Answer ... The various types of alternative investment funds (AIFs) commonly encountered in India are described in question 1.2.

Answer ... In accordance with the SEBI (Alternative Investment Funds) Regulations, 2012 (‘AIF Regulations’), the Securities and Exchange Board of India (SEBI) allows the establishment of an AIF in the form of:

• a trust;
• a limited liability partnership (LLP);
• a company; or
• a body corporate.

However, trusts are the prevailing choice for AIF structures due to specific legal, regulatory, tax and commercial considerations.

Structure:

Structure in the International Financial Services Centre (IFSC) Gujarat International Finance Tec City:

Inbound investments (AIFs in IFSC)

• Offshore shares, debt, derivatives, mutual funds etc
• Securities listed on IFSC exchange
• Companies in IFSC
• Indian shares, debt, derivatives, mutual funds etc
• Indian listed and unlisted companies
• Units of AIFs, REITs, InvITs

Outbound investments (AIFs in the IFSC):

• Offshore shares, debt, derivatives, mutual funds etc
• Foreign Securities listed on IFSC exchange
• Companies in IFSC

Under Indian law, a trust does not possess a distinct legal identity and relies on the legal personality of the trustee. Consequently, the trustee has the legal ownership of the trust property, while investors are the beneficial interest holders in the trust. Investment management agreements are formal legal documents that grant investment managers the authority by trustees to oversee and manage capital on behalf of investors.

In contrast, LLPs and companies possess separate legal identities, with investors participating as partners or shareholders in LLPs and companies registered as AIFs, although such arrangements are relatively uncommon.

Certain vehicle types – such as family trusts, employee stock ownership plan trusts, employee welfare trusts, gratuity trusts and securitisation trusts – are excluded from the definition of an AIF.

Answer ... Company:

LLP:

Trust:

Each legal structure has its own advantages and disadvantages, making the choice of structure dependent on specific business needs and objectives.

Answer ... The trust stands out as the pre-eminent AIF structure, driven by its alignment with specific legal, regulatory, tax and commercial considerations.

Of the different categories of AIFs, Category II is favoured due to its flexibility in structuring investment strategies and its sector-agnostic nature. This category accommodates the formation of private equity funds and real estate funds. In India, the Category II AIF is extensively adopted, given its versatility, enabling managers to articulate comprehensive investment policies and objectives for the AIF.

Answer ... Hedge funds: Hedge funds serve as investment vehicles that draw in private investors and strategically employ a diverse array of trading and investment strategies across domestic and international markets. They actively oversee their portfolios, utilising both long and short positions in traditional securities, alongside holdings in listed and unlisted derivatives.

Category III AIFs exhibit versatility by investing across a spectrum that includes:

• securities of both listed and unlisted investee companies;
• derivatives;
• complex or structured products; and
• other AIF units.

They can be either open-ended or closed-ended funds, with the latter adhering to a minimum tenure of three years. They are preferred investment strategies for hedge funds and private investment in public equity (PIPE) funds. They employ a wide array of trading strategies and leverage, encompassing investments in both listed and unlisted derivatives. Notably, the government provides no specific incentives or concessions for investments in these funds. Category III AIF funds, focusing on public equities, exhibit lower liquidity risk. Conversely, those engaged in real estate and private equity ventures carry a higher level of risk.

Private credit and private equity: ‘Private credit’ refers to a form of debt financing extended by non-bank lenders or funds that is not publicly issued or traded in open markets. The private credit market has garnered substantial attention from both high-net-worth individuals and institutional investors due to its distinct characteristics and appeal.

Private equity funds serve as investment vehicles created to aggregate capital from institutional investors and high-net-worth individuals. These funds leverage the pooled capital to acquire equity stakes in private companies, strategically aimed at generating significant returns on investment.

Category II funds are specifically designed for private equity, private credit and distressed assets funds. An AIF falling under this category can exclusively invest in securities, encompassing:

• non-convertible debentures;
• convertible cumulative debentures;
• optionally convertible debentures; or
• other variations of debt securities.

AIFs, including Category II funds, are constrained to investing solely in shares and securities, as outlined in Section 2(h) of the Securities Contracts (Regulations) Act, 1956. An important restriction for AIFs is the prohibition against providing loans. However, this restriction does not apply to special situation funds (SSFs). It is imperative that SSFs adhere to the due diligence requirements mandated by the Reserve Bank of India for their investors.

Specifically, a debt fund registered under Category II primarily focuses on investing in debt or debt securities of both listed and unlisted investee companies in accordance with its stated objectives.

Answer ... In India, the establishment of an investment fund necessitates mandatory registration as an AIF, unless the fund qualifies for a specific exemption. SEBI mandates that an AIF must be managed by a fund manager that is established in India. This regulatory requirement ensures that AIFs operating in the Indian market are overseen by managers which are locally based and accountable to the Indian regulatory authorities.

According to the AIF Regulations, a manager appointed by an AIF to oversee its investments can be an individual or an entity based in India. Managers are commonly structured as companies or LLPs. Investments made by an AIF are categorised as investments by residents under exchange control norms, contingent upon both the manager and the sponsor of the AIF being residents owned (with more than 50% ownership) and controlled. Where either the manager or the sponsor does not meet the criteria of being resident-owned or controlled, investments made by the AIF are designated as ‘downstream investments’ or ‘indirect foreign investments’ by the AIF. In such instances, compliance with the Foreign Exchange Management Act becomes mandatory.

In the IFSC, fund management entities have the flexibility to take on various forms, including:

• companies, trusts, LLPs or branches thereof; or
• any other form specified by the IFSC Authority.

Answer ... In India, AIFs must appoint a custodian for the safekeeping of their assets, as per the regulatory framework established by SEBI. The custodian plays a crucial role in ensuring the security and protection of the AIF’s assets.

The sponsor or manager of the AIF must engage a custodian registered with SEBI for the safekeeping of securities if the corpus of the AIF exceeds INR 5 billion. A Category III AIF must appoint a custodian, irrespective of its corpus size. Additionally, in the case of Category III funds dealing with commodity derivatives involving physical settlement, the appointed custodian is responsible for safeguarding the received securities and goods.

Furthermore, for Category I and Category II AIFs engaged in credit default swaps, the sponsor or manager must:

• appoint a custodian registered with SEBI; and
• adhere to specific terms and conditions stipulated by SEBI.

Further, in recently published consultation paper, SEBI mandated all AIFs, regardless of corpus, to appoint a custodian.

Answer ... Regulation 2(1)(q) of the AIF Regulations specifies that a ‘manager’ is an individual or entity appointed by the AIF to oversee its investments. As per SEBI’s practical requirements, the investment manager is expected to be an individual or entity located in India. In situations where foreign managers seek to establish funds domiciled in India, the investment manager may take the form of a subsidiary or a distinct entity set up within India.

Currently, there are no provisions allowing the re-domiciliation of funds into India. An AIF must be established within India, taking the form of a trust, a company or an LLP.