Alternative investment funds regulation
What is an alternative investment fund (AIF)?
AIF is an investment vehicle grouped privately according to the Alternative Investment Funds Regulation that raises funds from investors, whether Indian or foreign, to invest them in accordance with an investment policy defined for the benefit of its investors. The AIF may take the form of a trust or a company or a limited liability company or a legal person.
The FIA Regulations seek to extend the regulatory perimeter to unregulated funds with a view to ensuring systemic stability, increasing market efficiency, encouraging new capital formation, and consumer protection.
That are not covered
Currently, the AIF Regulations do not apply to mutual funds, collective investment schemes, family trusts, ESOP and other employee welfare trusts, portfolio companies, special purpose vehicles, funds managed by securitization or reconstruction companies and any group of funds that are directly regulated. by any other regulator in India.
An AIF must apply for general registration in one of the 3 categories:
Category I AIF: The following are covered by Category I
1. Funds investing in startups or startups or social enterprises or SMEs or infrastructure
2. Other sectors or areas that the government or regulators consider socially or economically desirable, including Venture Capital Funds.
3. AIF with positive spill-over effects on the economy, for which SEBI or the Government of India or other Indian regulators might consider certain incentives or concessions
Category II AIF: The following are covered by Category II
1. AIF for which the government or any other regulator does not grant specific incentives or concessions
2. That it will not exercise any leverage other than to comply with the daily operating requirements as allowed in this Regulation.
3. That it will include private equity funds, debt funds, funds of funds and other funds that are not classified as category I or III.
Category III AIF: The following are covered by Category III
1. AIFs, including hedge funds that trade for short-term returns;
2. Employing diverse or complex business strategies
3. That they can use leverage, including through investment in listed or unlisted derivatives.
Applicability of the AIF regulations to real estate funds
After knowing what an AIF is and its broad categories, we analyze whether the AIF Regulations are applicable to Real Estate Funds
First, the AIF has to apply for registration in accordance with the AIF regulations in one of the three categories mentioned above. Therefore, if a Fund does not fall into any of the three categories mentioned above, it will not request registration with SEBI.
If you look at Category 1, funds that invest in startups or early stage companies or social enterprises or SMEs or infrastructure require registration.
If we look at the definition of infrastructure, the Explanation of Regulation 2 (m) states that Infrastructure will be the one defined by the Government of India from time to time.
And in normal parlance, the term generally refers to the technical structures that support a society, such as roads, water supply, sewerage, electrical grids,
telecommunications, etc., and can be defined as “the physical components of interrelated systems that provide essential products and services to enable, maintain or improve the living conditions of society.
Therefore, the infrastructure does not include the real estate or construction activity, since this activity consists of investing in land, urbanizing the land through the construction of houses, townships and other residential and commercial projects.
But if the real estate fund carries out certain projects with a social purpose such as the purchase of land for charity, etc. then the fund can be covered by social risk funds.
The clause also establishes that “or other sectors or areas that the government or regulators consider socially or economically desirable and other Alternative Investment Funds that are specified”;
The IDA Regulation was notified a few days ago and to date, the Government has not specified other IDA funds in Category 1. Furthermore, what the government or regulators consider socially and economically viable is a very broad concept. However, until the Government makes a specific statement with specific Category 1 inclusions; a Real Estate Fund will not be covered by Category 1 and therefore would not require Registration.
Furthermore, the clause also states that: Alternative Investment Funds which are generally perceived to have positive side effects on the economy and for which the Board or Government of India or other Indian regulators might consider providing incentives or concessions.
By adding these lines to Category 1, SEBI has made Category 1 very vague and open to disputes and litigation, as what SEBI intends with positive side effects on the economy is not defined or clarified. Different people or organizations may have a different opinion on this, leading to unnecessary litigation and difficulties for business owners. However, until some clarity emerges on this, business owners should take a cautious approach when making the decision to apply for Registration under the AIF Regulations.
FIA category II
We now examine whether a real estate fund falls into category II AIF.
If we look at the funds covered by Category II above,
1. Will not be included in categories I and III.
2. Will not undertake leverage or indebtedness other than to meet day-to-day operational requirements and as permitted by these regulations;
3. They will be financed as private equity funds or debt funds for which the government or any other regulator does not grant specific incentives or concessions.
In the case of category I real estate funds, we note that currently they are not included in category I and not in category III, since they are basically hedge funds. Furthermore, the Government does not grant specific incentives or concessions to the real estate sector. Therefore, if we look at the applicability of the Real Estate Fund in Category II, these funds can be included in the Category II AIF if they do not take leverage or indebtedness, except for short-term requirements.
Impact of IDA on Real Estate Funds
Under these Regulations, the minimum investment amount must be Rs 1 million for each investor. Therefore, attracting investor funds would be difficult for real estate funds, which used to raise amounts of up to Rs 1 million from investors. Now they would need to find high-value investors, although this is not the only challenge that awaits those who are forming national corporations. Now they also have to invest 2.5% of the corpus or Rs 5 million, whichever is less, to ensure that the risk of the management company is aligned with that of the investor. In addition, a single investment in a company or a project cannot exceed 25% of the entire corpus.
Furthermore, a Real Estate Fund registered in the form of LLP would also be covered by the AIF Regulation. In an LLP structure, since investors are also partners, the risk of investor rights being misused is minimal. Therefore, the application of the AIF Regulations to the LLP Structure would reduce the flexibility available to that Structure.
If we look at the IDA Regulations from a short-term perspective, in light of the current difficult fundraising environment, the larger ticket size for investors could create some challenges and somehow restrict the growth of the class. of assets, but clearly, in the long term, these regulations appear to have an element of maturity to play a critical role in developing and shaping the future of the alternative asset class in India. It is also clear that alternative investments are more sophisticated and risky compared to equity and debt investments, and until the market matures, it is advisable that only HNIs and well-informed investors invest in this asset class and once as the market matures, it opens. to all. In the long term, we may see more investments in the alternative asset class (in terms of quantity and maturity) due to increased investor confidence in these funds.