Indias capital market regulator on Monday proposed to regulate private equity (PE) funds, venture capital (VC) funds,

PIPE or private investment in public equity funds, strategy funds and social sector funds under an omnibus alternative investment regulation. The objective is to help fledgling firms and eliminate systemic risks for investments of high networth individuals (HNIs) in privately managed funds. The Securities and Exchange Board of India, or Sebi, put up the draft alternative investment funds (AIF) regulations on its website on Monday inviting public comments till 30 August. So far most of these funds have been regulated under Sebis venture capital funds (VCF) norms. And since they have been broadly classified as VCFs, it is not possible to give targeted concessions to VCFs to promote start-ups, Sebi said. VCFs are being used as an omnibus investment fund, which leaves most of the private investment funds dissatisfied. The Indian Venture Capital Association and the Confederation of Indian Industry national committee on PEs and VCs were lobbying hard for regulatory changes. According to a June report by consultancy firm Grant Thornton India, PE investments over the past six years have touched $50 billion (around Rs2.2 trillion today). In comparison, capital raised through initial public offerings in this period was $31 billion. The total foreign direct investment flows into India over the past six years were about $116 billion and a significant part of this was through PEs and VCs. Since registration of VCFs is not mandatory, many unregistered funds take advantage of this, Sebi observed. The alternate asset industry needs to be regulated for fair and efficient functioning of financial market. The AIF regulation will cover VCFs, PIPE funds, PE funds, debt funds, infrastructure equity funds, real estate fund, SME (small and medium enterprises) funds, social venture funds and strategy funds, including hedge funds. Under the proposed set of regulations, an AIF will be a closed-end fund with a minimum size of Rs20 crore that can be raised 25% after securing Sebi approval. The minimum investment amount will be 0.1% of the fund, subject to a minimum amount of Rs1 crore and the sponsor of the fund or the partner will have to contribute at least 5%. An AIF will not be allowed to invest more than 25% of the fund in one company. The number of shareholders or partners in an AIF formed as a limited liability partnership will be capped at 50 and the tenure of the fund will be a minimum five years, extendable up to two years if approved by 75% of the unit holders. Each fund has to be a stand-alone entity and no further schemes can be launched under one registration, the draft regulations said.

The total investment in a registered VCF cannot exceed Rs250 crore. It will not invest in any company that is promoted even indirectly by any of the top 500 listed companies by market capitalization or by promoters. Going by the draft regulations, at least two-thirds of the investments by a VCF have to be made in unlisted equity shares and not more than one-third of the fund can be invested in the unlisted debt instruments of the investee company and preferential equity shares of a listed firm, subject to a lock-in period of one year. The PIPE funds, in contrast, will be allowed to invest in shares of those small listed firms that are not a part of any market indices in nationwide exchanges. They will be banned from dealing in securities of the investee company for five years. At least two-thirds of the investments have to be made in equity shares of such an investee company and not more than one-third of the fund can be invested in debt instruments of such companies. According to the draft norms, the PE funds will be required to invest at least 50% in equity shares of an unlisted company and cannot invest more than 50% in the equity of a company proposing to be listed. The so-called social venture funds will be required to target those investors willing to accept muted returns of up to 12% and will have to invest in social enterprises such as microfinance institutions that satisfy social performance norms laid down by the fund. Strategy funds, including hedge funds, may invest in derivatives and complex structural products, but they will be required to disclose their investment strategies to investors. Muneesh Chawla, managing director at Blue River Capital Advisors (India) Pvt. Ltd, a Mumbai-based PE fund, said: This is a timely and welcome step, especially because a lot of funds are raising domestic money and even some retail investors were putting money in PE without understanding it properly. According to him, Sebi has so far taken a view that the investors in PE funds were mostly institutions and, hence, the regulators role was minimal. Its approach has been passive. There are 266 portfolio managers registered with Sebi who offer tailor-made boutique investment management services to their clients. Even after Sebis mandate to segregate client accounts, the services provided by many portfolio managers are standardized portfolio strategies, where assets of clients are handled without customization, leading to proxy fund management through this route. Sebi said since the low minimum investment amount of Rs5 lakh makes these products accessible to retail investors, there is a need to recognize and regulate them as private pools of capital. All portfolio managers who seek to pool assets for investing in unlisted securities will be required to register as AIFs.

Sebi also proposed that those portfolio managers who intend not to deal in funds and only give advice will be required to register as investment advisers under a separate regulation. Under the proposed norms, any fund operating as a hedge fund will need to be registered as a strategy fund under AIF regulations, while PIPE funds, SME funds and VCFs will be considered as qualified institutional investors. Irrespective of their legal domicile, all AIFs that collect money from institutions and HNIs will come under the new regulations and will be registered with Sebi. The Securities and Exchange Board of India (SEBI) introduced new regulations for alternative investment funds (AIFs) under the name, SEBI (AIF) Regulations. The alternative investment funds generally raise capital through high net-worth capital investors with a definite investment strategy for better returns for the investors. The types of funds that fall into this category are private investment in public equity (PIPE), private equity funds (PEFs), venture capital funds (VCFs), debt funds, real estate funds, social venture funds, infrastructure funds, SME funds and strategy funds, which includes hedge funds. According to the SEBI regulation, any AIF body that seeks registration with the SEBI needs to fulfill these rules and procedures, as mentioned in the regulation. These can be companies, partnerships, trusts or corporate bodies, including LLPs. A lot of AIFs are not registered with SEBI. These entities need not comply with the regulation guidelines. SEBI said, there is need to recognize these AIFs as a different asset class, separate from public investors, creditors and promoter holdings, and thus any such body that seeks registration with SEBI or that is already listed needs to inform SEBI of the specific category of the AIF, the proposed size of the fund, the life cycle and the target customers. According to the regulation guideline, the minimum size of the AIF should be Rs 20 crores with a minimum investment of Rs 1 crore, or 0.1% of the fund size, whichever is higher. The fund size can be revised up to XX percent providing suitable reasons to SEBI, but funds will be closeended. In case of an AIF formed as LLP, the number of share holders can be a maximum of 50 while each unit size cannot be less than Rs 10 lakhs, acquired through either private placement or information memorandum. In addition to that, an AIF is not supposed to invest in NBFCs or gold financing companies. PIPE companies can invest in small listed companies, not presented in any of the market indices. Venture capital funds, which can have a maximum investment of Rs 250 crores, are not allowed to invest in any company that are sponsored by Top 500 listed companies (on the basis of their market capitalization) or any of their promoters. For debt funds, investment should be in unlisted debt instruments, although the facility of conversion of debt to equity can be present on the breach of the covenant. For infrastructure funds, two-thirds of the total investment needs to be in the infrastructure projects or companies. For real estate companies, investment should be in the real estate projects or special purpose vehicles (SPVs) undertaking real estate projects. Social venture funds are focused towards social investors ready for muted returns. SME funds will invest in SMEs both in the manufacturing, services and infrastructure sectors.

Regarding hedge funds, they need to be treated as strategy funds. Strategy funds would have to disclose 'information regarding the overall level of leverage employed, the leverage arising from borrowing of cash or securities and the leverage arising from position held in derivatives, the reuse of assets and the main source of leverage in their fund,' said the SEBI note. This is the first time Indian government is attempting to regulate domiciled hedge funds. "There has been a lot of discussion in the context of foreign institutions which are hedge funds investing in India because there is a belief that they introduce volatility in the markets. This is the first time that India domiciled funds would be so classified and regulated," said one lawyer said. Other than that, strategy funds will include every fund that does not fall into the other eight categories. Portfolio management companies that pool assets will need to register themselves as alternative investment funds, whereas companies offering only investment advice will register themselves as investment advisors. Public comments have been invited till August 30, 2011.