Regulation of Alternative Investment Funds
What is an Alternative Investment Fund (FIA)
AIF is a privately pooled investment vehicle under the Alternative Investment Funds Regulations which raises funds from investors, whether Indian or foreign, to be invested according to a defined investment policy for the benefit of its investors. The AIF may take the form of a trust, partnership, limited liability company, or legal entity.
The AIF Regulations seek to extend the regulatory perimeter to non-regulated funds with a view to guaranteeing systemic stability, increasing market efficiency, fostering new capital formation, and consumer protection.
Who is not covered
Currently, the AIF Regulations do not apply to mutual funds, collective investment plans, family trusts, ESOPs and other employee welfare funds, holding companies, special purpose vehicles, funds managed by securitization or redevelopment companies, and any group of funds that is directly regulated. by any other regulator in India.
An AIF must apply for registration broadly in one of 3 categories:
Category I AIF: The following are covered by Category I
1. Funds that invest in startups or early stage or social enterprises or SMEs or infrastructure
2. Other sectors or areas that the government or regulators deem socially or economically desirable, including venture capital funds
3. AIF with positive spillover effects on the economy, for which SEBI, 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. FIAs for which the government or any other regulator does not grant specific incentives or concessions
2. That it will not leverage more than to meet the daily operating requirements as permitted in these Regulations
3. Which will include Private Equity Funds, Debt Funds, Fund of Funds and those other funds that are not classified in category I or III
Category III AIF: The following are covered by Category III
1. AIFs, including hedge funds that trade with a view to earning short-term returns;
2. That employ diverse or complex commercial strategies
3. That they can use leverage even through investment in listed or unlisted derivatives
Applicability of the AIF Regulations to Real Estate Funds
After learning what an FIA is and its broad categories, we analyze whether the FIA Regulations are applicable to Real Estate Funds
First, AIF has to seek registration under the AIF Regulations under 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 apply for SEBI registration.
If we look at Category 1, funds that invest in start-ups or early-stage companies or social enterprises or SMEs or infrastructure require registration.
If we look at the definition of infrastructure, the Explanation to Regulation 2(m) states that Infrastructure will be 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, power grids,
telecommunications, etc., and can be defined as “the physical components of interrelated systems that provide basic products and essential services to enable, maintain or improve the living conditions of society”.
Therefore, infrastructures do not include real estate or construction activity, since this activity consists of investing in land, developing 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 may be covered by social enterprise funds.
The clause further provides 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 AIF Regulations were notified only a few days ago and, to date, the Government has not specified other AIF funds in Category 1. Furthermore, what is considered socially and economically viable by the government or regulators is a very broad concept. However, until the Government specifically comes out with specific listings in Category 1; a Real Estate Fund will not be covered by Category 1 and therefore would not require Registration.
In addition, the clause also provides that: Alternative Investment Funds which are generally perceived to have positive spillover effects on the economy and for which the Board or the Government of India or other regulators in India might consider providing incentives or concessions.
By adding these lines to Category 1, SEBI has made Category 1 very vague and open to dispute and litigation, as it is not defined or clarified what SEBI intends with positive spillover effects on the economy. Different people or organizations may have a different opinion on this, leading to unnecessary litigation and hardship for business owners. However, until there is some clarity on this, business owners should take a cautious approach to the decision to apply for Registration under the AIF Regulations.
FIA category II
We now examine whether a Real Estate Fund enters the Category II FIA
If we look at the funds covered by Category II above,
1. It will not fall into Category I and III
2. Will not engage in leverage or borrowing operations other than to meet daily operating requirements and as permitted by these regulations;
3. 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.
For the Real Estate Fund in Category I, we note that it currently does not fall into Category I and also does not fall into Category III as these are basically hedge funds. In addition, the Government does not grant incentives or specific concessions to the Real Estate Sector. Therefore, if we look at the applicability of Real Estate Funds in Category II, these funds may fall into Category II AIFs if they do not take leverage or borrow, except for short-term requirements.
Impact of the FIA on Real Estate Funds
As per these Regulations, the minimum investment amount should be Rs 1 crore from each investor. Therefore, attracting the funds from investors would be difficult for real estate funds, which used to raise amounts of less than INR 1 million from investors. Now they would have to find high-value investors, although this is not the only challenge facing those who obtain national corpora. Now they also have to invest 2.5% of the corpus or Rs 5 crore, whichever is less, to ensure that the risk of the management company is aligned with that of the investor. Furthermore, a single investment in a company or project cannot exceed 25% of the total corpus.
In addition, a Real Estate Fund registered in the form of an LLP would also be covered by the AIF Regulations. In an LLP structure, since the investors are also partners, the risk of investors’ rights being misused is minimal. Therefore, the application of the AIF Rules to the LLP Structure would reduce the flexibility available to such Structure.
If we look at the AIF Regulations from a near-term perspective, in light of the current difficult fundraising environment, the larger ticket size for investors could create some challenges and could somewhat constrain the growth of the asset class, but clearly In the long run, 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 riskier compared to equity and debt investments, and until the market matures, it is recommended that only HNIs and knowledgeable investors invest in this asset class and, once that the market matures, opens up. to all. In the longer term, we may see more investment in the alternative asset class (in terms of size and maturity) due to increased investor confidence in these funds.