bank of India (the RBI) had, in 20072, permitted VCFs to invest in equity and equity linked instruments of offshore venture capital undertakings (defined as foreign companies whose shares are not listed on any recognized stock exchange in India or abroad) within an overall industry-wide limit of US$ 500 million. The RBI had provided that the allocations of investment limits (from the industry-wide investment limit) to individual VCFs would be made by SEBI, subject to such terms and conditions as SEBI may deem necessary, thus delegating the authority to implement the framework for overseas investments by VCFs to SEBI. Accordingly, SEBI issued guidelines3 for VCFs to invest up to 10% of the investible funds in offshore venture capital undertakings having an Indian connection. The allocation of limits to individual VCFs is undertaken by SEBI on a case-by-case basis. However, so far, no such mechanism was expressly provided by SEBI for overseas investments by AIFs. With the advent of the AIF Regulations, which supplanted the VCF Regulations, a need was felt for providing a framework for overseas investments by AIFs.
Overseas Investment by AIFs
To facilitate overseas investments by AIFs, the RBI had issued a notification in December 20144, permitting AIFs to invest in equity and equity-linked instruments of offshore venture capital undertakings, subject to the overall limit of US$ 500 million. These investments were to be made in accordance with guidelines to be prescribed by SEBI in this regard, without any separate approval required from the RBI. In effect, the RBI had put the ball on overseas investments by AIFs in SEBI’s court to facilitate such investments. Accordingly, SEBI released a consultative paper on 24 April 2015, proposing guidelines on overseas investments by AIFs.
The consultative paper acknowledged that there has been a major shift of Indian entrepreneurs outside India and that many Indian entrepreneurs had set up headquarters outside India with back end operations and/or research and development being undertaken in India due to which a need was felt to permit higher overseas investments by domestic funds. The consultative paper proposed increasing the limit of overseas investments by AIFs/VCFs to 25% of their investible funds, allowing them opportunities to generate better returns globally, getting exposure to the international market practices and other benefits. The consultative paper provided certain other clarifications with respect to AIFs/VCFs which have been analysed herein.
Guidelines on Overseas Investments by Domestic Funds
Subject to the overall combined investment limit for AIFs and VCFs of US$ 500 million, SEBI has, vide the Guidelines, now permitted AIFs and VCFs to invest up to 25% of their investible funds in ‘equity and equity linked instruments’ of offshore venture capital undertakings (i.e. in foreign companies whose shares are not listed on a recognised stock exchange in India or abroad) having an ‘India connection’.
Notably, AIFs/VCFs desirous of making investments overseas will be required to submit their proposal (in the prescribed format) to SEBI for its prior approval. SEBI would allocate investment limits to each AIF/VCF from the overall limit of US$ 500 million on a first-come, first-served basis.
Further, as per the Guidelines, once approved by SEBI, AIFs/VCFs would be required to make overseas investments within 6 (six) months of receipt of such approval, failing which, their unutilised limit could be liable for reallocation to other applicants. The Guidelines also provide that AIFs/VCFs cannot invest in joint ventures/wholly owned subsidiaries (JV/WOS) while making overseas investments.
Finally, the Guidelines provide that where any AIFs/VCFs have received contributions exceeding 50% of their funds from a single NBFC, such AIF/VCF will be required to comply with the requirements specified by the RBI vide its guidelines on “opening of branches/subsidiaries/Joint venture/undertaking investment abroad by NBFCs” while making overseas investments.
In our understanding, the prohibition on AIFs/VCFs from investing in JV/WOS may have been introduced to ensure that the regime is utilised for making portfolio investments and not strategic investments.
Other Clarifications in Guidelines
SEBI has utilised this opportunity to issue certain other key clarifications for registered AIFs. Please see below a quick overview of these clarifications.
Tenure of AIF Schemes
SEBI has clarified that the tenure of any scheme of an AIF must be calculated from the date of the final closing of the scheme. The clarification provides a standard yardstick for the measure of scheme tenures and is hence a welcome step towards bringing uniformity to the interpretation of the AIF Regulations in context of the tenure of an AIF.
It is unclear whether this clarification would be applicable only prospectively or whether it would also impact existing AIFs which may have treated their tenures as commencing from their initial closings. This question would become more relevant for an AIF which nears the end of its tenure, and may mull over the extension of its tenure, which, as per the AIF Regulations, requires prior approval from the investors. In such a case, the investors may require the AIF to liquidate and distribute funds upon the expiry of their original tenures as per the fund documents, as opposed to agreeing to any extension of its term.
Fiduciary Duties of Managers/Sponsors/Trustees
The AIF Regulations explicitly place a fiduciary duty on sponsors and managers of AIFs towards their investors. The Guidelines have further elaborated on such duty of the sponsors/managers of the AIF by making specific prescriptions with respect to their operation and governance of AIFs.
Several checks and compliances have been contemplated for managers of AIFs, whereby the managers must:
- organise, operate and manage an AIF and its schemes in the interest of unitholders of the AIF/scheme;
- carry out all the activities of an AIF in accordance with the placement memorandum circulated to all unitholders and as amended from time to time in accordance with the AIF Regulations and circulars issued by SEBI;
- ensure scheme-wise segregation of bank accounts and securities accounts;
- not make any exaggerated statement, whether oral or written, either about their qualifications or capability to render investment management services or their achievements.
Additionally, it is clarified that in the interest of the unitholders, AIFs and their sponsors and managers will be obligated to:
- act in the interest of unitholders of an AIF/scheme and not take any action which is prejudicial to the interest of the unitholders and not place the interest of the sponsor/manager/trustee of the AIF or any of their associates above the interest of the unitholders of the scheme/AIF; and
- maintain high standards of integrity and fairness in all their dealings and in the conduct of the business and render, at all times, high standards of service, exercise due diligence and exercise independent professional judgment.
The AIF Regulations require that the manager/sponsor of an AIF must act in a fiduciary capacity towards its investors. The Guidelines have further elaborated the fiduciary obligations of a manager/sponsor of an AIF as mentioned in the AIF Regulations. These clarifications should lead to the refinement of the roles of AIF managers/trustees/sponsors vis-à-vis the investors. These clarifications are expected to improve the governance standards in the industry, which was found lacking in certain quarters.
No Assurance on Returns
SEBI has prohibited AIFs and their sponsors/managers/trustees from offering any assured returns to any prospective investors.
This clarification appears to be in response to several investor complaints received by SEBI in respect of AIFs/VCFs where the investors have represented that there has been a gross mis-selling of AIFs/VCFs as a product with assured returns. It seems that SEBI wishes to ensure that the risk associated with alternative investments is clearly understood by the investors and they are not misled in underestimating such risks due to an assurance of returns on the part of the sponsors/managers/trustees. Care should also be taken by managers while preparing a placement memorandum and other marketing material for funds so that no misleading statements with regard to the fund’s performance or potential returns are made therein.
Acknowledgement of PPM Receipt
It is noteworthy that the Guidelines have specifically required an AIF’s managers to ensure that the placement memorandum of an AIF is provided to the investors prior to accepting any commitment or investments in the AIF. Managers are also required to ensure that an appropriate acknowledgement is received from each of their investors for the receipt of the placement memorandum.
The above clarification seems to have been provided in response to complaints received by SEBI from certain investors stating that they were not provided with copies of the placement memorandum or made aware of the risks associated with their investments made in such funds. This requirement would also ensure that the basic hygiene of offering units of AIFs on a private placement basis would be maintained by fund managers.
The Guidelines are targeted at taking the regime of the AIF Regulations to the next level of evolution by bringing in standardised practices and better governance. The clarifications on the manner of marketing AIFs, on fiduciary duties of managers/sponsors etc. are expected to bring in credibility to AIFs as an investment platform.
The flexibility to invest higher amounts overseas is clearly in response to the market need, which should be much appreciated by the industry. As per the data released by SEBI5, as of 30 June 2015, AIFs alone have raised capital commitments worth nearly INR 25,000 Crores (approx. US$ 384 billion). While compared with the aggregate commitments received by AIFs, the present limit of US$ 500 million might seem low, we are hopeful that once full utilisation of the limit is made, the RBI may consider increasing the limit for the benefit of the domestic funds industry.