Investments By Category – III Alternative Investment Fund (AIF) with Foreign Investment Considerations

1. Introduction

Alternative investment funds (AIFs) are investment vehicles that fall outside of traditional investment categories like stocks, bonds, and cash. These funds pool capital from investors to invest in a wide range of alternative assets that typically offer diversification, potential for higher returns, and lower correlation with traditional financial markets. AIFs can involve complex investment strategies and can be suitable for investors with a higher risk tolerance.

As per Regulation 2(1)(b) of AIF Regulations it means “any fund established or incorporated in India in the form of a trust or a company or a limited liability partnership or a body corporate which, –

(i) is a privately pooled investment vehicle which collects funds from investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors; and

(ii) is not covered under the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996, Securities and Exchange Board of India (Collective Investment Schemes) Regulations, 1999 or any other regulations of the Board to regulate fund management activities.”[1]

There are total three categories of AIFs, but this article will broadly cover Category III (CAT III) AIF and Investment that can be made by these funds, receiving foreign investment.

2. Category III of AIF

Regulation 3(4)(c) of AIF Regulation on CAT III means “AIFs which employ diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives.” [2]Example includes Hedge funds, PIPE Funds, and the Funds that aim to generate short-term returns or open-ended funds that do not receive specific incentives or concessions from the Government of India or any other regulatory body falling under the CAT III AIF classification.

2.1 The AIF Regulations have prescribed certain conditions for CAT III. These are:

i. Minimum investor contribution shall be at least INR 1 Crore.[3]

ii. Minimum fund size shall be INR 20 crore.[4]

iii. The CAT III AIF can be either open ended or closed ended.[5]

iv. The continuing interest of Sponsor / Manager shall be 5% of the Corpus or INR 10 crore, whichever is lower.[6]

v. The CAT III AIF cannot invest more than 10% in one investee company.[7]

2.1 Fees and Filings

SEBI registration fees for CAT III AIF is INR 15,00,000 and per scheme filing fees is INR 1,00,000.[8]

3. Investment by CAT III AIF with Foreign Investment considerations

When it comes to the kind of investment that can be made by a CAT III AIF receiving foreign investment, Schedule VIII (5) of the Foreign Exchange Management Non-Debt Instruments Rules, 2019 (NDI Rules) comes into picture. It states “An Alternative Investment Fund Category III which has received any foreign investment shall make portfolio investment in only those securities or instruments in which a FPI is allowed to invest under the Act or rules or regulations made thereunder.”[9]

Investment allowed to Foreign Portfolio Investor[10] (also applicable to CAT III AIF with Foreign Investment considerations).[11]

1. “A foreign portfolio investor shall invest only in the following securities, namely-

a. shares, debentures and warrants issued by a body corporate; listed or to be listed on a recognized stock exchange in India;

b. units of schemes launched by mutual funds under Chapter V, VI-A and VI-B of the Securities and Exchange Board of India (Mutual Fund) Regulations, 1996;

c. units of schemes floated by a Collective Investment Scheme in accordance with the Securities and Exchange Board of India (Collective Investment Schemes) Regulations, 1999;

d. derivatives traded on a recognized stock exchange;

e. units of real estate investment trusts, infrastructure investment trusts and units of Category III Alternative Investment Funds registered with the Board;

f. Indian Depository Receipts;

g. any debt securities or other instruments as permitted by the Reserve Bank of India for foreign portfolio investors to invest in from time to time; and

h. such other instruments as specified by the Board from time to time.

2. Where a foreign portfolio investor, prior to commencement of these regulations, holds equity shares in a company whose shares are not listed on any recognised stock exchange, and continues to hold such shares after the initial public offering and listing thereof, such shares shall be subject to lock-in for the same period, if any, as is applicable to shares held by a foreign direct investor placed in similar position, under the policy of the Government of India relating to foreign direct investment for the time being in force.

3. Nothing contained in sub-regulation (2) shall be deemed to prejudice the applicability of any other law, regulation or guideline.

4. In respect of investments in the secondary market, the following additional conditions shall apply –

a. A foreign portfolio investor shall transact in the securities in India only on the basis of taking and giving delivery of securities purchased or sold;

b. Nothing contained in clause (a) shall apply to –

i. any transactions in derivatives on a recognized stock exchange;

ii. short selling transactions in accordance with the framework specified by the Board;

iii. any transaction in securities pursuant to an agreement entered into with the merchant banker in the process of market making or subscribing to unsubscribed portion of the issue in accordance with Chapter IX of the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2018;

iv. any other transaction specified by the Board;

c. The transaction involving dealing in securities by a foreign portfolio investor shall be only through stock brokers registered with the Board;

d. Nothing contained in clause (c) of this sub-regulation shall apply to –

i. transactions in Government securities and such other securities falling under the purview of the Reserve Bank of India carried out in the manner as specified by the Reserve Bank of India;

ii. sale of securities in response to a letter of offer sent by an acquirer in accordance with the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011;

iii. sale of securities in response to an offer made by any promoter or acquirer in accordance with the Securities and Exchange Board of India (Delisting of Equity shares) Regulations, 2009;

iv. sale of securities in accordance with the Securities and Exchange Board of India (Buy-back of Securities) Regulations, 2018;

v. divestment of securities in response to an offer by Indian companies in accordance with Operative Guidelines for Disinvestment of Shares by Indian Companies in the overseas market through issue of American Depository Receipts or Global Depository Receipts as notified by the Government of India from time to time;

vi. any bid for, or acquisition of, securities in response to an offer for disinvestment of shares made by the Central Government or any State Government;

vii. any transaction in securities pursuant to an agreement entered into with merchant banker in the process of market making or subscribing to unsubscribed portion of the issue in accordance with Chapter IX of the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2018;

viii. transactions in corporate bonds by foreign portfolio investors;

ix. transactions on the electronic book provider platform of recognised stock exchanges;

x. transactions to receive, hold and sell unlisted securities as referred at regulation 20(2) and transactions in unlisted securities received through involuntary corporate actions including a scheme of a merger or demerger approved in accordance with the provisions of the Companies Act, 2013 as well as the applicable guidelines issued by the Board or pursuant to implementation of any resolution plan approved under the Insolvency and Bankruptcy Code, 2016 or in accordance with the guidelines issued by the Government of India or the Reserve Bank of India or any other regulator for a scheme of debt resolution: Provided that such unlisted holdings of the foreign portfolio investor shall be treated as Foreign Direct Investment;

xi. transactions for transfer of right entitlements;

xii. purchase or sale transactions of illiquid or suspended or delisted securities by a foreign portfolio investor; Explanation – Illiquid securities shall mean those securities that are not frequently traded in terms of Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2018;

xiii. transactions between registered foreign portfolio investors, who are multi-investment manager structure of the same beneficial owner and have common Permanent Account Number; and

xiv. any other transaction as may be specified by the Board;

e. A foreign portfolio investor shall hold, deliver or cause to be delivered securities only in the dematerialized form.

Provided that any shares held in the physical form, before the commencement of these regulations, may continue to be held in the physical form, if such shares cannot be dematerialised: Provided further that all the Rights Entitlements may be held or transferred in non-dematerialized form.

5. In respect of investments in the debt securities, the foreign portfolio investors shall also comply with terms, conditions or directions, specified or issued by the Board or Reserve Bank of India, from time to time, in addition to other conditions specified in these regulations.

6. Unless otherwise approved by the Board, securities shall be registered in the name of the foreign portfolio investor as a beneficial owner as defined in clause (a) of sub-section (1) of section 2 of the Depositories Act, 1996.

7. The purchase of equity shares of each company by a single foreign portfolio investor including its investor group shall be below ten per cent of the total paid-up equity capital on a fully diluted basis of the company:

Provided that where the total investment under these regulations by a foreign portfolio investor including its investor group exceeds the threshold of below ten per cent of the total paid up equity capital in a listed or to be listed company on a fully diluted basis, the foreign portfolio investor shall divest the excess holding within five trading days from the date of settlement of the trades resulting in the breach:

Provided further that in case the foreign portfolio investor fails to divest the excess holding, the entire investment in the company by such foreign portfolio investor including its investor group shall be considered as investment under the Foreign Direct Investment, as per the procedure specified by the Board and the foreign portfolio investor and its investor group shall not make further portfolio investment in that company under these regulations,

Explanation I – ‘investor group’ shall have the meaning as provided under regulation 22(3) of these regulations.

Explanation II – ‘fully diluted basis’ means the total number of shares that would be outstanding if all possible sources of conversion are exercised.

8. An entity, registered as a foreign portfolio investor shall be permitted to invest in Indian securities as a person resident outside India in accordance with provisions of [the Foreign Exchange Management Act, 1999, rules and regulations made thereunder].

9. 16[***]

10. A foreign portfolio investor may lend or borrow securities in accordance with the framework specified by the Board in this regard.

11. The investment by the foreign portfolio investor shall also be subject to such other conditions and restrictions as may be specified by the Government of India from time to time.”

4. Analysis of the above regulation

The above regulations define the types of investments that FPIs can make in India. This is crucial for any CAT III AIF that receives foreign investment, as these funds must adhere to the same rules. The said regulations have been divided into 9 parts for better understandings.

1. Permitted investments for FPIs / CAT III AIF:

a. Investment made in shares, debentures, and warrants issued by a body corporate that are listed or to be listed on a recognized stock exchange in India.

b. Schemes of Mutual Fund.

c. Schemes of Collective Investment Fund under SEBI Regulations, 1999.

d. Derivatives traded on recognized stock exchange.

e. Investments in Real Estate Investment Trusts, Infrastructure Investment Trusts, and CAT III AIFs registered with SEBI.

f. Investment in Indian Depository Receipts, allowing investment in Indian Companies.

g. Any other instrument authorised by SEBI or RBI.

2. Lock-in period for prior to Initial Public Offering (IPO) of Equity Investments: If FPI holds equity shares in a company prior to its listing on a stock exchange (i.e., unlisted shares), these shares will be subject to a minimum lock-in period before the IPO. This lock-in period prevents FPIs from quickly selling their holdings after the listing, ensuring their investment behaviour aligns with the regulations governing Foreign Direct Investment (FDI).

3. Other Applicable Laws: Even though the FPI regulations offers a detailed guideline, it doesn’t supersede any other existing laws or regulations. FPIs are required to stick to the relevant rules set by authorities such as SEBI, RBI, and the Government of India, and ensures that their investments comply with the wider legal framework.

4. Conditions for Secondary Market Investments:

a. Transactions shall be based on delivery – FPIs are allowed to transact in securities on the basis of delivery, this means that they must take the immediate delivery of the securities they buy or sell.

b. Exceptions to the above conditions – Transactions such as derivative transactions, short selling and transactions involving market-making or unsubscribed portions of issues are exempted from transaction based on delivery.

c. All the transactions of the FPI should be conducted by a SEBI registered stock brokers. However, certain government and regulatory transactions are exempted from using stock brokers. These include transactions in government securities, sales before takeover offers, and specific corporate bond transactions.

5. Investment in debt securities is subject to specific conditions set out by SEBI or RBI. The conditions may include restrictions on the types and amounts of debt securities that can be purchased, relating to liquidity, credit rating, and maturity.

6. Securities held by FPIs should be registered in their name as beneficial owners, it assists in determining foreign ownership in Indian Companies.

7. Equity limits: FPI can hold up to 10 percent of the total paid-up equity capital on a fully diluted basis of a company. If this limit is breached, the FPIs are required to divest the excess holding within five trading days. Failure to do so may result in the entire investment being considered FDI, subject to FDI regulations.

8. FPIs who are non-resident are allowed to invest in Indian securities subject to Foreign Exchange Management Act (FEMA), 1999.

9. FPIs are permitted to lend or borrow securities as per SEBI regulations and are subject to restrictions imposed by the Government of India from time to time.

5. Fund raised from Foreign Investors in CAT III AIFs[12]

*Note:  Data of Funds raised from Employees, Sponsor, Manager and EBTM are not included.

6. Implications on AIF for non-compliance

Failure to comply with regulations under AIF Regulations, 2012 the SEBI Act, 1992[13] prescribes penalty to be at least one lakh rupees, but it can increase up to one lakh rupees for each day till the failure continues. However, the total penalty, shall not exceed one crore rupees or three times the amount of profit made from the such failure or whichever is greater.

7. Conclusion

AIFs, especially CAT III, is a flexible investment vehicle with a wide range of strategies such as hedge funds, PIPE funds, and those targeting short-term returns. These funds are designed to meet the needs of sophisticated investors, both domestic and international, and operate within a rigorous regulatory framework by SEBI, RBI and Government of India. CAT III AIFs are permitted to implement complex trading strategies, the use of leverage and derivatives, which make them different from AIFs of categories.

The FEMA, AIF and FPI regulations are primary laws governing foreign investments in these funds. Specifically, any CAT III AIF receiving foreign investments must comply with the same guidelines that govern FPIs. These regulations provide clear rules regarding permissible investments, transaction terms, and equity ownership limits, all of them together contribute towards transparency and stability of Indian securities market. Non-compliance with AIF regulations can result in significant penalties, mandating the need for strict adherence to the legal and regulatory requirements. Failure to comply may lead to severe financial penalties and could undermine investor confidence in the fund’s operations.

[1] Regulation 2(1)(b) of AIF Regulations, 2012

[2] Regulation 3(4)(c) of AIF Regulation, 2012

[3] Regulation 10(c) of AIF Regulation, 2012

[4] Regulation 10(b) of AIF Regulation, 2012

[5] Regulation 13(c) of AIF Regulation, 2012

[6] Regulation 10(d) of AIF Regulation, 2012

[7] Regulation 15(d) of AIF Regulation, 2012

[8] Schedule-2, Part A of AIF Regulation, 2012

[9] Schedule VIII (5) of the Foreign Exchange Management Non-Debt Instruments Rules, 2019

[10] Regulation 10 of Securities and Exchange Board of India (Foreign Portfolio Investors) Regulations, 2019

[11] Schedule VIII (5) of the Foreign Exchange Management Non-Debt Instruments Rules, 2019

[12] https://www.sebi.gov.in/statistics/1392982252002.html

[13] Section 15 EA of SEBI Act, 1992