Understanding the Three Categories of Alternative Investment Funds: Cat I, II, and III
Regulatory authorities categorize Alternative Investment Funds (AIFs) into three distinct categories, which serve different investment objectives and risk profiles. In the I, II, and III categories, investors can access a range of opportunities for exposure to alternative assets. Investors can use these categories to guide their decisions when selecting an AIF that meets their financial needs.
Category I
Early-stage startups, small and medium enterprises (SMEs), social ventures, or infrastructure projects are the main areas of investment for Category I AIFs. Economic growth and innovation are the main objectives of these funds. Investments in this category include:
Venture Capital Funds: Focused onhigh-growth startups and emerging businesses.
Infrastructure Funds: Designated for infrastructure development, such as energy, airports, and roads.
Social Venture Funds: Fostering socially conscious businesses.
SME Funds: Providing capital to small and medium-sized businesses.
Category I Alternative Investment Funds are ideal for investors seeking long-term growth opportunities, government incentives, and exposure to promising industries.
Category II
Category II AIFs are a viable option for investors seeking predictable returns, as they do not offer specific government incentives. The funds invest in a range of alternative assets, such as:
Private Equity Funds: Investing in unlisted companies for long-term value creation
Debt Funds: Debt funds focus on credit investments, including structured debt and high-yield securities.
Real Estate Funds: Investing in residential and commercial properties
Investors who prefer participating in early and late-stage private deals should consider Category II Alternative Investment Funds, as they offer a balance between risk and reward without excessive speculation.
Category III
Equity funds, hedge funds and derivatives trading are among the riskier, more complex strategies employed by Category III Alternative Investment Funds to achieve superior returns. Hedging and short-selling are also common tactics employed by these funds. Among the Category III AIFs, there are primary categories:
Hedge Funds: Engaging in conservative or aggressive investing or trading strategies.
High-Frequency Trading: Utilizing algorithm-based trades for quick profits.
The ideal target audience for these funds is high-net-worth individuals and institutional investors with a strong risk appetite and knowledge of alternative investment options.
To invest, it is important to be familiar with the three types of Alternative Investment Funds. An AIF can be accessed for those investors who are looking for long-term, steady returns or opportunities for high-risk, high-reward investments. Before investing, it is important to obtain the opinion of financial experts on how the fund operates and whether its regulatory compliance meets certain requirements. By selecting a specific category of Alternative Investment Funds, portfolio holders can optimize their investments and diversify alternative assets.
SEBI Extends Deadlines for Alternative Investment Funds to Transition Investments into Dematerialized Form
On 14th February 2025, the Securities and Exchange Board of India (SEBI) issued an important circular regarding the timelines for holding investments in dematerialized form by Alternative Investment Funds (AIFs). The circular introduced a relaxation in the previously set deadlines, granting AIFs additional time to transition their investments into electronic or demat format.
The shift towards dematerialization has been a significant regulatory push aimed at improving transparency, ease of trade, and reducing operational risks within India’s financial markets. However, implementing such changes, particularly for Alternative Investment Funds, requires careful planning due to the nature of the investments these funds typically hold. AIFs, which include venture capital funds, private equity funds, and hedge funds, often deal with illiquid, complex, and long-term investments, making this transition a challenging process.
The relaxation of timelines for AIFs provides much-needed flexibility, allowing fund managers more time to ensure compliance without disrupting their operations or investment strategies. SEBI’s decision acknowledges the practical difficulties faced by AIFs, such as the requirement to convert non-dematerialized assets into dematerialized form (this needs the cooperation of the investee companies) and the complexity of managing large portfolios of diverse investments.
One of the key aspects of this relaxation is the facilitation of a smoother operational framework for AIFs. By providing this extension, SEBI is supporting the funds in aligning with global best practices in investment management, without overburdening them with overly rigid deadlines. It’s crucial for the growth of India’s investment ecosystem that Alternative Investment Funds have ample time to make this transition successfully, as the push for greater transparency and efficiency is vital for attracting both domestic and international investors.
Another significant outcome of the SEBI circular is its potential to improve liquidity. AIFs managing assets in dematerialized form are likely to see smoother processes when it comes to trading, settling, and monitoring these investments. This could ultimately lead to a more vibrant and accessible market, fostering increased investor confidence.
While the relaxation of timelines provides an important buffer for AIFs, it is also a reminder that the Indian investment ecosystem continues to evolve. The move towards greater digitization and automation within the financial markets aligns with broader global trends in asset management, positioning AIFs for sustained growth in the coming years.
For Alternative Investment Funds, it’s important to take full advantage of this extended timeline to ensure that all necessary measures are in place for dematerializing their holdings. SEBI’s decision to relax the deadlines provides the breathing room needed to complete this transformation successfully, ensuring a more robust, transparent, and efficient market for all stakeholders involved.
For more information, you can access the full SEBI circular here.
AIFs: A Fresh Path into Private Equity
Private equity has always been a favourite for experienced investors looking for substantial returns. But now, AIFs are offering a different path into these kinds of deals. Unlike the more traditional private equity firms, AIFs operate with clearer rules and guidelines, which helps bring more openness and understanding.
AIF Funds are a great option for private equity investors because they provide a bunch of benefits, such as:
Greater Flexibility: Investors can choose from various fund structures to suit their risk appetite and investment horizon.
Diversified Portfolios: AIFs allow exposure to multiple industries and asset classes, reducing risk.
Professional Fund Management: Experienced managers oversee the fund’s investments, optimizing returns for investors.
AIF Funds and Venture Capital: Fuelling New Businesses and Innovation
Venture capital funding is essential for nurturing startups and fostering innovation. AIFs have become a crucial source of capital for early- and growth-stage companies, offering tailored investment strategies that align with the dynamic startup ecosystem.
Some key ways in which AIF Funds are impacting the venture capital sector include:
Increased Capital Flow: AIF’s pool investments from investors (including accredited investors), increasing startup capital.
Risk Mitigation: By diversifying across multiple startups, they help mitigate risks associated with venture capital investments.
Long-Term Growth: They often have extended investment horizons, providing startups with stable funding for scaling operations.
Regulatory Support and Market Expansion
Governments and financial regulators worldwide have recognized the significance of AIF Funds in driving economic growth. In India, the Securities and Exchange Board (SEBI) has established clear guidelines to regulate AIFs, ensuring investor protection and promoting market expansion. With favourable regulatory environments, AIFs are expanding their reach into new sectors, including fintech, healthcare, and clean energy, further diversifying investment opportunities.
The increasing prominence of AIF Funds in private equity and venture capital has opened new avenues for investors and entrepreneurs alike. By providing flexible investment structures, access to diversified portfolios, and professional fund management, AIFs are redefining how capital is allocated in alternative investments. As the financial landscape evolves, AIFs will remain a cornerstone of private equity and venture capital growth.
Investors looking to capitalize on the transformative potential of AIF Funds should conduct thorough research and consult with financial advisors to navigate the complexities of this dynamic investment space.
AIF Funds: Reshaping the World of Private Equity and Venture Capital
Alternative Investment Funds (AIFs) are making a difference in the private equity and venture capital scene. They offer a regulated way for investors to put their money to work as a pool. Through an AIF Fund, wealthy individuals, big institutions, and family offices can tap into profitable deals in addition to the usual stock market route. As the private equity and venture capital world changes, AIFs are becoming a key player in how investments are made, where capital goes, and how wealth is built.
AIFs: A Fresh Path into Private Equity
Private equity has always been a favourite for experienced investors looking for substantial returns. But now, AIFs are offering a different path into these kinds of deals. Unlike the more traditional private equity firms, AIFs operate with clearer rules and guidelines, which helps bring more openness and understanding.
AIF Funds are a great option for private equity investors because they provide a bunch of benefits, such as:
Greater Flexibility: Investors can choose from various fund structures to suit their risk appetite and investment horizon.
Diversified Portfolios: AIFs allow exposure to multiple industries and asset classes, reducing risk.
Professional Fund Management: Experienced managers oversee the fund’s investments, optimizing returns for investors.
AIF Funds and Venture Capital: Fuelling New Businesses and Innovation
Venture capital funding is essential for nurturing startups and fostering innovation. AIFs have become a crucial source of capital for early- and growth-stage companies, offering tailored investment strategies that align with the dynamic startup ecosystem.
Some key ways in which AIF Funds are impacting the venture capital sector include:
Increased Capital Flow: AIF’s pool investments from investors (including accredited investors), increasing startup capital.
Risk Mitigation: By diversifying across multiple startups, they help mitigate risks associated with venture capital investments.
Long-Term Growth: They often have extended investment horizons, providing startups with stable funding for scaling operations.
Regulatory Support and Market Expansion
Governments and financial regulators worldwide have recognized the significance of AIF Funds in driving economic growth. In India, the Securities and Exchange Board (SEBI) has established clear guidelines to regulate AIFs, ensuring investor protection and promoting market expansion. With favourable regulatory environments, AIFs are expanding their reach into new sectors, including fintech, healthcare, and clean energy, further diversifying investment opportunities.
The increasing prominence of AIF Funds in private equity and venture capital has opened new avenues for investors and entrepreneurs alike. By providing flexible investment structures, access to diversified portfolios, and professional fund management, AIFs are redefining how capital is allocated in alternative investments. As the financial landscape evolves, AIFs will remain a cornerstone of private equity and venture capital growth.
Investors looking to capitalize on the transformative potential of AIF Funds should conduct thorough research and consult with financial advisors to navigate the complexities of this dynamic investment space.
How is SEBI Pushing For Growth and Transparency in AIFs?
India’s financial landscape is undergoing a transformative shift, fuelled by a confluence of factors. A decade-long surge in wealth has seen AIF funds experience more than 100-fold increase in AUM, boasting a robust 56% CAGR between FY14 (Rs 0.13 lakh crore) and FY24 (Rs 11.35 lakh crore). The growing population of affluent Indians (ultra HNIs), projected to double by 2026 as per a Knight Frank Wealth Report, have created a fertile ground for diverse investment opportunities in AIFs.
India’s booming economy and youthful demographic profile have positioned it as a prime market for alternative investments. SEBI, recognising this potential, has taken proactive steps to modernise the regulatory framework for AIF funds. Recent circulars issued in 2024 aim to streamline processes, enhance transparency, and address emerging challenges in these investment products. These initiatives show the regulator’s commitment to fostering a robust and investor-friendly financial ecosystem.
As India continues its trajectory of growth, it is poised to become a global financial hub. The increasing sophistication of Indian investors, coupled with a conducive regulatory environment, will further propel the growth of alternative investments.
Here is a look at a few of these circulars on AIF funds and their implications for investors.
Facilitating Debt Raising by AIFs through Encumbrance Creation
In a circular dated April 26, 2024, SEBI introduced a framework allowing Category I and II AIFs to create encumbrances on their equity holdings in investee companies. That is, AIF funds can pledge their shares in investee companies. This move aims to ease debt raising for these companies, particularly those operating in infrastructure sectors. While this provides much-needed flexibility, it is crucial to understand the accompanying conditions:
Encumbrances are restricted to specific purposes: SEBI explicitly limits the use of encumbrances to borrowing for the development, operation, or management of projects within infrastructure sub-sectors defined by the Central Government.
Transparency and investor consent are paramount: AIFs are mandated to disclose encumbrances and their associated risks in their Private Placement Memorandums (PPMs). For encumbrances created before the circular’s issuance, specific consent requirements from investors apply.
Strict usage of borrowed funds: SEBI emphasized that borrowings against encumbered equity investments can only be utilized for the intended infrastructure project and prohibits their diversion into other investments, including investments in other companies. This restriction must be explicitly included in the investment agreement between the AIF and the investee company.
Duration limitations and considerations for foreign investments: The encumbrance duration is capped by the scheme’s remaining tenure, preventing extended encumbrances beyond the AIF’s lifespan. Additionally, AIFs with substantial foreign investment face stricter requirements aligned with the RBI Master Direction on Foreign Investments in India.
Investor protection and the prohibition of guarantees: The circular safeguards investors by ensuring they are not exposed to liabilities exceeding the encumbered equity in case of default. Additionally, AIFs are explicitly barred from issuing guarantees for the investee company.
The circular mandates the Standard Setting Forum for AIFs (SFA) to develop implementation standards ensuring proper encumbrance utilisation. Compliance with these provisions forms a crucial part of the AIF’s Compliance Test Report.
Thus, share pledging by AIFs in infrastructure companies is like a double-edged sword. This strategy is not without its risks. Fluctuations in share prices can expose AIFs to potential losses and the risk of default by the investee company can damage the fund’s reputation.
However, it enables AIFs to unlock additional capital, enhance returns, and adapt to market dynamics. By using their existing equity investments as collateral, AIFs can secure loans without liquidating their assets, thereby maximizing returns for both the fund and its investors.
Simplifying PPM Changes for AIF Funds
In another circular issued on April 29, 2024, SEBI eased the process for AIFs to intimate changes in their PPMs (private placement memorandum) by exempting certain changes from the mandatory involvement of a merchant banker. This relaxation aims to reduce compliance costs and streamline procedures for AIFs. That is, PPMs of AIF funds can be submitted directly to the regulator rather than through a merchant banker.
PPM is a key document for AIF funds which discloses essential information to investors, following a mandated template. These include fee details, history, exit process and more.
A detailed list of changes eligible for direct filing with SEBI is also mentioned in the circular. These include updates to market outlook sections, changes in contact details or service providers, adjustments to fund size or commitment periods, and the inclusion of new disclosures mandated by regulations.
Large Value Funds for Accredited Investors receive further exemption, allowing them to directly file any PPM changes with SEBI, accompanied by an undertaking signed by key personnel of the AIF Manager.
Strengthening Due Diligence Requirements for AIFs
Based on the circular issued on October 8, 2024, SEBI underlined the commitment to investor protection and regulatory compliance by strengthening due diligence requirements for AIFs, their managers, and key personnel.
SEBI identified specific areas requiring stringent due diligence checks:
Preventing ineligible investors from accessing QIB benefits: The circular aims to prevent investors who wouldn’t qualify for Qualified Institutional Buyer (QIB) status individually from obtaining these benefits through AIFs.
Preventing ineligible investors from accessing QB benefits: Similar to the QIB provision, this measure ensures that only investors who qualify as Qualified Buyers (QBs) under the SARFAESI Act can access the benefits associated with this status through AIFs.
Addressing the issue of evergreening of stressed assets: The circular tackles the practice of RBI-regulated lenders using AIFs to mask the true status of stressed loans or assets, ensuring compliance with RBI’s norms on income recognition, asset classification, provisioning, and restructuring.
Ensuring compliance with FDI regulations for investments from bordering countries: This provision ensures AIF funds comply with the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019, specifically regarding investments originating from countries sharing land borders with India.
The market regulator further mandates adherence to implementation standards developed by SFA for conducting these due diligence checks. The circular outlines consequences for failing these checks, including the exclusion of problematic investors or the complete prohibition of the investment. Existing investments also fall under the purview of these due diligence requirements, with reporting obligations for non-compliant investments.
Providing Flexibility in Managing Unliquidated AIF Investments
Another circular provides AIFs and their investors with much-needed flexibility in managing unliquidated investments during the closing stages of a scheme. It introduces the concept of a ‘Dissolution Period’, providing an additional avenue for liquidating remaining investments after the initial Liquidation Period.
The Dissolution Period requires approval from at least 75% of investors and necessitates specific conditions, including arranging bids for a minimum percentage of unliquidated investments.
The circular also introduces mandatory in-specie distribution of unliquidated investments if the AIF funds cannot secure the required investor consent for the Dissolution Period or in-specie distribution during the Liquidation Period. This provision streamlines the process for handling unliquidated assets, ensuring a clear path forward even when consensus is challenging.
Recognising the challenges faced by schemes with expiring Liquidation Periods, the circular grants a one-time extension to schemes whose Liquidation Period expires on or before July 24, 2024. This fresh Liquidation Period extends to April 24, 2025, providing these schemes with additional time to liquidate their assets or utilize the newly available options for handling unliquidated investments.
Finally, SEBI discontinued the option of launching new Liquidation Schemes from April 25, 2024, onward, while existing Liquidation Schemes will continue to operate under the previous regulations.
Takeaway
Changes like simplification in PPM and addressing emerging challenges like liquidation period extensions foster an environment of ease while also ensuring transparency for AIF Funds in India, a segment that has seen a massive spike in assets under management. The recent regulatory measures reflect SEBI’s commitment to promoting a healthy AIF ecosystem as India continues its trajectory of growth and aims to become a global financial hub.
A significant growth of alternative investments in India is seen in both Portfolio Management Services (PMS) and Alternative Investment Funds (AIFs), driven by the country’s economic expansion and the evolving investment preferences of High-Net-Worth Individuals (HNIs) and Ultra-High-Net-Worth Individuals (UHNIs).
Source: SEBI
Before we dive into the growth of Indian alternative investments, let’s understand the changes in preferences a bit more.
Rising Demand for Wealth-Building Products
India’s robust economic growth, coupled with increasing disposable income among HNIs and UHNIs, has fueled a surge in demand for sophisticated investment avenues, leading to significant expansion in the alternative investment landscape.
Source: The Knight Frank Wealth Report, 2022, 2023, *estimated.
This trend is driven by investors seeking to diversify their portfolios beyond traditional assets and achieve higher returns. Notably, the Indian alternative investment industry (PMS invest & AIF fund) has exhibited a remarkable compound annual growth rate (CAGR) of 33% over the past decade (FY14 to FY24). As India aims to become a $10 trillion economy by 2035, alternative investments are expected to play a crucial role in wealth creation.
Shifting Investment Preferences
While the Indian equity market has performed well in recent years, HNIs and UHNIs are increasingly seeking alternative investment options to optimise their wealth. A report by 360 ONE Wealth and CRISIL highlights a shift away from traditional investments, with UHNIs and HNIs showing growing interest in alternatives such as PMS funds, AIF funds, Real Estate Investment Trusts (REITs), and private equity, aiming for annual returns of 12-15%. The report also notes that 41% of HNIs and UHNIs work with multiple wealth management firms, indicating a preference for professional advice in managing their investments. This trend is particularly prevalent among those under 40.
The rapid growth of alternative investments, surpassing the growth rates of mutual funds and other asset classes over the past five years, underscores their appeal. The Knight Frank Wealth Report projects a 50% increase in the number of UHNIs by 2028, while HNIs are expected to more than double by 2026 in India. This expanding pool of capital is actively seeking alternative investment options with the potential to deliver higher returns than traditional instruments.
Growth of PMS and AIFs
The rising income levels and specific investment objectives of HNIs and UHNIs are driving the demand for specialized PMS funds and AIF funds tailored to meet their unique needs. The PMS industry in India has witnessed consistent growth, with Assets Under Management (AUM) managed by PMS providers increasing at a CAGR of 23% over the past decade (FY14 to FY24). The AUM reached Rs 7.43 lakh crore as of September 2024.
While PMS services has seen a strong growth, it is the AIF fund industry that has really taken off.
AIFs, privately pooled investment vehicles offering flexibility in investment strategies and asset classes, have exhibited even more impressive growth, achieving a CAGR of 48% over the past ten years (FY15 to FY25 – Q1FY25). Their AUM now stands at Rs 11.78 lakh crore as of June 2024. This growth is primarily attributed to the increasing popularity of Category II AIFs, which encompass private equity, private credit, real estate funds, venture capital, venture debt, and infrastructure funds. Notably, real estate has emerged as the top sector, contributing 17% of investment by AIFs.
Within Category II AIFs, the majority of investments have been directed towards private equity, followed by private credit, infrastructure funds, and real estate according to many experts. This category has experienced tremendous growth with a CAGR of 65% in the past decade!
Drivers of Growth in AIFs
Several factors contribute to the remarkable growth of AIFs in India:
First, India’s position as a top-five global economy, along with its youthful demographic profile, provides a strong foundation for AIF funds. This along with increasing income levels, growing investor awareness, and supportive regulatory reforms are fuelling the AIF industry’s growth.
Also, expanding infrastructure, a thriving start-up ecosystem, and a conducive business environment contribute to the success of AIFs. Another reason is India’s burgeoning start-up ecosystem, with a projected 250 unicorns by 2025, presents significant opportunities for AIFs to provide tailored solutions like venture debt.
But most importantly, alternative investments, both PMS and AIF, offer investors a diverse range of opportunities to diversify their portfolios across listed and unlisted equities, fixed-income instruments, and other asset classes and provide an opportunity for superior returns.
Outlook
The Indian alternative investment industry, with its current AUM of Rs 19.21 lakh crore (approximately $0.23 trillion), has significant room for growth compared to the global AUM of $16.78 trillion. Preqin forecasts the global alternatives industry to reach $29.2 trillion in AUM by 2029.
If this growth trajectory continues, the overall industry is projected to surpass Rs 100 lakh crore by 2030, marking an over 5-fold increase in just 6 years, as per PMS Bazaar estimates. However, the potential for long-term growth depends on sustained economic growth, favourable economic conditions, and continued investor interest.
How is SEBI Pushing For Growth and Transparency in AIFs?
India’s financial landscape is undergoing a transformative shift, fuelled by a confluence of factors. A decade-long surge in wealth has seen AIF funds experience more than 100-fold increase in AUM, boasting a robust 56% CAGR between FY14 (Rs 0.13 lakh crore) and FY24 (Rs 11.35 lakh crore). The growing population of affluent Indians (ultra HNIs), projected to double by 2026 as per a Knight Frank Wealth Report, have created a fertile ground for diverse investment opportunities in AIFs.
India’s booming economy and youthful demographic profile have positioned it as a prime market for alternative investments. SEBI, recognising this potential, has taken proactive steps to modernise the regulatory framework for AIF funds. Recent circulars issued in 2024 aim to streamline processes, enhance transparency, and address emerging challenges in these investment products. These initiatives show the regulator’s commitment to fostering a robust and investor-friendly financial ecosystem.
As India continues its trajectory of growth, it is poised to become a global financial hub. The increasing sophistication of Indian investors, coupled with a conducive regulatory environment, will further propel the growth of alternative investments.
Here is a look at a few of these circulars on AIF funds and their implications for investors.
Facilitating Debt Raising by AIFs through Encumbrance Creation
In a circular dated April 26, 2024, SEBI introduced a framework allowing Category I and II AIFs to create encumbrances on their equity holdings in investee companies. That is, AIF funds can pledge their shares in investee companies. This move aims to ease debt raising for these companies, particularly those operating in infrastructure sectors. While this provides much-needed flexibility, it is crucial to understand the accompanying conditions:
Encumbrances are restricted to specific purposes: SEBI explicitly limits the use of encumbrances to borrowing for the development, operation, or management of projects within infrastructure sub-sectors defined by the Central Government.
Transparency and investor consent are paramount: AIFs are mandated to disclose encumbrances and their associated risks in their Private Placement Memorandums (PPMs). For encumbrances created before the circular’s issuance, specific consent requirements from investors apply.
Strict usage of borrowed funds: SEBI emphasized that borrowings against encumbered equity investments can only be utilized for the intended infrastructure project and prohibits their diversion into other investments, including investments in other companies. This restriction must be explicitly included in the investment agreement between the AIF and the investee company.
Duration limitations and considerations for foreign investments: The encumbrance duration is capped by the scheme’s remaining tenure, preventing extended encumbrances beyond the AIF’s lifespan. Additionally, AIFs with substantial foreign investment face stricter requirements aligned with the RBI Master Direction on Foreign Investments in India.
Investor protection and the prohibition of guarantees: The circular safeguards investors by ensuring they are not exposed to liabilities exceeding the encumbered equity in case of default. Additionally, AIFs are explicitly barred from issuing guarantees for the investee company.
The circular mandates the Standard Setting Forum for AIFs (SFA) to develop implementation standards ensuring proper encumbrance utilisation. Compliance with these provisions forms a crucial part of the AIF’s Compliance Test Report.
Thus, share pledging by AIFs in infrastructure companies is like a double-edged sword. This strategy is not without its risks. Fluctuations in share prices can expose AIFs to potential losses and the risk of default by the investee company can damage the fund’s reputation.
However, it enables AIFs to unlock additional capital, enhance returns, and adapt to market dynamics. By using their existing equity investments as collateral, AIFs can secure loans without liquidating their assets, thereby maximizing returns for both the fund and its investors.
Simplifying PPM Changes for AIF Funds
In another circular issued on April 29, 2024, SEBI eased the process for AIFs to intimate changes in their PPMs (private placement memorandum) by exempting certain changes from the mandatory involvement of a merchant banker. This relaxation aims to reduce compliance costs and streamline procedures for AIFs. That is, PPMs of AIF funds can be submitted directly to the regulator rather than through a merchant banker.
PPM is a key document for AIF funds which discloses essential information to investors, following a mandated template. These include fee details, history, exit process and more.
A detailed list of changes eligible for direct filing with SEBI is also mentioned in the circular. These include updates to market outlook sections, changes in contact details or service providers, adjustments to fund size or commitment periods, and the inclusion of new disclosures mandated by regulations.
Large Value Funds for Accredited Investors receive further exemption, allowing them to directly file any PPM changes with SEBI, accompanied by an undertaking signed by key personnel of the AIF Manager.
Strengthening Due Diligence Requirements for AIFs
Based on the circular issued on October 8, 2024, SEBI underlined the commitment to investor protection and regulatory compliance by strengthening due diligence requirements for AIFs, their managers, and key personnel.
SEBI identified specific areas requiring stringent due diligence checks:
Preventing ineligible investors from accessing QIB benefits: The circular aims to prevent investors who wouldn’t qualify for Qualified Institutional Buyer (QIB) status individually from obtaining these benefits through AIFs.
Preventing ineligible investors from accessing QB benefits: Similar to the QIB provision, this measure ensures that only investors who qualify as Qualified Buyers (QBs) under the SARFAESI Act can access the benefits associated with this status through AIFs.
Addressing the issue of evergreening of stressed assets: The circular tackles the practice of RBI-regulated lenders using AIFs to mask the true status of stressed loans or assets, ensuring compliance with RBI’s norms on income recognition, asset classification, provisioning, and restructuring.
Ensuring compliance with FDI regulations for investments from bordering countries: This provision ensures AIF funds comply with the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019, specifically regarding investments originating from countries sharing land borders with India.
The market regulator further mandates adherence to implementation standards developed by SFA for conducting these due diligence checks. The circular outlines consequences for failing these checks, including the exclusion of problematic investors or the complete prohibition of the investment. Existing investments also fall under the purview of these due diligence requirements, with reporting obligations for non-compliant investments.
Providing Flexibility in Managing Unliquidated AIF Investments
Another circular provides AIFs and their investors with much-needed flexibility in managing unliquidated investments during the closing stages of a scheme. It introduces the concept of a ‘Dissolution Period’, providing an additional avenue for liquidating remaining investments after the initial Liquidation Period.
The Dissolution Period requires approval from at least 75% of investors and necessitates specific conditions, including arranging bids for a minimum percentage of unliquidated investments.
The circular also introduces mandatory in-specie distribution of unliquidated investments if the AIF funds cannot secure the required investor consent for the Dissolution Period or in-specie distribution during the Liquidation Period. This provision streamlines the process for handling unliquidated assets, ensuring a clear path forward even when consensus is challenging.
Recognising the challenges faced by schemes with expiring Liquidation Periods, the circular grants a one-time extension to schemes whose Liquidation Period expires on or before July 24, 2024. This fresh Liquidation Period extends to April 24, 2025, providing these schemes with additional time to liquidate their assets or utilize the newly available options for handling unliquidated investments.
Finally, SEBI discontinued the option of launching new Liquidation Schemes from April 25, 2024, onward, while existing Liquidation Schemes will continue to operate under the previous regulations.
Takeaway
Changes like simplification in PPM and addressing emerging challenges like liquidation period extensions foster an environment of ease while also ensuring transparency for AIF Funds in India, a segment that has seen a massive spike in assets under management. The recent regulatory measures reflect SEBI’s commitment to promoting a healthy AIF ecosystem as India continues its trajectory of growth and aims to become a global financial hub.
The Indian Portfolio Management Services (PMS) industry has seen a significant uptick in interest from High Net-worth Individuals (HNIs) and Ultra-High Net-worth Individuals (UHNIs). This surge is driven by the growing number of wealthy individuals seeking personalised investment strategies that align with their specific risk tolerance and wealth creation needs. PMS Funds offers a tailored solution, providing access to a diverse range of equity and debt instruments, and enabling investors to benefit from expert portfolio management.
Over the past decade, the PMS investment industry has experienced robust growth, with Assets Under Management (AUM) expanding at a Compound Annual Growth Rate (CAGR) of 22%. As of September 2024, the AUM reached an impressive Rs 7.43 lakh crore, underscoring the industry’s immense potential.
Recognising the increasing importance of PMS Funds, the Securities and Exchange Board of India (SEBI) has taken proactive steps to enhance investor protection and streamline regulations. One significant initiative is the simplification of PMS distributor regulations. Given the customised nature of PMS India offerings, distributors play a vital role in connecting investors with suitable portfolios. By easing regulatory requirements, SEBI aims to facilitate better access to invest in PMS services and promote greater transparency in the industry.
Another notable regulatory change introduced by SEBI is the enhancement of digital on-boarding processes. This move aligns with the increasing adoption of digital technologies in the financial industry and aims to streamline the client onboarding experience, making it more efficient and convenient for investors. By leveraging digital tools, PMS providers can expedite the onboarding process, reduce paperwork, and enhance overall client satisfaction.
Here is a detailed note.
Streamlining Oversight of PMS Distributors
In May this year, SEBI introduced a significant change in the oversight of PMS distributors by mandating their registration with the Association of Portfolio Managers in India (APMI) effective January 1, 2025. This move centralises distributor oversight at the industry level, simplifying compliance procedures for Portfolio Managers who are now responsible for ensuring their distributors are registered with APMI and adhere to the relevant SEBI regulations and codes of conduct.
By mandating APMI registration, SEBI aims to foster a more efficient and transparent ecosystem to invest in PMS providers. This aligns with the regulatory body’s broader goal of promoting collective oversight of distributors.
Further, this approach mirrors the existing framework in the mutual fund industry, where distributors are required to register with the Association of Mutual Funds in India (AMFI) and obtain an AMFI Registration Number (ARN). APMI is expected to release the specific criteria for distributor registration by July 1, 2025. This move signifies a step towards enhancing the overall regulatory landscape for the PMS India industry and promoting investor protection.
Enhancing Digital On-boarding and Fee Transparency in PMS
In the same month, another circular from SEBI brought a welcome change to the PMS investment landscape by facilitating digital on-boarding for clients and enhancing transparency in fee structures.
One notable move is the acceptance of typed or electronically written confirmations of understanding fees and charges for clients onboarded digitally, moving away from the previous requirement of handwritten confirmations. This change, effective from October 1, 2024, signifies SEBI’s push towards a more digitally inclusive environment.
Further, SEBI promoted fee transparency by mandating Portfolio Managers to provide clients with a comprehensive fee calculation tool. This tool, covering multi-year scenarios and incorporating the high watermark principle where applicable, aims to provide clients with a clearer understanding of potential fee implications.
Apart from this, the circular mandated the inclusion of detailed fee illustrations in the PMS-client agreement and periodic reports. These illustrations cover various market scenarios, including portfolio value increases, decreases, and stagnation, providing clients with a realistic picture of fee dynamics.
There is also an introduction of a ‘Most Important Terms and Conditions (MITC)’ document. This document, to be provided to and acknowledged by all clients. It summarises critical aspects of the Portfolio Manager-client relationship, promoting clarity and understanding of their mutual rights and obligations.
Takeaway
These recent SEBI circulars represent a concerted effort to streamline the regulatory landscape governing PMS funds, balancing flexibility with robust investor protection measures. These measures will undoubtedly shape the future of PMS India, promoting a more efficient and investor-friendly environment.
Further, as the Indian economy continues to grow and the number of affluent individuals increases, the PMS industry is poised for further expansion. With supportive regulatory measures and increasing investor awareness, the PMS investment sector in India is well-positioned to play a crucial role in meeting the evolving investment needs of high-net-worth individuals in India.
Navigating New Waters: A Look at SEBI’s Circular on AIF Fund Due Diligence
India’s alternative investment funds (AIF funds), which includes private equity funds, debt funds, real estate funds, and funds of funds, has grown from 2.08 lakh crore (June 2019) to Rs 9.33 lakh crore (June 2024) in a span of five years. An annual average growth of 35%!
So, considering the growth potential, it is understandable that the Securities and Exchange Board of India (SEBI) is sitting up and taking notice for better protection of investors’ interest.
SEBI’s recent circular on October 8 this year is one such example. The market regulator has introduced stricter due diligence requirements, sparking a wave of discussions and debate within the industry. While some view the new regulations as an unnecessary burden, others believe they represent a crucial step toward greater transparency, accountability, and ultimately, investor protection.
Need for change
AIF funds are a diverse range of asset classes including private debt, private equity, venture capital, hedge funds, SME funds, infrastructure funds, and more, catering to high-net-worth individuals and sophisticated investors. These funds often operate in complex structures compared to traditional investment avenues such as mutual funds or fixed deposits. This complexity can create opportunities for regulatory arbitrage, and entities might work in a grey area of regulation.
SEBI’s circular aims to address this issue by plugging potential loopholes and ensuring a level playing field.
For instance, there are reports of misuse of benefits intended for specific categories of investors. Qualified Institutional Buyers (QIBs) and Qualified Buyers (QBs), as defined under various regulations, enjoy certain privileges, such as preferential allotment in IPOs and access to specific financial instruments. The SEBI circular seeks to prevent AIFs from being used as a conduit for ineligible investors to access these benefits. By mandating thorough due diligence, particularly when investors contribute significantly to a scheme’s corpus, SEBI aims to ensure that only genuinely qualified individuals or entities reap these advantages.
The change
The core objective is to ensure that AIFs are not used as a vehicle to bypass regulations established by various financial sector regulators, including SEBI and the Reserve Bank of India (RBI). As such, the circular outlines four key areas for the application of the new due diligence norms.
Streamlining investment by QIBs and QBs
One key area of focus is preventing ineligible investors from accessing benefits intended for Qualified Institutional Buyers (QIBs) and Qualified Buyers (QBs).
QIBs are sophisticated investors with substantial financial resources and expertise. They include entities like mutual funds, scheduled commercial banks, multilateral financial institutions, systematically important NBFCs, and Foreign Venture Capital Investors (FVCIs).
And QIBs typically include financial institutions with experience in investing in and managing distressed assets. This circular applies to both AIFs as QIBs under ICDR Regulations and QBs under SARFAESI Act.
The regulations specifically target practices of such AIFs pooling capital from smaller entities that don’t individually qualify as QIBs to gain access to benefits like preferential share allocations in IPOs.
Similarly, regulations address concerns about AIF funds being used by group entities to gain QB status under the SARFAESI Act, which allows them to subscribe to Security Receipts (SRs) issued by Asset Reconstruction Companies (ARCs) and potentially influence the management of underlying assets.
What’s the change?
AIF fund managers are required to perform thorough due diligence when an investor or a group of related investors contributes 50% or more to a scheme’s corpus. This due diligence aims to verify whether the investor(s) independently qualify as QIBs or QBs based on their own financial standing and expertise, or if they are government-backed entities.
Investments from countries sharing land borders
Similar due diligence process will be required for AIFs that receive investments from entities located in countries sharing a land border with India. These requirements stem from the Foreign Exchange Management Act (Non-Debt Instruments) Rules, 2019 (NDI Rules). This stipulates that such investments require government approval to invest in the equity instruments of Indian companies.
What’s the change?
As such AIF schemes where 50% or more of the corpus is contributed by investors who are citizens of or have beneficial owners situated in a land bordering country must undergo specific due diligence checks. This check must align with the standards set by the Standard Setting Forum for AIFs (SFA), which was established by SEBI.
If the due diligence reveals that 50% or more of the AIF fund is contributed by such investors, the AIF manager must report details of those investors and the scheme to their custodian within 30 days of the investment. Custodians then compile this information received from AIFs every month and report it to SEBI within 10 working days from the end of each month.
AIFs and evergreening
Evergreening refers to the practice of extending new loans to borrowers solely to enable them to repay existing loans that are nearing default. This practice masks the true financial health of the borrower and the lender’s asset quality. It allows lenders to avoid classifying loans as non-performing assets (NPAs).
In this regard, there are concerns about RBI-regulated lenders, such as banks and non-banking financial companies (NBFCs), potentially using AIFs as a conduit for evergreening their stressed loans. This is achieved by structuring investments in AIFs in a way that allows these lenders to indirectly support their borrowers without triggering the RBI’s asset classification and provisioning norms.
SEBI and the Reserve Bank of India (RBI) have introduced several measures to address the issue of evergreening through AIF funds.
What’s the change?
SEBI’s circular mandates stringent due diligence for AIF funds where RBI-regulated investors contribute 25% or more to the corpus or have significant influence over investment decisions.
The AIF fund manager must ensure that the scheme’s investments do not enable the RBI-regulated investor to indirectly acquire an interest or exposure in the investee company beyond permissible limits. This involves scrutinising the RBI-regulated investor’s existing financial exposure to the proposed investee and verifying compliance with relevant RBI circulars and directives on income recognition, asset classification, provisioning, and loan restructuring.
SEBI has banned AIF funds that prioritise distributions to certain investors and the RBI has restricted RBI-regulated entities from investing in AIFs with downstream investments in their debtor companies, unless they make 100% provisions for such investments. This prevents the use of AIF structures to mask the true nature of the lender’s exposure to the borrower.
Takeaway
The stricter due diligence requirements introduced by SEBI for AIF fund managers, particularly for investments from RBI-regulated entities and those from countries sharing land borders with India, could significantly increase the cost and complexity of managing AIF funds. This may divert resources away from investment activities and could prolong the onboarding process for new investors, especially those from countries sharing land borders.
While the circular doesn’t explicitly state how to handle investments that don’t meet the due diligence criteria, but it is implied that they would require government approval (Investments from countries sharing land borders). This could impact the AIF fund’s ability to quickly deploy capital.
Further, the increased compliance burden and reporting requirements may deter large investors seeking efficient and flexible investment structures, especially those specialising in niche opportunities or catering to investors with higher risk appetites. This could drive such investors towards other assets, potentially discouraging large investors.
Overall, this is a significant step by SEBI to tighten AIF fund rules to ensure enhanced stability of the Indian financial ecosystem.
The ‘Future of India’ is larger than the headlines. Larger than our government. Larger than the bureaucracy; larger than the titans of industry; the billboard-heads of local politics; the chaos of daily life; the difficulty of doing business; larger than our social challenges; our mosaic of states; larger than our inconsistent enforcement of the law; larger than capital controls; larger than bank re-KYCs; larger than trading strategies and stock tips masquerading as business news.
The real driver of growth and source of optimism for India’s future is India’s entrepreneurs and their teams. India’s strength is reflected through these heroes. Toiling day in and day out, building India brick by brick.
The ‘Future of India’ resides in the Bangalore-based founder who built a hugely profitable trade execution platform and asset management company from scratch, without raising any outside capital. It is in the founder of a Jhunjhunwala-backed healthcare services company employing 15,000 people, on its way to 50,000. It is in the second-generation operator of an industrial company who turned around the family business by cleaning up the balance sheet and restoring profitability. While these are visible examples, there are countless other founders, operators and teams all across the country who are putting their shoulders to the wheel.
Even though the market capitalisation of large and medium listed companies is 330 lakh crore rupees, it is the smaller listed and unlisted companies that provide a bulk of the revenue and employment in the country. Micro, Small and Medium Enterprises (MSMEs) employ 11.1 crore people versus roughly 1-2 crore in listed companies, and MSMEs contribute more to India’s GDP than large and mid-cap listed companies combined.
This is the promise – the Future of India – lakhs of companies, entrepreneurs and teams driving India’s economic engine with more power than any other single force.
On February 1, 2018, when Mr. Arun Jaitley raised Long Term Capital Gains (LTCG) tax on listed shares from 0% to 10%, he had an important accompanying statement in his budget speech: “…all gains up to 31stJanuary, 2018 will be grandfathered.” This ensured that the tax was prospective from February 1, 2018 and not applicable retrospectively on accumulated unrealised gains on securities held for many years before that date. Crucially, the grandfathering clause is not present in Ms. Nirmala Sitharaman’s budget speech of July 23, 2024, in which LTCG tax was increased from 10% to 12.5%. This means that any unrealised gains between February 1, 2018 and July 22, 2024 will, if and when realised, be liable for the incremental tax, in addition to any gains realised prospectively from the date of the announcement. (Since I’m no tax expert, I can only wonder what happens to those unfortunate souls who traded between market opening and 12:18pm on July 23rd expecting a 10% tax on their gains).
All-in-all, for the long-term investor earning mid-teen returns on their portfolio, this should not pinch too much but, as a matter of principle, this point seems to have been lost in the noble attempt to simplify LTCG tax for different asset classes.
Tax stability and planning are important to investors, and governments should try not to change the rules too often.
However, as investors we must remind ourselves that taxes are not more important than the investment decisions themselves. An excellent investment opportunity that is likely to produce 20, 30 or 40% per annum pre-tax returns should not become undesirable due to marginal or even material changes in the capital gains tax rate. This is even more true for the long-term investor who can defer the tax payment for years or even decades.
“South Indians spend a lot of money on weddings. Even though we’re present in only 4 states of the South, we’ve managed a turnover of more than Rs. 1,300 crores, that too with only a few stores in Tamil Nadu. We’re going to invest heavily in Tamil Nadu”
This is a paraphrase of a conversation we had with Bharadwaj Balaji Rachamadugu (Link), Senior Vice President at Sai Silks, a prominent South India-based saree player that houses the popular brand Kalamandir. Incorporated in 2005, the promoters chose South India as a base to start a business when they moved back from the US. Their decision stands validated as the company has smartly scaled up, premiumized its offerings, and introduced innovative formats that have been well accepted by the market. Bharadwaj’s interview echoed many a positive sentiment around the South Indian market which he’s acting on, as the company sets its eyes on Tamil Nadu, the country’s largest consumer of sarees.
A similar story replicates in the case of Indian Terrain, a menswear brand launched in 2000. Venky Rajgopal founded the brand with the vision of catering to the vibrant colours of South India and the evolving tastes of modern India. The clothing brand has capitalised on the government’s ‘vocal for local’ initiative.
This made us ponder over the peculiarities of the markets and companies from the Southern peninsula in India. Stocks from the South can be set apart for three reasons:
Most South Indian businesses have operated conservatively. They are fundamentally sound, their balance sheets are not over-leveraged. Take the case of the TVS group, Murugappa group and TTK group.
Businesses in the south typically demonstrate consistent growth, dividends, and performance, resulting in increased earnings predictability. They could serve as a reliable anchor in one’s portfolio, offering defensive stability.
The South Indian market has its own idiosyncrasies. As Bharadwaj told us, South Indians spend big on occasions like weddings. So much so that the saying goes, borrow or steal to get your daughter or a son married in as flamboyant a way as possible. A saying that also offers business and consequently, investment opportunities for textile companies based in the South
South India’s Textile Market
The southern belt of India is becoming increasingly attractive for investments, with Karnataka, Andhra Pradesh, Telangana, Tamil Nadu, and Kerala leading the way in textiles. It is not unknown that threads from South India travel all across India starting from the northern belt to southern. It’s no wonder then that Coimbatore is often referred to as the Manchester of the South of India. Even before the silk saree major Nalli expanded its footprint to the east and made more people aware of its heritage, travelling all the way south for saree shopping from various parts of the country was not unusual. A study by Technopak indicated that the South India saree market is expected to touch ₹30,800 crore by FY25 growing at a CAGR of 6%.
However, it’s not all smooth sailing. The last couple of months have seen many mills and factories across the textile value chain shut down. Where the industry used to export 30% of the yarn produced, now it is less than 5% as per The Hindu. Exacerbating the issue is the fluctuation in cotton prices caused by high import duties and increased input costs like electricity charges which has disrupted supply of yarn, needless to say, a crucial raw material for garment production
Expansion plans
Despite the issues emanating from the cotton mills, companies like Sai Silks have massive growth plans. Sai Silks is now expanding deep into Tamil Nadu with its premium segment as well. With nine stores in the state already, their goal is to expand to about 15 to 18 more. Sai Silks also envisions expanding more into Kerala, Karnataka, Telangana and other parts of India.
What sets apart the stocks of the south?
However, South Indian companies are known for their resilience and strong fundamentals that have historically helped them beat challenges. Companies in the south are not only strong with numbers and in assessing the need of the hour but they also believe in maintaining substantial cash reserves which aid in overcoming difficult periods. But businesses are not just susceptible to financial and operational difficulties. Legacies have ended due to familial and internal disputes. The structure of South Indian companies closely resembles that of multinational corporations that don’t draw a wall of professionalism that shields operations from the corporate drama.
Take the case of Chennai-based Murugappa Group that saw tensions boil when within Valli Arunachalam sought representation on Ambadi Investments, the holding company of the ₹74,220-crore Murugappa Group following her father’s passing. The members managed to resolve the dispute without it spilling over and affecting operations or financials.
The TVS group, one of India’s oldest and most prominent family business groups with over 110 years of history, began its journey with a unified approach. However, in late 2020, the family decided to divide the group’s businesses among its different streams formally. By early 2022, this division was legally finalised, enabling each stream of the TVS family to independently operate its businesses as separate entities. The split was executed peacefully with the businesses continuing on the path to prosperity.
But here’s the most interesting characteristic of the South Indian market – its people and their tastes. A report drafted from the summit held by the author stated how “south Indians prefer south indian brands” and that brands must not offend the audience here (https://www.exchange4media.com/marketing-news/south-indians-prefer-south-indian-brands-132138.html) This customer peculiarity gives brands emanating from the region a leg-up over others attempting to enter.
The South Indian companies offer stability and growth potential to investors, supported by their solid financial footing and strategic expansion plans and even external factors like customer loyalty which are in their favour. For these reasons we find these companies well-positioned to capitalise on growth opportunities, consumer demand and overcome challenges of varied nature thus making them compelling considerations for investment portfolios.
