Legal, Taxation and Regulatory Implications

Even someone who knows nothing about investments and the capital markets knows that this is a source to make money. Much like the rats of Hamelin followed blindly to the beat of the Pied Piper’s song, so too do thousands of hopefuls flock to the capital markets every day with dreams of making their fortunes.

Of course, when the motivating factor is as strong as endless wealth, unsavoury characters also start cropping up from the weeds. After all, who would want to pass up the opportunity to make some easy money?

This is why it is so important to have a strong regulatory environment with clear guidelines.

The Securities and Exchange Board of India (SEBI) oversees alternative investments like private equity (PE) and venture capital (VC) in India. It started in 1988 and got official powers in 1992.

Unlike the US and Europe, where PE/VC is less regulated because the investors are usually knowledgeable institutions, in India, even regular people invest in VC/PE, making regulation different.

Here’s what SEBI focuses on:

• Managing the capital markets
• Encouraging sustainable growth
• Looking out for the investors’ best interests
• Keeping an eye out for red flags and discrepancies

In the past few modules, we have covered the details of how private markets work and the different investment strategies. In this module, we’re going to explore the regulatory, taxation and legal implications of private markets. This chapter is dedicated to the regulations and guidelines set forth by SEBI.

SEBI has three big roles – it acts like a judge (Quasi-Judicial), like an enforcer (Quasi-Executive), and like a lawmaker (Quasi-Legislative).

As a Quasi-Judicial body, SEBI has the authority to make legal judgments on disputes and issues related to the stock market. This power helps in resolving conflicts and maintaining fairness in the financial arena.

In its Quasi-Executive role, SEBI enforces the rules and regulations it sets for the market. This includes monitoring market activities, inspecting the accounts of financial intermediaries, and ensuring compliance with its directives.

As a Quasi-Legislative entity, SEBI can draft and implement new regulations that aim to enhance the stability and integrity of the market.

The combination of these powers ensures that SEBI can effectively regulate the market, protect investor interests, and maintain a transparent and efficient trading environment.

Historically, private equity and venture capital funds operated without regulation. It was a land divided by vested interests, where each party only looked out for its own best interests. The power struggle, as you can imagine, was frequent and the atmosphere was volatile.

Then came the SEBI (Venture Capital Funds) Regulations in 1996. However, this was but a band-aid over a gaping shotgun wound. It was a one-size-fits-all solution and disregarded the intricacies that define each asset class or investment type. The umbrella approach highlighted the need for more tailored regulations.

In response, SEBI released a concept paper in 2011 proposing AIF Regulations. This looks quite different from the current version. Initially, the draft featured various elements like nine different AIF categories and numerous commitments for sponsors. After extensive discussions with industry experts, the regulations were refined and an updated version was released.

The SEBI (Alternative Investment Funds) Regulations, 2012, introduced on May 21, 2012, represented a turning point in India’s private capital sector. The AIF Regulations aim to oversee and manage the funds formed in India for pooling investments, either domestic or international, through private placements. However, foreign funds directly investing in India are not covered by these regulations.

Categories and Registration

Under the AIF Regulations, domestic PE funds must register as AIFs with SEBI. Pre-existing PE funds, established before these regulations, should register under the older VCF Regulations and can operate under these until their term ends without needing AIF registration.

The only exemptions exist for certain trusts and companies. The following are exempt from obtaining registration under the AIF Regulations:

• PE funds established before the implementation of the AIF regulations are exempt from registration.
• Funds unable to adhere to AIF Regulations can request an exemption from SEBI.
• Existing PE funds not pursuing new investments, while reporting their activities to SEBI, are exempt.
• Funds overseen by securitisation or asset reconstruction companies registered with RBI are also exempt.

As for capital, that can only be raised through private placements. Existing unregistered capital pools must register within six months. Pre-existing SEBI-registered funds, however, are governed under the old regulations. The only caveat is that they cannot launch new schemes without re-registering.

SEBI categorises AIFs into three types based on investment strategies and risk.

• Category I AIFs focus on sectors beneficial to the economy and are closed-ended. Examples include venture capital, early-stage, social ventures, and the infrastructure sector.
• Category II encompasses closed-ended funds like private equity, real estate, and debt funds, without leverage.
• Category III AIFs include funds using diverse or complex trading strategies. These funds employ leverage and invest in derivatives, like hedge funds.

Investment Norms and Limitations

The AIF Regulations detail specific investment norms for each particular category. The key conditions include:

• Minimum fund size of ₹200 million
• Cap of 1000 investors per AIF,
• Minimum investment of ₹10 million per investor
• Only raises funds through private placement

Operational Standards

SEBI outlines operational standards for AIFs, including valuation norms, conflict of interest policies and investor redressal mechanisms. These ensure operational integrity and ethical conduct.

Sponsor commitments can differ by category, with a maximum of 2.5% or ₹50 million for Category I and II AIFs, and 5% or ₹100 million for Category III. But, they must disclose their investments in the AIF to the other investors.

These funds can explore opportunities beyond Indian borders, adhering to RBI and SEBI’s global playbook. Transparency is the cornerstone, with mandatory disclosures painting a clear picture of investments and valuations.

Fundraising and Investor Relations

Detailed guidelines govern fundraising activities, minimum investment requirements, and investor qualifications. These measures prevent mis-selling and ensure that only informed investors participate in such high-risk investment avenues.

While there are no explicit restrictions on who can invest, there are important limitations on fundraising activities. These are governed by several regulations:

• AIF Regulations: An Alternative Investment Fund (AIF) is restricted to having no more than 1,000 investors, especially if it’s structured through a non-corporate investment vehicle.
• Companies Act Constraints: If an AIF opts for a private limited company structure, it cannot offer shares to more than 200 shareholders.
• Foreign Investment Guidelines: Foreign investment in AIF units is generally open to non-residents, excluding those from specific countries like Pakistan and Bangladesh, without needing RBI’s nod. However, certain conditions apply.

  For example, Category III AIFs with foreign investments are limited to portfolio investments in areas permissible for foreign portfolio investors under the Foreign Exchange Management Act 1999 and related regulations.

• Investments from Specific Nations: Government approval becomes necessary when investments flow into Indian companies from countries like China, Pakistan, and a few others. This also applies if the beneficial owner of the investment is based in or a citizen of these countries.

Disclosure and Reporting Requirements

Regular reporting on fund performance, investment strategy, and risk metrics to both investors and SEBI ensures transparency and allows for informed decision-making by all stakeholders.

For Category I and II AIFs, appointing a custodian for large funds is optional. However, for Category III AIFs, it is mandatory. Each year, AIFs must share details about their performance and strategies with investors. They have to maintain these records for five years post-winding up.

Also, closed-ended AIFs can transition to stock market listings post-closure. But, the guidelines to script this new chapter are still being finalised by SEBI.