CHAPTER 4 (PART 3): AIF REGULATORY FRAMEWORK

Specific Investment Conditions, Special Dispensation for Angel Funds, and Special Situation Funds (SSFs)

1. Introduction to Specific Investment Conditions

The SEBI (Alternative Investment Funds) Regulations, 2012 establish customized investment limits, borrowing boundaries, and operational structures for different sub-categories of AIFs. Because Category I AIFs are deemed to have a positive impact on the economy or society, they are granted special concessions but are subjected to specific sector-focused thresholds. Conversely, Category II AIFs act as broad-based private capital pools that do not utilize leverage but enjoy operational flexibility in later-stage investing. This part outlines the strict investment rules, underwriting allowances, insider trading exemptions, and specialized frameworks for Angel Funds and Special Situation Funds.

2. 4.1.10 Specific Investment Conditions for Category I AIFs

Category I Alternative Investment Funds must comply with a combination of general investment rules and sub-category specific conditions to maintain their tax-incentivized, socially or economically desirable status.

A. General Investment & Operational Conditions (All Category I AIFs)

• Permitted Investment Instruments: Category I AIFs must invest in investee companies, Venture Capital Undertakings (VCUs), special purpose vehicles (SPVs), limited liability partnerships (LLPs), units of other Category I AIFs of the same sub-category/scheme, or in units of Category II AIFs.
• Hedging & Credit Derivatives: They are permitted to engage in hedging, including buying or selling Credit Default Swaps (CDS), in accordance with the specific conditions and guidelines laid down by SEBI.
• Strict Leverage and Borrowing Prohibition: Category I AIFs are strictly prohibited from borrowing funds (either directly or indirectly) or engaging in any form of leverage for the purpose of making portfolio investments.
• Temporary Borrowing Exception: A fund may borrow funds solely to meet temporary funding requirements or day-to-day operational needs, subject to the following limits:
  1. The borrowing must not exceed 10% of the investable funds of the scheme.
  2. The borrowing tenure must not exceed 30 days.
  3. The fund cannot borrow on more than four (4) occasions in a single year.
• Investor Drawdown Shortfall Borrowing: To facilitate ease of doing business and provide operational flexibility, Category I AIFs are permitted to borrow specifically to cover temporary shortfalls in the drawdown amounts called from investors for investee company transactions. This is subject to:
  1. Compliance with additional terms specified by SEBI.
  2. A mandatory 30-day cooling-off period between any two periods of borrowing. This cooling-off period is calculated from the exact date on which the previous borrowing was repaid in full.

B. Venture Capital Funds (VCFs) Specific Conditions

In addition to the general Category I rules, funds registered specifically as Venture Capital Funds (VCFs) must satisfy the following conditions:

• The 75% Equity/Equity-Linked Rule: At least 75% of the investable funds of a VCF scheme must be invested in unlisted equity shares or equity-linked instruments of a Venture Capital Undertaking (VCU), or in companies listed (or proposed to be listed) on a Small and Medium Enterprise (SME) exchange or the SME segment of a stock exchange.
• ICDR SME Underwriting Allocations: VCFs can enter into formal agreements with merchant bankers to subscribe to the unsubscribed portions of public issues made by SME companies, or to receive or deliver securities during market-making activities on SME exchanges, as permitted under Chapter IX of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018.
• Insider Trading (PIT) Exemptions on SME Investments: VCFs are formally exempt from sub-regulations (1) and (2) of regulation 3, and sub-regulation (1) of regulation 4 of the SEBI (Prohibition of Insider Trading) Regulations, 2015 when investing in companies listed on an SME exchange or SME segment, provided that:
  1. The investment is made pursuant to a comprehensive due diligence review of the target listed SME.
  2. The VCF discloses any trading in the securities of the target company resulting from such due diligence to the stock exchanges where the SME is listed within two (2) working days of the trade.
  3. The acquired investment is subject to a strict one (1) year lock-in period from the exact date of investment.

C. SME Funds Specific Conditions

Funds registered under the SME sub-category of Category I AIFs must adhere to the following specific parameters:

• The 75% SME Asset Rule: At least 75% of the investable funds of an SME Fund scheme must be invested in unlisted securities or partnership interests of VCUs, investee companies which are classified as SMEs under the MSMED Act, 2006, companies listed (or proposed to be listed) on an SME exchange, or in units of Category II AIFs that invest primarily in such VCUs or SME companies.
• SME Underwriting Allowances: SME Funds can partner with merchant bankers to underwrite the unsubscribed portions of SME public offerings or participate in market-making processes as defined by SEBI ICDR Regulations.

D. Social Impact Funds Specific Conditions

Social Impact Funds (formerly categorized as Social Venture Funds) are designed to channel capital toward ventures that address social development goals while delivering sustainable social metrics:

• Minimum Grant Size Threshold: When a Social Impact Fund receives grants from benefactors, the minimum grant amount received from a single provider must not be less than INR 10 lakh.
• Accredited Investor Exemption: This minimum grant contribution limit of INR 10 lakh does not apply if the grant provider is a certified Accredited Investor.
• No Profit/Gain Attribution: It is a strict regulatory rule that no commercial profits, financial gains, or returns can be attributed to the provider of such grants.
• 100% SSE Listed NPO Allocation: A Social Impact Fund (or its schemes) launched exclusively for a Not-for-Profit Organization (NPO) registered or listed on a recognized Social Stock Exchange (SSE) is permitted to invest/deploy 100% of its investable funds directly in the securities of such SSE-listed NPOs.

3. 4.1.11 Specific Investment Conditions for Category II AIFs

Category II AIFs operate as broad private capital pools (such as private equity, debt, or pre-IPO funds) that are barred from using leverage for investing but are granted specific operational room for debt and equity allocations.

• Permitted Portfolio Targets: Category II AIFs must invest primarily in investee companies or in the units of other AIFs as disclosed in their Placement Memorandum.
• Strict Borrowing & Leverage Bans: Category II AIFs are prohibited from using leverage or borrowing funds directly or indirectly for the purpose of making investments. They may borrow funds only to meet temporary day-to-day operational requirements under the same strict limits as Category I (max 10% of investable funds, max 30 days tenure, max 4 times a year).
• Investor Drawdown Shortfall Borrowing: Similar to Category I, Category II AIFs are allowed to borrow to meet temporary funding shortfalls arising from called-down capital (drawdown amounts) from investors. This borrowing requires a 30-day cooling-off period calculated from the date of previous borrowing repayment before any fresh shortfall borrowing can be initiated.
• Hedging & Credit Default Swaps: Category II AIFs can buy or sell Credit Default Swaps (CDS) as risk management or investment tools in accordance with SEBI guidelines.
• SME Public Issue Underwriting: They can enter into agreements with merchant bankers to underwrite unsubscribed portions of SME public issues or participate in market-making activities under Chapter IX of SEBI ICDR Regulations.
• Insider Trading (PIT) Exemptions: Category II AIFs enjoy the same exemptions from the SEBI (Prohibition of Insider Trading) Regulations, 2015 as VCFs when investing in SME listed stocks, subject to conducting formal due diligence, disclosing trades within 2 working days to the stock exchanges, and maintaining a one (1) year lock-in period on the acquired shares.

4. 4.1.12 Special Dispensation for Angel Funds

Angel Funds are established as a distinct sub-category of Venture Capital Funds under Category I AIFs. Because angel investments occur at the highly risky, formative seed stage of a startup, SEBI provides them with a highly flexible, simplified operating regime.

A. Strict Regulatory Definition of an "Angel Investor"

To commit capital to an Angel Fund, a contributor must be certified as an Angel Investor by meeting one of the following criteria:

1. Individual Investor: Must hold net tangible assets of at least INR 2 crore (completely excluding the value of their primary residence). Additionally, they must possess:
   • Prior early-stage investment experience, or
   • Experience as a serial entrepreneur, or
   • Experience as a senior management professional with at least ten (10) years of experience.
2. Body Corporate: Must maintain a net worth of at least INR 10 crore.
3. Institutional Pooling Entity: Must be a registered AIF under SEBI AIF Regulations or a VCF registered under the legacy VCF Regulations of 1996.

B. Formation and Conversion Framework

• Specific Registration Requirement: An Angel Fund must be specifically registered as an Angel Fund with SEBI, despite being a VCF sub-category.
• Conversion Option: Any registered Category I AIF that has not made any investments since obtaining its registration is eligible to apply to SEBI for conversion into a registered Angel Fund.

5. 4.1.13 Investment in Special Situation Funds (SSVs) and Stressed Loans

Special Situation Funds (SSFs) are Category I AIFs that invest in stressed assets, bad debts, or special corporate restructuring situations.

A. SSF Corpus & Investment Boundaries

• Minimum Corpus Size: Each scheme launched by an SSF must maintain a minimum corpus of INR 100 crore.
• Minimum Entry Capital Commitments:
  • Standard Investors: The minimum investment contribution by a single investor in an SSF scheme is INR 10 crore.
  • Accredited Investors: The minimum investment is lowered to INR 5 crore for certified Accredited Investors.
  • Employees & Directors: For employees or directors of the SSF, or employees/directors of its Investment Manager, the minimum entry limit is INR 25 lakh.
• Source Capital Restrictions: An SSF is strictly prohibited from accepting any capital investments from other AIFs, unless the investing AIF is itself a registered Special Situation Fund.
• No Associate Transactions: An SSF must not make any investments in its associates, in units of other AIFs managed/sponsored by its own Manager/Sponsor, or in AIFs managed by their associates.

B. Acquisition of Stressed Loans (RBI Master Direction, 2021)

When an SSF acquires stressed loans in India, it must strictly comply with Clause 58 of the RBI (Transfer of Loan Exposure) Directions, 2021:

1. Eligibility List: The SSF can only acquire stressed loans if it is formally included in the relevant Annex of the RBI Master Direction.
2. Mandatory 6-Month Lock-In: Stressed loans acquired by an SSF are subject to a minimum lock-in period of six (6) months.
3. Lock-In Recovery Exception: This 6-month lock-in requirement is completely waived if the stressed loan is successfully recovered from the borrower before the 6 months expire.
4. Investor Due Diligence Parity: The SSF must satisfy the exact same initial and ongoing customer/investor due diligence requirements that the RBI mandates for investors in Asset Reconstruction Companies (ARCs).

Important Terms & Exam Definitions

1. The 75% Rule (Category I VCF & SME): The statutory mandate requiring VCFs to invest 75% of investable funds in unlisted equity/equity-linked VCU assets, and SME Funds to invest 75% in unlisted or SME listed securities.
2. Shortfall Borrowing (Drawdown): A special SEBI exemption allowing Category I and II AIFs to temporarily borrow capital to cover transient investor defaults on capital calls, subject to a 30-day cooling-off rule.
3. Angel Investor: A highly qualified HNIs (assets >= INR 2 crore) or corporate (net worth >= INR 10 crore) who funds startup-stage entities via Angel Funds.
4. Special Situation Fund (SSF): A Category I AIF scheme (corpus >= INR 100 crore, investor entry >= INR 10 crore) dedicated to acquiring stressed assets and restructurings.
5. RBI (Transfer of Loan Exposure) Directions, 2021: The primary banking regulation governing how SSFs can acquire and manage stressed debt portfolios with a mandatory 6-month lock-in.