India AIFs: A new phase

Securing approval for an India-domiciled private equity fund used to take more than a year. That changed in 2012 with the introduction of sweeping reforms to Alternative Investment Fund (AIF) legislation, which set the industry on course to rise from a mere 20 active vehicles to more than 600. Last year, a record 130 applications were approved.

“AIFs have become the de facto vehicle in order to invest in the country going forward,” states Siddarth Pai, a partner at 3one4 Capital, a seed investment specialist that achieved a final close of INR4 billion ($57 million) on its latest fund in December.

The fund in question – Continuum I – is a category one AIF, reserved for venture capital and other early-stage managers. Indian GPs that exist higher up the food chain, concentrating on growth and buyout deals, must opt for category two. According to the Securities & Exchange Board of India (SEBI), total committed capital across both categories was more than INR1.98 trillion as of September 2019, up from INR180 billion in 2014.

Initial uncertainty

Several blue-chip investors from Tata Opportunities Fund to Kedaara Capital have embraced the structure, but it took them time to come around. “Some GPs created two separate pockets of capital – one for foreign investors and another as an AIF for domestic investors,” says Gaurav Ahuja, a managing director at ChrysCapital, which continues to use offshore-domiciled funds. “In a way, the two different structures were being tested.”

Regulatory uncertainty was a key concern in the first couple of years. A move by the government in 2015 to broaden the official definition of a start-up, making it easier for nascent businesses to qualify for policy incentives, eased matters. This coincided with a general upturn in India private equity fundraising as foreign institutional investors reengaged with the country.

“Indian GPs raised record sums [in AIFs] as foreign investors made ever bigger commitments, especially by those taking a long-term view on India,” says Thiha Tun, a London-based private funds partner with Dechert.  

Regulators also began to respond to industry demands for improvements to the AIF regime. Automatic approval for foreign investments into AIF-registered funds came into force later in 2015. A year later, revisions were made to India’s double taxation agreements with Mauritius and Singapore, which equalized capital gains treatment for onshore and offshore investors. As a result, offshore structures lost some of their appeal.

“Opening up to global investors really helped really kickstart pooling of capital in AIFs,” says Richie Sancheti, a Mumbai-based lawyer at Nishith Desai Associates. “Indian investors tend to be somewhat risk-averse and don't appreciate the asset class as much as global investors do.”

Last year, the industry achieved another breakthrough when it convinced SEBI to allow pass-through taxation for losses incurred by AIFs. Local managers now make the case that under this liberalized regime, AIFs are a more powerful investment vehicle than the foreign portfolio investor (FPI) structure primarily used to make investments from offshore funds.

AIFs can tap domestic capital sources and don’t need to worry about foreign investment restrictions in certain sectors. For example, offshore players can only own up to 49% of single brand retail, insurance, banking and telecom businesses. Further, AIFs don’t have to adhere to a mandatory one-year lock-up period after an investee goes public.

"Since good IPOs are priced such as to provide a decent post IPO pop, this flexibility of no-lock up for an AIF is very useful. You can also do put-call options with little or no restrictions, differentiated pricing structures, buyback options, structured deals within the gamut of an equity investment that an overseas investor cannot do,” says Bobby Pauly, a partner at Tata Opportunities Fund.

Progress impeded?

Some restrictions do remain. AIFs are subject to limits on what percentage of the corpus can be invested in any one company, on the use of leverage, and on investments in companies incorporated outside India. This means IT services companies – a popular target for private equity – are beyond their reach. There is a $750 million cap on total outbound investment by category one AIFs and exposure to a single foreign company usually cannot exceed 10%.

For many investors, though, the advantages outweigh the drawbacks, hence the rising uptake. While offshore feeder vehicles are still used to channel contributions from foreign LPs into India-domiciled master funds, some groups – notably endowments and foundations – are said to be comfortable enough to participate in the onshore structure directly. The fund recently raised by 3one4 is a case in point.

The rise of the AIF is not purely a foreign capital story. Interest in private equity and venture capital from local high net worth individuals has increased substantially in recent years. It is hoped this will in turn lead to more domestic institutional involvement, which is currently limited to a relatively small number of financial institutions.

However, the attention showered on the structure has proved to be a double-edged sword. Citing the inexperience of many local investors participating in the asset class, SEBI is considering new rules that have unnerved the industry. Last month, it announced plans for performance benchmarking – fund managers would have to pay independent third parties to verify their track records – and standardization of private placement memorandums.

“If they bring in these reforms, Indian GPs are going to be subject to a very different set of rules compared to GPs in other parts of the world,” observes Tun of Dechert.

Concerns within the private equity community center on whether benchmarking would deliver any insight – any system would require considerable thought given the variety of strategies pursued in the market – and additional costs incurred due to the rising compliance burden. GPs already pay high indirect taxes in the form of an 18% goods and service tax levy on management fees. “They won't drop it,” says 3one4’s Pai. “It has been made clear to everyone that this is not going to go away.”

If these issues prove intractable, offshore funds or hybrids could stage a resurgence. Fund formation lawyers report a recent uptick in queries regarding Singapore-based feeders.

Viewed from a wider standpoint, a successful AIF regime is integral to an Indian economy seeking to bounce back from a recent slump. Private equity and venture capital are expected to play a part in this, but much rests on facilitating the flow of capital, from foreign and domestic sources, into and out of investment vehicles that operate with relative freedom.

“India is aspiring to be a $5 trillion economy and our supply of local capital is yet to meaningfully pick up,” concedes Sancheti of Nishith Desai. “A clear path to grow the economy requires mobilizing patient foreign investment.”

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• Topics
• South Asia
• Regulation
• Fundraising
• GPs
• LPs
• India
• ChrysCapital Management
• Tata Capital
• 3one4 Capital