M & A CritiqueWhat is an Alternative Investment Fund (AIF)
AIF is an Alternative Investment Fund Regulations 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. AIF may be in the form of a trust or a company or a limited liability partnership or a body corporate.
Why AIF
AIF Regulations endeavor to extend the perimeter of regulation to unregulated funds with a view to ensuring systemic stability, increasing market efficiency, encouraging the formation of new capital and consumer protection.
Who are not covered
Currently, the AIF Regulations do not apply to mutual funds, collective investment schemes, family trusts, ESOP and other employee welfare trusts, holding companies, special purpose vehicles, funds managed by securitisation or reconstruction companies and any such pool of funds which is directly regulated by any other regulator in India.
Categories of AIFs
An AIF needs to seek registration broadly under one of the 3 categories –
Category I AIF: The following are covered under Category I
- Funds investing in start-up or early-stage ventures or social ventures or SMEs or infrastructure
- Other sectors or areas which the government or regulators consider as socially or economically desirable including the Venture Capital Funds
- AIFs with positive spillover effects on the economy, for which certain incentives or concessions might be considered by SEBI or Government of India or other regulators in India
Category II AIF: The following are covered under Category II
- AIFs for which no specific incentives or concessions are given by the government or any other Regulator
- Which shall not undertake leverage other than to meet day-to-day operational requirements as permitted in these Regulations
- Which shall include Private Equity Funds, Debt Funds, Fund of Funds and such other funds that are not classified as category I or III
Category III AIF: The following get covered under Category III
- The AIFs including hedge funds which trade with a view to making short-term returns;
- Which employ diverse or complex trading strategies
- Which may employ leverage including through investment in listed or unlisted derivatives
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Applicability of AIF Regulations to Real Estate Funds
After knowing what an AIF is and its broad categories, we analyse whether AIF Regulations are applicable to the Real Estate Funds
Firstly AIF has to seek registration under AIF Regulations under one of the three categories stated above. Therefore if a Fund does not fall under any of the three categories stated above, then it will not seek the registration with SEBI.
- If we look at the Category 1, registration is required by funds which invest in start-up or early-stage ventures or social ventures or SMEs or infrastructure
If we look at the definition of infrastructure, Explanation to Regulation 2 (m) states that Infrastructure shall be as defined by the Government of India from time to time.
And in the normal parlance the term typically refers to the technical structures that support a society, such as roads, water supply, sewers, electrical grids, telecommunications, and so forth, and can be defined as “the physical components of interrelated systems providing commodities and services essential to enable, sustain, or enhance societal living conditions.
Therefore infrastructure does not include the real estate or construction activity since this activity deals in investing in land, developing the land by way of construction of flats, townships and other residential and commercial projects.
But if the real estate fund carries on certain projects for a social purpose like purchasing land for charity etc.; then the fund may be covered under social venture funds.
- The clause further states that ‘or other sectors or areas which the government or regulators consider as socially or economically desirable and such other Alternative Investment Funds as may be specified;’
The AIF Regulations have been notified just a few days back and till date, no other AIF funds have been specified in the Category 1 by the Government. Further what the government or regulators consider as socially and economically viable is a very broad concept. However, till the Government specifically comes out with specific inclusions under Category 1; a Real Estate Fund will not be covered under Category 1 and therefore would not require Registration.
- Further, the clause also states that – Alternative Investment Funds which are generally perceived to have positive spillover effects on economy and for which the Board or Government of India or other regulators in India might consider providing incentives or concessions will be included
By adding these lines to the Category 1, SEBI has made the category 1 very vague and open to dispute and litigations since what SEBI intends with positive spillover effects on the economy is not defined or clarified. Different people or organizations may have a different opinion on this which would lead to unnecessary litigations and hardships to business owners. However, till any clarity comes on this, the business owners need to take a cautious approach to the decision of seeking Registration under AIF Regulations.
Category II AIF
Now we examine whether a Real Estate Fund falls under the Category II AIF
If we look at the funds covered by Category II above, they
- Shall not fall in Category I and III
- Shall not undertake leverage or borrowing other than to meet day-to-day operational requirements and as permitted by these regulations;
- Shall be funded such as private equity funds or debt funds for which no specific incentives or concessions are given by the government or any other Regulator
For Real Estate Fund under Category I, we notice that at present it does not fall under Category I and it also does not fall under Category III since these are basically hedge funds. Further, no specific incentives or concessions are given by the Government to the Real Estate Sector. Therefore if we look at the applicability of Real Estate Fund under Category II, these funds may fall under the Category II AIFs if they do not take leverage or borrowing except for short-term requirements.
Impact of AIF on the Real Estate Funds
Under these Regulations, the minimum investment amount has to be Rs 1 crore from each investor. Therefore attracting the funds from the investors would become tough for the real estate funds, who used to raise amounts as less as INR 1 million from the investors. Now they would need to find high-value investors though this is not the only challenge that lies ahead for those raising domestic corpuses. They now also have to invest 2.5% of the corpus or Rs 5 crore, whichever is lower, to ensure that the managing company’s risk is aligned with that of the investor. Moreover, a single investment in a company or a project cannot exceed 25% of the entire corpus.
Further, a Real Estate Fund registered in the form of an LLP also would be covered under the AIF Regulations. In an LLP Structure, since the investors are also partners, the risk to the rights of the investors being misused is very minimum. Therefore applying the AIF Regulations to the LLP Structure would reduce the flexibility available to such a Structure.
Conclusion
If we look at the AIF Regulations from a short-term perspective, in light of the difficult fundraising environment today, the higher ticket size for investors could potentially throw up some challenges and could in a manner constrict the growth of the asset class, but clearly, in the long run, these regulations appear to have an element of maturity to play a pivotal role in the development and shaping up of the future of alternate asset class in India. It is also clear that alternative investments are more sophisticated and risky as compared to investments in equity and debt and till market matures it is advisable that only HNIs and well-informed investors make an investment in this asset class and once the market matures it is made open to all. In the long run, we may see more investments in the Alternative asset class (in terms of quantum and maturity) due to the increased investor confidence in these funds.
