India regulation: SEBI takes a stand

But this is poised to change. The Securities and Exchange Board of India (SEBI) last week announced regulatory proposals that would tighten its control over alternative investment funds (AIFs), which include investors and vehicles within the private equity, venture capital, PIPE, infrastructure and real estate spaces, among others. The proposals, which will be open to for public comment until August 30, are intended to improve AIF market coordination and transparency.

Law firms and fund managers alike are scrambling to distill the rules and voice their concerns before the draft is etched in stone. While many say the changes would represent a breath of fresh air for what is currently a poorly defined business landscape, they agree that certain aspects might be counterproductive, hindering growth at a critical time for the nascent industry.

“In terms of fundraising and disclosure and the multiple registration requirements, I think this is going to complicate things more than the industry needs and may end up putting people off,” Akil Hirani, managing partner at Majmudar & Co., International Lawyers, tells AVCJ. “A middle ground would have been better.”

Mix and match no more?

At the heart of SEBI’s draft is a push for transparency that would force funds to clearly delineate their investment purposes – and stick with it. Currently, AIFs adhere to a set of rules enacted in 1996 that were only supposed to incubate start-up companies and encourage innovation. As a result, all funds are currently categorized as simply venture capital funds (VCFs), regardless of their investment mandate. This is clearly insufficient for India’s fast-evolving AIF landscape.
“It has been found over the years that VCFs are being used as a vehicle for many other funds such as private equity, PIPE, real estate,” SEBI released in its draft prospectus. Its response is to narrow the scope of regulation into nine sub-categories, ranging from private equity vehicles to social venture funds.

The first step for funds is to outline a clear investment intention at launch, eliminating questions for investors. Currently, single funds in India can be classified as a fusion of investment disciplines, such as growth and infrastructure vehicles, and PIPE and debt vehicles. Should the regulations pass as proposed, funds would have to place their capital into vertical categories without deviating into other areas, which could prove limiting.
“Right now one of the big appeals to investing in India is the range of sectors and investment styles that can be mixed and matched to make up a fund portfolio,” says Shantanu Surpure, managing attorney at Sand Hill Counsel in Mumbai. “In some ways, there will be less flexibility going forward and it’s unclear whether that will affect appetite for private equity investing.”

Observers cite other drawbacks that may also adversely impact the industry. AIF sponsors must contribute at least 5% of the fund’s total corpus. This is a tall order  for newly launched vehicles that, although commanding sufficient demand from investors to reach their fundraising target, do not necessarily have much capital themselves. Furthermore, the size of venture capital funds is capped at INR2.5 billion ($55.7 million), which might prove limiting to global VC players, with billions of dollars at their disposal, that maintain a focus on India.

“I don’t know why you would necessarily say that this helps the smaller funds because in some ways it hurts them,” Surpure continues. “To tell a VC fund that it can’t raise more than INR2.5 billion (approximately US$55 million) doesn’t make any sense because it keeps these funds potentially too small on purpose -  possibly putting them in the super angel fund class which is not a strategy for a typical Series A and B early stage fund.”
There are more gray areas that SEBI will have to address if it expects the industry to come out on its side. Questions regarding the extent that overseas funds will be affected, as well as issues of tax and the fate of those already fundraising are yet to be fully addressed. And while industry observers assume that AIFs will have to register their funds according to category, it may be the case that they can register a fund three times, each time in a different category.

SEBI has noted that funds already registered as VCFs under the 1996 laws would be able to continue operating in their existing manner until the specific fund or scheme winds up. Each fund therefore has a fresh start in a new regulatory landscape, but it also implies that first movers in the space, who have amassed their wealth in previous years, have an advantage. This might have an impact on where new vehicles choose to incorporate.
“Depending on how the regulations materialize, fund managers may find that Singapore is a keen alternative to India to set up a fund, and we will probably see people relocating there,” Hirani says. “Then funds can decide how they want to make the investments into India and broker their supporting partnerships.”

More transparency, fewer conflicts

It is perhaps best to view the proposals in the context of global re-regulation. The US Dodd-Frank Act and the EU’s Alternative Investment Fund Managers Directive are the most prominent examples of government efforts to exert more control over how funds interact with investors. The goal – and it varies in degree between markets – is to drive down risk exposure and ensure greater accountability. SEBI is no different.

“While institutions and high net worth individuals are expected to be savvy investors and need not be protected from market and credit risk, there is a need for a framework to deter from fraud, unfair trade practices and minimize conflicts of interest,” the regulatory draft states.
Its overarching solution to this is to create an environment of transparency that orders fund managers to provide financial, risk management, operational and transactional information to LPs, and disclose all fees up front. Further to this, the 5% ante that sponsors must invest in a fund cannot be garnered from LP fees.

Under the proposals, sponsors must declare all potential conflicts of interest. The onus is placed on the fund manager to “address all investor complaints” – this may seem obvious, but enacting rules with such a depth of detail is a departure from the laissez faire government of yesteryear. “For the last 18 months the PE industry has been making a lot of representations to the regulators,” says Vikram Utamsingh, head of transactions and restructuring and private equity advisory at KPMG India. “For the first time ever we are seeing some regulation that will deal with the uniqueness of private equity.”

While sources across India’s private equity industry agree that a more hands-on SEBI does provide advantages, the extent of the drawbacks of a more regulated sector are yet to be seen. And in regards to last week’s proposals, some still question if more stringent rules are misplaced.
“The focus of these laws should be on regulating managers and advisors, as opposed to regulating funds in this manner,” Hirani says. “It’s the GPs who really need to be regulated.” 

In detail: The draft rules for funds oversight

The Securities and Exchange Board of India’s (SEBI) proposed changes seek to define more clearly the role of alternative investment funds (AIF) – including private equity and venture capital vehicles – for investors and companies, and in doing so, provide parameters for funds’ operations.
The draft defines an AIF as a closed-end fund managing at least INR20 million ($4.5 million) in capital. Each AIF investment tranche must account for more than 0.1% of the fund – or at least INR10 million – and the fund’s sponsor must contribute at least 5%.

Additionally, an AIF would be prohibited from investing more than 25% of its capital in a single company, and AIFs will only be permitted to have 50 limited-liability partners. Each fund’s tenure must be at least five years, though this may be extended by two years if approved by three-quarters of their shareholders.

Private equity funds, specifically, would be required to invest at least 50% of capital in unlisted companies and no more than 50% in companies that have made listing proposals.

Venture capital funds (VCFs), meanwhile, are to be capped at INR2.5 billion, and are prohibited from investing in any company that is backed, directly or indirectly, a top-500 domestically listed company. At least two-thirds of VCF capital must be invested in unlisted equity, and no more than one-third of a VCJ’s investment can be allocated to unlisted debt instruments of portfolio companies.

PIPE funds face a similar cap on their exposure to debt instruments, but are obliged to commit at least two-thirds of their capital to publicly listed equities. PIPE targets are to be small-sized, and not part of any market indices in exchanges having nationwide terminals.
To conclude, SEBI notes that social venture funds must target social enterprises such as microfinance firms, while strategy funds would be allowed to invest in derivatives and other structured products, but must disclose their investment strategies to investors.

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• Topics
• PIPEs
• South Asia
• Regulation
• Venture
• AIF Capital