SEBI’s Stricter Norms for AIFs: Safeguarding Fund Structures

The Securities and Exchange Board of India (SEBI) is the regulator of the capital markets in India. It is responsible for protecting the interests of investors and promoting the development and regulation of the securities market. One of the segments of the securities market that SEBI regulates is the Alternative Investment Funds (AIFs).

What are AIFs?

AIFs are privately pooled investment vehicles that collect funds from sophisticated investors, whether Indian or foreign, for investing in accordance with a defined investment policy for the benefit of their investors. AIFs do not include funds covered under the SEBI (Mutual Funds) Regulations, 1996, SEBI (Collective Investment Schemes) Regulations, 1999 or any other regulations of SEBI to regulate fund management activities.

AIFs can be registered in one of the following categories, and in sub-categories thereof, as may be applicable:

• Category I AIFs: These are funds that invest in start-up or early stage ventures or social ventures or SMEs or infrastructure or other sectors or areas that the government or regulators consider as socially or economically desirable. They include venture capital funds, SME funds, social venture funds, infrastructure funds and such other AIFs as may be specified by SEBI.
• Category II AIFs: These are funds that do not fall in Category I and III and do not undertake leverage or borrowing other than to meet day-to-day operational requirements and as permitted by SEBI. They include real estate funds, private equity funds, funds for distressed assets and such other AIFs as may be specified by SEBI.
• Category III AIFs: These are funds that employ diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives. They include hedge funds, PIPE funds and such other AIFs as may be specified by SEBI.

Why did SEBI introduce stricter norms for AIFs?

SEBI introduced stricter norms for AIFs in order to safeguard the fund structures and ensure transparency and accountability in their operations. Some of the key norms introduced by SEBI are:

• Standardised approach to valuation of investment portfolio of AIFs: SEBI issued a circular on June 21, 2023, prescribing a standardised approach to valuation of investment portfolio of AIFs. The circular specifies the principles, methodologies and procedures for valuation of various types of assets held by AIFs. It also mandates that valuation shall be conducted by an independent valuer appointed by the AIF or its trustee or its manager. The circular aims to ensure consistency, comparability and reliability of valuation across AIFs.
• Master Circular for AIFs: SEBI issued a Master Circular for AIFs on April 1, 2023, consolidating all the provisions from various circulars issued by SEBI up to March 31, 2023, pertaining to AIFs. The Master Circular covers various aspects such as registration, investment conditions, reporting requirements, disclosure obligations, governance framework and compliance norms for AIFs. The Master Circular aims to provide a comprehensive reference document for AIFs and their investors.
• Amendment to AIF Regulations: SEBI amended the AIF Regulations on January 25, 2022, to incorporate certain changes based on the recommendations of the Alternative Investment Policy Advisory Committee (AIPAC). Some of the key changes are:
• Allowing co-investment by sponsors or managers along with AIFs in portfolio companies subject to certain conditions.
• Allowing angel funds to invest in overseas venture capital undertakings up to 25% of their investible corpus.
• Enhancing disclosure requirements for Category III AIFs with respect to leverage, risk management and performance.
• Clarifying the definition of associates and related parties for conflict of interest purposes.
• Foreign investment in AIFs: SEBI issued a circular on January 11, 2024, allowing foreign investors to invest in AIFs registered with SEBI under certain conditions. The circular specifies that foreign investment in Category I and II AIFs shall be subject to sectoral caps applicable to foreign direct investment (FDI), while foreign investment in Category III AIFs shall be subject to sectoral caps applicable to foreign portfolio investment (FPI). The circular also lays down reporting requirements for foreign investment in AIFs.
• Compulsory dematerialization of units of AIFs: SEBI issued a circular on January 12, 2024, amending Regulation 15 of the AIF Regulations to require all fresh investments made by an AIF after September 2024 to be held in dematerialized form. The circular provides some exceptions for investments not eligible for dematerialization or those held by liquidation schemes. The circular aims to facilitate ease of compliance and strengthen investor protection in AIFs.

What are the benefits of stricter norms for AIFs?

The stricter norms for AIFs are expected to have several benefits for the fund industry and its stakeholders. Some of the benefits are:

• Improving the quality and credibility of valuation of AIF portfolio assets.
• Enhancing the transparency and disclosure standards for AIF operations and performance.
• Strengthening the governance and compliance framework for AIF management.
• Providing more flexibility and options for co-investment and cross-border investment by AIFs.
• Aligning the regulatory framework with international best practices and market developments.

What is the size and growth of the AIF industry in India?

According to SEBI data, as of December 2018, there were 102 registered AIF schemes in India with a cumulative net commitment raised of Rs. 63,736 crore (about $8.5 billion) and a cumulative net investment made of Rs. 24,976 crore (about $3.3 billion). The Category I AIFs accounted for 38% of the commitments raised and 40% of the investments made, while the Category II AIFs accounted for 62% of the commitments raised and 60% of the investments made.

According to a report by CRISIL, the AIF industry in India has doubled to $72 billion as of September 2021 from $36 billion in 2016 end – an increase of more than 100% in assets under management (AUM) for registered funds alone. The report also states that Category II AIFs have been the dominant category, accounting for 83% of the total AUM, followed by Category III AIFs with 12% and Category I AIFs with 5%.

According to another report by Cafe Mutual, the AIF industry reported an annual growth of 30% in FY 2022-23, with the AUM increasing from Rs. 6.41 lakh crore (about $86 billion) in March 2022 to Rs. 8.34 lakh crore (about $112 billion) as on March 2023. Of the total AUM, Category II funds accounted for the largest share of Rs. 6.94 lakh crore (about $93 billion), 34% higher than last year.

According to yet another report by VCCircle, the AIF industry in India is expected to grow at a compound annual growth rate (CAGR) of 25% over the next five years, reaching $180 billion by 2026. The report also predicts that Category III AIFs will witness the fastest growth, followed by Category I and II AIFs.