Alternative Investment Funds: A Growing Asset Class and a Regulatory Balancing Act

The International Monetary Fund continues to be optimistic about India's economic prospects, raising its GDP growth forecast for FY 2024-25 to 7%. High-net-worth individuals, accredited investors, and institutional investors—including banks, insurance companies, and development finance institutions—can access a diverse range of products in the form of SEBI-regulated AIFs, tailored to their specific investment goals and risk appetites. Indian fund managers continue to innovate, introducing new AIF strategies that provide such investors, both Indian and foreign, with opportunities to participate in India's growing economy.

Since their inception in 2012, AIFs have experienced significant growth and evolution as an asset class. Indian AIF managers have garnered over INR 11.7 lakh crore in cumulative commitments. SEBI has strived to maintain a delicate balance between fostering AIF growth and ensuring regulatory compliance.

The past few years have witnessed a surge in regulatory activity surrounding AIFs with SEBI implementing several measures to ensure that enhanced governance norms are adopted by AIFs. These range from introducing a standardised format for PPMs, to the addition of another layer of scrutiny through the appointment of a merchant banker to sign-off on the disclosures under the PPM, issuance of detailed valuation guidelines for AIFs, and more recently, the issuance of guidelines around specific due diligence checks to be implemented by AIFs to prevent facilitation of circumvention of other regulatory frameworks.

The recent amendments notifying specific due diligence requirements for AIFs in certain scenarios seem to be designed to prevent the misuse of AIFs for regulatory arbitrage. This includes instances where a single investor or an "investor group" forms an AIF solely to achieve "qualified buyer" or "qualified institutional buyer" status when they may not independently qualify as such. Additionally, AIFs with RBI-regulated entities as managers/sponsors or as significant investors or as associates of the manager/sponsor who are investing in the AIF or where such RBI-regulated entities by itself, or through its representative(s)/nominee(s), has majority or veto power in voting over decisions of the investment committee are subject to enhanced scrutiny to address concerns about evergreening of stressed loans and prevent circumvention of RBI's regulations. Lastly, given that Foreign Direct Investment (FDI) from persons resident in countries sharing a land border with India or where the beneficial owner of an investment into India is situated in or is a citizen of any such country, has been subject to government approval since Press Note 3 of 2020 issued by Department for Promotion of Industry and Internal Trade, SEBI has also prescribed enhanced diligence measures for AIFs with majority investment from such investors.

Before judging SEBI to be a harsh regulator, fund managers should be mindful of SEBI’s philosophy behind such increased scrutiny. SEBI is of the view that the enhanced trust that would result from adherence to such obligations, underlying principles, and implementation standards, along with verification of the adherence, would provide regulatory comfort for introduction of other Ease of Doing Business proposals/measures relating to AIFs and obviate the need for granular regulations. Among the other notable regulatory changes introduced last year, SEBI has mandated that at least one member of the investment manager's key team must possess the NISM Series-XIX-C: Alternative Investment Fund Managers Certification, in addition to a relevant professional qualification. This NISM certification requirement replaced the previous requirement of 5 years of professional experience in advising or managing capital pools. This change is expected to encourage first-time fund managers to enter the AIF space. Additionally, SEBI finally established a clear framework for AIFs and Venture Capital Funds (VCFs) set-up in the regulatory regime that preceded AIFs to deal with unliquidated investments at the end of their tenure. This has been an issue plaguing AIFs and particularly VCFs for a while, and especially in light of delays to exits caused due to COVID. This framework includes the option of extending the tenure through a "dissolution period," or making mandatory in-specie distributions, and provides greater flexibility for fund managers to address the issue of unliquidated investments within the prescribed framework. In addition to the growth of domestic AIFs, the last few years has also seen the emergence of GIFT City as a prominent international financial services hub, attracting numerous fund managers seeking to cater to both Indian and foreign investors. Its ranking has climbed from 67 to 57 in the Global Financial Centres Index 2024, reflecting its growing appeal. The Hon’ble Minister of Finance and Corporate Affairs, Ms. Sitharaman, has highlighted GIFT City's importance in India's vision to become a developed nation by 2047.

The Government’s intent to promote GIFT City is evident by amendments by SEBI to the SEBI (Foreign Portfolio Investors) Regulations, 2019 allowing up to 100% aggregate participation by non-resident Indians, overseas citizen of Indias and resident Indian individuals in FPIs based out of GIFT City, along with the introduction of IFSCA's Single Window IT System (SWIT System), have further enhanced GIFT City's attractiveness. The SWIT System should go a long way facilitating ease of doing business by streamlining the application process and bringing together various government agencies and regulators on a single digital platform.

The Union Budget 2024-2025 envisages the introduction of Variable Capital Company (VCC) structures in GIFT City. VCCs, a globally recognized investment vehicle, are particularly prevalent in Singapore and offer several advantages. By setting up VCCs in GIFT City, fund managers can manage multiple funds with diverse investment strategies and cater to investors with varying risk profiles within a single structure, positioning GIFT City as a competitive alternative to Singapore given India’s good standing and track record of compliance with international Know-Your-Customer (KYC) and Prevention of Money Laundering (PMLA) norms. Furthermore, the recently introduced IFSC (Listing) Regulations, 2024, which enable the direct listing of securities and financial products on IFSC stock exchanges, should enhance GIFT City's attractiveness for capital raising.

In conclusion, the future of AIFs as an asset class appears promising. Recent developments in the industry have fostered a balanced regulatory environment that offers flexibility to fund managers while ensuring investor confidence. The availability of ample capital and strong regulatory support bode well for the continued growth and success of AIFs in India as well as GIFT City, it appears that they are poised to play an important role in the India growth story.