The government’s flagship “Make in India” project is aimed at reviving economic growth and making India a manufacturing hub, with the cascading effect of job creation at all levels across urban and rural India. A key driver of the Make in India initiative is increased investment activity in small and medium enterprises (SMEs) and infrastructure. In addition to increased spending by banks and financial institutions, wider participation is required from all sources, particularly private equity investors.
In India private equity capital has long been recognized as an alternative asset class by the government, yet accessing foreign capital by domestic investment funds has not been seamless owing to restrictions under the extant Foreign Direct Investment Policy (FDI Policy) read with the Foreign Exchange and Management Act, 1999 (FEMA), and the regulations issued under FEMA.
Acknowledging the need to remove the impediments, the finance minister during his 2015-16 budget speech proposed allowing foreign investment in domestic investment funds, which are registered with the Securities and Exchange Board of India (SEBI) as alternative investment funds (AIFs) under the SEBI (Alternative Investment Funds) Regulations, 2012 (AIF Regulations). On 16 November 2015, the government notified amendments to FEMA permitting foreign investment in AIFs under the automatic route.
The AIF Regulations, which repealed and replaced the SEBI (Venture Capital Funds) Regulations, 1996, seek to regulate all types of privately pooled domestic investment vehicles, which hitherto were unregulated. AIFs can be registered under category I (AIFs that have a positive spillover effect on the economy such as venture capital, social venture, SMEs and infrastructure funds), category II (private equity and debt funds) or category III (hedge funds). The AIF Regulations permit AIFs to be set up as a company, trust or limited liability partnership (LLP). AIFs often are set up as trusts due to tax and operational reasons.
While the AIF Regulations permit AIFs to collect funds from domestic as well as foreign investors, the FDI Policy took no specific cognizance of AIFs. The FDI Policy thus became incongruous when it came to the ability of AIFs to accept foreign investment and thus the Foreign Investment Promotion Board was approving proposals relating to foreign investment in AIFs on a case-to-case basis. The government has removed this roadblock by providing for a comprehensive framework pertaining to investment and dealing in units or partnership interest of AIFs by foreign investors.
The amendment defines “unit”, as beneficial interest in an “investment vehicle”, including shares or partnership interest. “Investment vehicle” means AIFs, real estate investment trusts (REITs) and infrastructure investment trusts (InvIts) registered with SEBI, thus paving the way for foreign investment in the units of AIFs, REITs and InvIts.
The amendment, apart from permitting foreign investors to acquire, purchase, hold, sell or transfer the units of an investment vehicle under the automatic route, also permits foreign investors to pledge the units to secure credit facilities. Recognizing the uniqueness of the asset class, the lock-in restrictions applicable to securities of an Indian company containing optionality clause do not apply to units held by foreign investors.
The amendment’s highlight is that it settles that downstream investment by AIFs will be regarded as foreign investment if neither the sponsor nor the investment manager of the AIF is Indian “owned and controlled”. The amendment further clarifies that the extent of foreign investment in the corpus of the AIF will not be considered when determining foreign investment in the investee companies, thus settling the debate regarding foreign investors’ exercise of fiduciary decision making as an influencing factor.
“Ownership and control” of the sponsor or investment manager organized as a company will be determined as provided in the FDI Policy. SEBI will determine the classification in respect of sponsors or investment managers organized in forms other than companies. Further, LLPs cannot act as sponsor or investment manager of AIFs, as ownership and control in LLPs cannot be determined under the extant FDI Policy.
As regards foreign investment in AIFs organized as LLPs, recently the government issued a press note removing the requirement of prior approval. Further, LLPs having FDI have now been permitted to invest in another company or LLP in sectors where foreign investment up to 100% is permitted under automatic route and there are no FDI-linked performance conditions.
The amendment has brought cheer to the foreign investor community, particularly the non-resident Indian community for which AIFs have been opened as a new asset class for investment. At the same time, the amendment is likely to reignite the level playing field demand of category III AIFs, which unlike category I and category II AIFs do not offer pass through tax benefits to investors.
The amendment is consistent with the government’s theme of “minimum government, maximum governance” and will help “Make in India” become a reality.
Luthra & Luthra Law Offices is a full-service law firm with offices in Delhi, Mumbai, Bangalore and Hyderabad. Kanchan Sinha is a partner and Shikhar Kacker is a managing associate at the firm. The views of the authors are personal. This article is intended for general informational purposes only and is not a substitute for legal advice.