Key Takeaways

  • SEBI has cast new investor diligence obligations on AIF managers, which extends to underlying investors
  • As per the new rule, the manager of an AIF is not permitted to on-board new inves- tors or draw down capital from existing investors unless the diligence conditions have been complied with
  • SEBI has not provided any grandfathering mechanism, which means that some AIFs may face immediate or near-term deal-completion issues
  • In the longer term, the new rule may lead to negotiations on various terms of fund economics and governance


On 9 December 2022, the Securities and Exchange Board of India ("SEBI") issued a circular directing managers to ensure that investors in an alternative investment fund ("AIF") satisfy certain investor diligence criteria at the time of on-boarding investors ("Circular"). This is the first time that SEBI has cast a direct obligation in respect of investor diligence of AIFs (although it is worth noting that, in the wake of PN3, managers have in any event been cautious when accepting commitments from investors that ultimately source their funds from countries sharing land borders with India such as China, Taiwan and HK).

In this piece, we examine the new investor diligence obligation on AIF managers and analyse some of the operational issues that may arise on account of the new obligation.

The New Diligence Requirements

As per the Circular, managers of AIFs are required to "ensure" the following at the time of on-boarding investors to the AIF:

  1. Investors in an AIF are residents of a country whose securities market regulator is a signatory to the International Organization of Securities Commissions' Multilateral Memorandum of Understanding or a signatory to the bilateral Memorandum of Understanding with SEBI (the "IOSCO Condition") – as it happens most jurisdictions investing in India meet the IOSCO Condition; and
  2. No investor (or its underlying investors contributing 25% or more in the corpus of investor (or identified on the basis of control)), is a person mentioned in the Sanctions List notified from time to time by the United Nations Security Council and is not a resident in a country that is identified in the public statement of the Financial Action Task Force ("FATF") as:
    1. a jurisdiction having strategic 'Anti-Money Laundering' or 'Combating the Financing of Terrorism' deficiencies to which counter measures apply; or
    2. a jurisdiction that has not made sufficient progress in addressing the deficiencies or has not committed to an action plan developed with the FATF to address the deficiencies (the "FATF List Condition" and together with the IOSCO Condition, the "Twin Diligence Conditions").

The Circular has defined "control" to include "the right to appoint majority of the directors or to control the management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of shareholding or management rights or shareholders agreements or voting agreements or in any other manner".

As an aside, these diligence requirements are pari materia to the eligibility conditions set out in Regulations 4(d) and 4(f) of the SEBI (Foreign Portfolio Investors) Regulations, 2019 ("FPI Regulations"). The Twin Diligence Conditions are also comprised in the definition of "foreign jurisdiction" in the International Financial Services Centres Authority (Fund Management) Regulations, 2022 ("Fund Management Regulations") although funds set up in IFSCs do not seem to be precluded from accepting commitments from investors who would not have satisfied the Twin Diligence Conditions.

How does FATF classify jurisdictions?

Historically, FATF identified jurisdictions on the following basis:

  1. countries to which counter measures apply (defined as 'blacklist' by FATF);
  2. countries which have strategic deficiencies, and have not made sufficient progress or have failed to commit to an action plan in addressing such deficiencies; and
  3. countries which have strategic deficiencies, but have put in place an action plan to address these efficiencies and are working towards it.

Till 2015, the identification for countries belonging to these lists were clear. From 2016, the lists were published differently, and the original difference between (a), (b) and (c) was slowly getting diluted/ ambiguous from a language perspective. To add to this, our legislations (including the FPI Regulations, Fund Management Regulations, and the recent AIF Circular) continue to use the language in the lists published before 2016 (instead of tracking the language in the current lists).

Today, the FATF publishes 2 lists: (a) black listed countries; and (b) grey listed countries. Many countries in the 'grey list', including Cayman Islands, have been identified as countries with strategic deficiencies or those who have not made sufficient progress. For instance, the 'grey list' published in 2022 makes the following notes for Cayman:

"The FATF urges the Cayman Islands to swiftly complete its action plan as all deadlines have now expired and to address the above-mentioned strategic deficiency by February 2023."

Hence, while the intent appears to be limited to barring blacklisted countries, there is a natural apprehension around 'grey list' countries also being disqualified. In fact, the exact same ambiguity arose in the context of FPIs in 2020. Several industry participants reached out to SEBI for clarification in the context of Mauritius based FPIs. SEBI took note of the concern, examined the concept of 'black list' and 'grey list', and specifically exempted FPIs from Mauritius from the application of the rule. While this was helpful, concern still continued on whether the exemption was only for Mauritius or for all 'grey list' countries.

In our discussions with the SEBI, SEBI has clarified that the restrictions are currently only meant to apply to 'blacklisted' jurisdictions, and not to the 'grey list'. However, fund managers which use Cayman as their feeder vehicles need to carefully evaluate Cayman's FATF compliance status.

Carve-outs and other obligations in the Circular

There are two other important aspects in the SEBI Circular, which are set out below:

  1. The Circular has also been made applicable in respect of existing AIFs. Where an AIF has already on-boarded an investor that subsequently does not fulfil either of the Twin Diligence Conditions, the manager is not permitted to draw down capital from such investor for the purposes of making investments until such investor again fulfils the Twin Diligence Conditions.
  2. Interestingly, the IOSCO Condition can be dispensed with if the Government of India grants approval in respect of such country, but that's not the case with the FATF List Condition.

Operational Issues

The Circular is likely to present a number of operational issues for new and existing AIFs. A good starting point to examine these issues is to understand the kind of investors the Circular is likely to impact. Additionally, we anticipate that the following 5 issues may arise in the weeks and months to follow:

  1. Due Diligence Exercise: The Circular is clear that managers must "ensure" that investors in an AIF meet the Twin Diligence Conditions. It remains to be seen if the Circular mandates managers to undertake a diligence exercise or it could satisfy itself simply on the basis of investor representations and warranties. The word 'ensure' seems to imply a higher degree of care by the manager and which may raise attendant challenges with respect to the extent of documentation required and investor reluctance to share documentation.
  2. Activating the carve-out: As mentioned above, the Circular seeks to restrict AIFs from accepting commitments from investors that are resident in jurisdictions whose securities regulators are not signatories to the IOSCO Multilateral Memorandum of Understanding or a bilateral memorandum of understanding with SEBI. At the same time, it appears to be SEBI's clear intent to carve out sovereign wealth funds and allied institutions from this restriction. However, it is not clear whether this carve-out will take effect automatically. The Circular suggests that the Government of India needs to give its approval in respect of countries whose government / government-related investors can invest in an AIF. This may take the form of a separate government notification, can invest in an AIF. This may take the form of a separate government notification, which is still awaited.
  3. Deal completion risk: If an AIF has already on-boarded an investor who subsequently does not fulfil either of the diligence conditions, then the manager should suspend drawing further capital from such investor. This could present difficulties from a deal completion perspective. There may very well be AIFs that have signed term sheets and/or taken investment committee approvals for deals which they may not now be able to complete given that they may have investors who do not fulfil the diligence conditions. Eventually, deals could have to be dropped or funded through alternative sources, both of which could have cost implications for AIFs. Impacted investors would also have to realign their investment strategies and identify alternate structures to complete the committed funds.
  4. Restructuring / Withdrawal: Fund managers will have to draw a fine balance between the competing interests of various constituencies of investors – the investors who are precluded from contributing capital on account of the Circular on the one hand; and the investors who actually participate in deals (and who may be required to 'over- contribute' to deals) on the other hand. In some cases, it may be possible for investors to undertake a restructuring exercise that would allow them to invest the remainder of their commitment through a jurisdiction that is not barred pursuant to the Twin Diligence Conditions. However, this may not solve for a scenario in which an underlying investor is itself resident in a jurisdiction that is barred pursuant to the Twin Diligence Conditions. If the 'freeze' on drawdowns continues for extended time, it may not be in the best interests of the underlying investor to remain invested in the AIF and continue to bear fees and other expenses without participating in the benefits of the investments made by the AIF. In such circumstances, the underlying investor may wish to negotiate its withdrawal from the AIF or at the very least a release of its obligations to make further contributions to the AIF.
  5. Bespoke terms of continuation: The FATF lists are periodically subject to review and therefore a jurisdiction that is currently on the list may find itself off the list in due course. Whilst an extended 'freeze' on drawdowns may frustrate the investment strategies of an investor that is hit by the Circular as well as the AIF itself, it may not be in the best interests of the investor to seek premature withdrawal from the AIF. In such circumstances, the investor could be forced to remain invested in the AIF though in suspended animation until it complies with the Twin Diligence Conditions. During this time, the manager cannot draw down capital from the investor except for bearing fees and expenses.
  6. Practically, there are possibly two approaches that could be employed when the drawdown 'freeze' is lifted. One, the investor is treated as an "excused" investor in respect of all deals in which it could not participate on account of the Circular. In this scenario, the investor would naturally not participate in any proceeds arising from the investments in respect of which it has been "excused". Two, the investor belatedly participates in investments that were made whilst the drawdown 'freeze' was in effect by making an equalization contribution (including a premium) that will be distributed to the investors who actually participated in such investments. There may be further issues on how the premium should be calculated (e.g. as a fixed percentage based on the hurdle / preferred return rate or a bespoke mechanism that more closely captures the uplift in value of the investments).


There can be little quarrel with SEBI's intent behind introducing these diligence conditions for on-boarding investors in AIFs (as well as for drawing down commitments from already on-boarded investors in existing AIFs). Similar diligence conditions were introduced for non-banking financial companies ("NBFCs") i.e. investors of existing NBFCs were permitted to continue with their investments or bring in additional investments to support continuity of business in India if their initial contribution was made prior to their jurisdiction being classified as an FATF non-compliant jurisdiction. The Reserve Bank of India was also mindful to only prohibit new investors of non-compliant jurisdictions from exercising 'significant influence' in the NBFC. So, it may have been more equitable if SEBI had provided for a similar grandfathering mechanism for existing AIFs and applied the diligence requirement only to the on-boarding of investors.

As the lists that are referenced in the Circular are updated periodically, some jurisdictions may find themselves on and off the list from time to time, which could have a disruptive effect on the operations of AIFs. Another query which may crop up in the coming days is whether a specific carve out should be provided to allow investments from investors not meeting the FATF List Condition with prior approval of the government as in the case of the IOSCO condition.

On a parting note, it is worth reiterating that the definition of "foreign jurisdiction" in the Fund Management Regulations sets out similar diligence standards. So, the natural question that arises is whether the IFSCA will now introduce some guidance on the kind of diligence that must be undertaken by fund managers in respect of investors that come into funds set up in GIFT City.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.