Venture capital (VC) fundraising and deals have a promising outlook particularly with the government’s desire to create an ecosystem in which entrepreneurs can mushroom. For this to happen, one cannot rely solely on funds from offshore jurisdictions. It is important to have a strong domestic fundraising environment so as to facilitate multiple investments.
In view of the above India’s capital market regulator – the Securities and Exchange Board of India (SEBI) – issued the SEBI (Alternative Investment Funds) Regulations, 2012 (AIF Regulations), to regulate domestic investment vehicles.
(1) Under the AIF Regulations, VC funds, angel funds, infrastructure funds, and small and medium-sized enterprise funds are classified as category I AIFs. Private equity (PE) funds and real estate funds are classified as category II AIFs and hedge funds are classified as category III AIFs. Further, the AIF Regulations require all pooling vehicles to be registered with SEBI and stipulate various investment conditions and restrictions, including on offshore investments, for each of the AIF categories.
(2) As per the AIF Regulations, the entities involved in setting up a typical AIF are: (a) investment vehicle – a privately pooled investment vehicle in the form of a trust or a limited liability partnership; (b) sponsor – the entity or person that sets up the investment vehicle; (c) investment manager – an entity that is appointed by the investment vehicle to manage investments and which employs investment professionals, evaluates potential investment opportunities and incurs the expenses associated with day-to-day operations and administration of the fund; and (d) trustee – an entity appointed to manage the investment vehicle trust in accordance with the trust deed.
(3) As per the AIF Regulations, both category I and category II AIFs are closed-end investment vehicles having a minimum tenure of three years which can be extended with prior investor consent. Currently, the fundraising period for PE/VC funds is typically 12 to 18 months.
The initial closing of the fund depends on various market factors and the track record of the manager. Often initial closing occurs after a minimum amount of capital has been raised by the fund. After initial closing subsequent closings occur throughout the life cycle of fundraising. It is recommended that managers consult with local counsel while raising capital outside of India, so as to ensure compliance with applicable local securities laws.
(4) As per the AIF Regulations, the following documents must be submitted to SEBI at the time of registration:
(a) Private placement memorandum (PPM): This is the primary marketing document through which the fund markets its interests to prospective investors. As per the AIF Regulations, the PPM must contain a business section, which consists of investment objective, strategy, track record of investment manager and team; a summary of principal terms; risk considerations; and legal and tax considerations.
The summary of principal terms relates to the key economic terms of the fund, which include tenure, investor capital commitment, investment period, subsequent investments, fees and expenses, winding up, key service providers, distribution waterfall, key man event and removal of manager with or without cause, conflict of interest and any such information necessary for an investor to take an informed decision.
(b) Contribution agreement: An investor subscribes to a fund by executing a contribution agreement, which sets out the investor’s capital commitment, rights and obligations, including representations and warranties confirming that they are qualified to invest.
(c) Investment management agreement: This contains general terms under which the investment manager is authorized to act as the fund’s manager in exchange for the management fee.
Often funds enter into side letters with certain investors that demand additional or special economic, informational or other benefits as a condition of their investment. Side letters are not required to be submitted to SEBI and the validity and enforceability of side arrangements have to be tested in a court.
(5) Thus, prior to setting up a fund, one must analyse the structure depending on the fund objective and sector focus so as to ensure that it is compliant and optimal from a legal, regulatory and tax standpoint. With the government now allowing up to 100% foreign investment under the automatic route in AIFs, AIFs can be structured to allow residents as well as non-residents, foreign portfolio investors and non-resident Indians to invest directly in the fund without floating multiple structures in different jurisdictions.
Recommendations made by the SEBI-constituted, Narayan Murthy-led Alternative Investment Policy Advisory Committee on creating a favourable AIF tax regime, unlocking diverse domestic capital pools from pension funds, insurance companies, banks, charitable endowments. etc., and promoting onshore fund management are a positive move for the AIF industry, which if implemented could help create a steady and progressive regime for pooled investment structures in India.
Rajesh Begur is the managing partner of ARA LAW, a ﬁrst-generation law ﬁrm with ofﬁces in Mumbai and Bengaluru. Pooja Chitalia is a senior associate at the ﬁrm.
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