Chapter 2: Growth of Alternative Investment Funds in India and Suitability of Category III AIFs (Part 1)

This chapter covers the historical growth of the Indian Alternative Investment Fund (AIF) landscape, the regulatory evolution leading to the current framework, and a comprehensive breakdown of the various types of AIFs registered under the Securities and Exchange Board of India (SEBI).

2.1 Evolution and Growth of Category III AIFs in India

The alternative investment landscape in India, particularly for Category III AIFs (which include hedge funds), has transitioned from a highly restricted, niche segment into a robust and dynamic institutional market.

2.1.1 Evolution of Hedge Funds: Up to 2012

• Origin of the Term: The term "hedge funds" was first coined and came into active use in 1949 when Alfred Winslow Jones’s company, A.W. Jones & Co., launched the first-ever hedge fund.
• Classic Characteristics: Historically, hedge funds were defined by their use of three distinct investment techniques to maximize investor returns:
  1. Incentive Fees (performance-linked fees paid to the manager).
  2. Short Selling (the ability to sell securities not owned to profit from price declines).
  3. Leverage (using borrowed capital to amplify exposure).
• Portfolio Diversification: Over time, hedge funds expanded beyond equities to incorporate a wider array of financial instruments, such as fixed-income securities, convertible securities, currencies, and complex derivatives.

2.1.2 Registration of Hedge Funds as Foreign Institutional Investors (FIIs): Up to 2012

Prior to the formal launch of the AIF Regulations in 2012, offshore hedge funds had limited avenues to invest in India. In 2004, SEBI opened a restricted window for hedge funds to seek registration within the existing framework of the SEBI (Foreign Institutional Investors) Regulations. However, to control and monitor systemic risks, SEBI imposed three strict conditions:

2.1.3 Trends Post-2012: Consolidation and Growth

The modern era of alternative investments in India officially began when SEBI introduced the landmark SEBI (Alternative Investment Funds) Regulations on May 21, 2012. This regulations replaced the older venture capital frameworks and formally categorized privately pooled investment vehicles into three distinct categories (Category I, II, and III AIFs).

The growth trajectory of Category III AIFs post-2012 can be divided into key regulatory and market developments:

1. High-Net-Worth Investor (HNI) Adoption

The AIF industry quickly gained traction among ultra-rich billionaires, HNIs, and family offices in India. Wealthy investors sought sophisticated strategies that could deliver absolute returns and hedge against equity market downturns, leading to several new fund houses and asset management companies launching Category III AIF schemes.

2. Liberalisation of Foreign Inflows (2015 RBI Reforms)

To boost foreign capital participation, the Reserve Bank of India (RBI) issued Notification No. FEMA 355/2015-RB on November 16, 2015. This reform significantly liberalised investment restrictions on:

• Persons Resident outside India
• Registered Foreign Portfolio Investors (RFPI)
• Non-Resident Indians (NRIs)

Under these rules, investments made by AIFs into Indian companies are considered "foreign investments" if neither the Sponsor nor the Manager of the AIF is Indian "owned and controlled". Additionally, a Category III AIF that accepts foreign investment is permitted to make portfolio investments only in securities and instruments in which RFPIs are permitted to invest.

3. Alternative Investment Policy Advisory Committee (AIPAC) Recommendations

To continually refine the ecosystem, SEBI formed the Alternative Investment Policy Advisory Committee (AIPAC) under the chairmanship of Shri Narayan Murthy. AIPAC made critical recommendations aimed at:

• Rationalising and improving the tax regime for AIFs (especially Category III).
• Boosting the flow of domestic institutional capital (from pension funds, insurance companies, and banks) into the alternative asset class.

4. Mutual Fund TER Rationalisation & Manager Migration

When SEBI amended the SEBI (Mutual Funds) Regulations to rationalise the Total Expense Ratio (TER) of equity-oriented mutual funds, it placed caps on the expenses mutual fund managers could charge.

• This incentivised top-tier mutual fund managers to move to the AIF space, where they could structure Category III AIFs with greater operational flexibility.
• Under the Category III AIF model, managers can charge a fixed management fee alongside performance-based fees (incentive fees) on the "Additional Return" earned above a pre-specified "Reference Hurdle Rate". In contrast, mutual fund managers are prohibited from charging performance-linked incentive fees.

5. Product Innovation and Risk Monitoring

As the market consolidated, Category III AIFs evolved beyond basic equity strategies:

• Asset Expansion: Funds began exploring newer asset classes, such as taking exposures in exchange-traded Commodity Futures and Commodity Options contracts.
• Hedging & Long-Short Equities: Advanced long-short strategies emerged, investing in listed mid-cap and small-cap securities while implementing hedges through stock-based and index-based Futures and Options (F&O) contracts.
• Special Situations: Specialized funds began focusing on arbitrage and corporate events, such as merger arbitrage, buybacks, de-listings, open offers, rights offers, and convertible arbitrage.
• Investor Protection: To manage risks associated with leverage, SEBI established strict leverage and concentration limits. Under these guidelines, Category III AIFs must keep their investors well-informed via periodic disclosures regarding the total funds raised, total investment exposure, concentration limits, and leverage taken.

Key Takeaways: Section 2.1

• First Hedge Fund: Launched by Alfred Winslow Jones in 1949.
• AIF Regulations Inception Date: May 21, 2012.
• FEMA 355/2015-RB (Nov 16, 2015): Allowed foreign investors, NRIs, and RFPIs to invest in AIFs under liberalised rules.
• Narayan Murthy Committee (AIPAC): Recomended tax rationalisation and institutional capital integration.
• Category III Performance Fees: Charged on the "Additional Return" achieved over and above the "Reference Hurdle Rate".

2.2 Types of Alternative Investment Funds (AIFs)

Under the SEBI (Alternative Investment Funds) Regulations, 2012, a Sponsor can register several types of funds depending on the target asset class, investment strategy, and socio-economic objectives.

2.2.1 Venture Capital Fund (VCF)

VCFs are privately pooled vehicles that invest primarily in unlisted securities of start-ups, early-stage ventures, or emerging venture capital undertakings. These businesses are typically characterized by new product development, technology-based activities, intellectual property rights, or highly innovative business models. VCFs include specialized sub-categories such as Angel Funds and Migrated Venture Capital Funds.

• Start-Up Definition: As defined by the Department for Promotion of Industry and Internal Trade (DPIIT), Ministry of Commerce and Industry (vide notification dated February 19, 2019), a start-up is a private limited company or LLP that is not more than 10 years old and has not recorded a turnover exceeding INR 100 crore in any financial year. It must be engaged in innovation, development, or improvement of products, or have a scalable business model with high employment/wealth generation potential.
• Venture Capital Undertaking (VCU): Refers to a domestic Indian company that is not listed on a recognised stock exchange at the time the AIF makes the investment.

Angel Funds (Specialized Sub-Category)

Angel funds pool capital from "Angel Investors" to invest in very early-stage start-ups. SEBI has established strict criteria to define who qualifies as an Angel Investor:

1. Individual Investor: Must possess net tangible assets of at least INR 2 crore (excluding the value of their principal residence), AND must meet one of the following:
   • Has experience as an early-stage investor (assisting start-up ventures).
   • Has experience as a serial entrepreneur (promoted or co-promoted more than one start-up).
   • Is a senior management professional with at least 10 years of experience in the corporate sector.
2. Body Corporate: Must have a net worth of at least INR 10 crore.
3. Registered AIF: Any AIF registered under the SEBI AIF Regulations or a venture capital fund registered under the older 1996 VCF Regulations.

2.2.2 Private Equity Fund (PE)

Private Equity Funds invest primarily in equity or equity-linked instruments of later-stage unlisted companies that have established business models and operational track records.

• Objective: PE funds aim to achieve superior returns by providing growth capital, executing management buyouts (MBOs), or executing Leveraged Buyouts (LBOs) where they acquire controlling interest (usually 51% or more of the share capital or voting rights) in a target company.
• Value Unlocking: Unlike early-stage VCFs, PE funds seek returns by actively handholding the management, restructuring operations, creating value, and eventually exiting at higher valuations through an Initial Public Offering (IPO) or trade sale.

2.2.3 Debt Fund

Debt Funds primarily invest in debt, debt-linked securities, or securitised debt instruments of listed or unlisted investee companies.

• Focus on Unlisted Debt: They provide private credit to companies that may face borrowing constraints from traditional commercial banks.
• Distressed Debt & Refinancing: A major growth area for debt funds in India is providing refinancing solutions, structural debt, or participating in "insolvency resolutions" and distressed debt acquisitions conducted under the Insolvency and Bankruptcy Code, 2016 (IBC).

2.2.4 Infrastructure Fund

Infrastructure Funds pool capital to invest primarily in unlisted equity, debt, partnership interests, or securitised debt instruments of companies or Special Purpose Vehicles (SPVs) engaged in developing, operating, or holding infrastructure assets (e.g., roads, power plants, telecom towers).

• Investor Profile: Given the high illiquidity, long gestation periods, and long amortization timelines of infrastructure debt/equity, the key investors in this space are long-term institutional giants such as Sovereign Wealth Funds (SWFs), Multi-lateral Funds, and thematic institutional allocators.

2.2.5 SME Fund

Small and Medium Enterprise (SME) Funds invest primarily in the unlisted securities of investee companies that qualify as SMEs, or listed securities of SMEs that are proposed to be listed on the SME exchange or SME segment of a recognised stock exchange.

• SME Definition: SME has the same meaning as defined under the Micro, Small and Medium Enterprises Development (MSMED) Act, 2006, as amended from time to time.

2.2.6 Hedge Fund

A Hedge Fund is defined under SEBI AIF Regulations as an AIF that:

• Employs diverse or complex trading strategies.
• Invests and trades in securities having diverse risks or complex products, including listed and unlisted derivatives.
• May employ leverage and short-selling strategies to generate absolute returns in both bull and bear markets.

2.2.7 Social Impact Fund (Formerly Social Venture Fund)

Social Impact Funds are vehicles that invest primarily in the securities or units of "Social Ventures" or "Social Enterprises" that satisfy defined social performance norms.

• Social Ventures: Formed with the primary purpose of promoting social welfare, solving societal problems, or providing public benefits.
• Permissible Investee Structures: These include:
  • Public Charitable Trusts registered with the Charity Commissioner.
  • Societies registered for charitable purposes or the promotion of science, literature, or fine arts.
  • Section 8 companies registered under the Companies Act, 2013.
  • Micro-finance Institutions (MFIs).

2.2.8 Special Situations Fund

Special Situations Funds invest in "Special Situation Assets" in accordance with their stated investment objectives and are eligible to act as a Resolution Applicant under the Insolvency and Bankruptcy Code, 2016.

• Special Situation Assets include:
  1. Stressed loans available for acquisition as per Clause 58 of the Master Direction - Reserve Bank of India (Transfer of Loan Exposures) Directions, 2021.
  2. Stressed loans acquired as part of a Resolution Plan approved under the IBC, 2016.
  3. Security Receipts (SRs) issued by an Asset Reconstruction Company (ARC) registered with the RBI.
  4. Securities of companies whose stressed loans are up for acquisition, or whose borrowings are subject to corporate insolvency resolution under the IBC and have a credit rating of 'D' (default) or equivalent.

2.2.9 Corporate Debt Market Development Fund (CDMDF)

Introduced via the SEBI (AIF) (Second Amendment) Regulations, 2023 (effective June 15, 2023), the CDMDF is a unique close-ended AIF established as a trust with a 15-year tenure.

• Structure & Issuance: Units of the CDMDF are issued exclusively to Asset Management Companies (AMCs) of mutual funds.
• Primary Objective: During periods of market dislocation, the fund acts as a backstop facility to purchase corporate debt securities from debt-oriented mutual fund schemes, providing much-needed liquidity.
• Eligible Purchases: The debt securities bought by CDMDF must:
  • Be listed and carry an investment-grade rating.
  • Have a residual maturity not exceeding five years on the date of purchase.
  • Have no material possibility of default or adverse credit news/views.
• Normal Market Conditions: During non-dislocated periods, the CDMDF is mandated to invest its funds only in highly liquid, low-risk debt instruments as specified by SEBI.

Key Takeaways: Section 2.2

• DPIIT Start-up Limits: Age <= 10 years; Turnover <= INR 100 crore.
• Individual Angel Investor Asset Limit: Net tangible assets >= INR 2 crore.
• Corporate Angel Investor Net Worth Limit: Net worth >= INR 10 crore.
• Controlling Interest in PE: Typically 51% or more of share capital/voting rights.
• Special Situations Credit Rating: Invests in companies with default credit ratings of 'D' or equivalent under IBC.
• CDMDF Tenure: 15-year close-ended trust.

2.3 Regulatory Categories of AIFs

For registration and operational compliance, SEBI groups all the above-mentioned fund types into three distinct categories under the SEBI (Alternative Investment Funds) Regulations, 2012:

1. Category I AIF

• Description: AIFs that invest in start-ups, early-stage ventures, social ventures, SMEs, infrastructure, or other sectors that the government/regulators consider socially or economically desirable.
• Includes: Venture Capital Funds (VCFs), SME Funds, Social Impact Funds, Infrastructure Funds, Special Situation Funds, and Corporate Debt Market Development Funds (CDMDF).
• Incentives: These funds may receive specific concessions or incentives from the government or regulators.

2. Category II AIF

• Description: Funds that do not fall under Category I or Category III, and are prohibited from undertaking leverage or borrowing except to meet day-to-day operational requirements as permitted by SEBI.
• Includes: Private Equity (PE) Funds, Debt Funds, and Pre-IPO Funds.
• Incentives: No specific incentives or concessions are provided.

3. Category III AIF

• Description: Funds that employ diverse or complex trading strategies and may employ leverage (up to 2 times the NAV), including through investment in listed or unlisted derivatives.
• Includes: Hedge Funds, open-ended funds, or funds trading to make short-term returns.
• Incentives: No specific concessions or incentives are provided by the government.

Important Terms to Remember

• A.W. Jones & Co.: Launched the first hedge fund in 1949.
• Venture Capital Undertaking (VCU): An unlisted domestic Indian company.
• Angel Investor: High net-worth individual or corporate entity providing early-stage seed capital.
• Backstop Facility: A liquidity provider of last resort during market dislocation (such as the CDMDF for corporate bonds).
• Maximum Marginal Rate (MMR): The highest tax slab rate (currently 39% including surcharge/cess) applicable to business income of Category III trusts.
• Resolution Applicant: An entity eligible to submit a resolution plan for a stressed corporate debtor under the IBC, 2016.