CHAPTER 14: REGULATORY FRAMEWORK (PART 5 OF 7)

General and Specific Investment Conditions, Portfolio Concentration Limits, Investment in Associates, and Special Asset Classes (Angel Funds & Special Situation Funds)

1. General Investment Conditions for All AIFs

To maintain systemic stability and protect investor interests, the Securities and Exchange Board of India (SEBI) imposes a rigorous set of investment conditions and operational limits on all registered Alternative Investment Funds (AIFs). These rules dictate how capital is deployed, how conflicts of interest are mitigated, and how un-invested capital is safeguarded.

I. Core Strategy Alignment and Modifications

• Mandatory PPM Disclosures: Every AIF scheme must clearly state its investment strategy, investment purpose, and investment methodology within its Private Placement Memorandum (PPM) before soliciting capital.
• The Two-Thirds Modification Rule: A fund manager cannot unilaterally alter the core strategy of an active scheme. Any material alteration to the fund's registered investment strategy requires the prior formal consent of at least two-thirds (2/3rds) of the unitholders by value of their investment in that specific scheme.

II. Offshore Investments: Permissible Frameworks & Prohibitions

Indian AIFs are permitted to invest in offshore/overseas companies, subject to an aggregate industry-wide limit of USD 1,500 million allocated on a first-come-first-served basis. However, SEBI enforces strict compliance guardrails on these outbound flows:

• Signatory Mandate: An AIF can only invest in an overseas investee company that is incorporated in a country whose securities market regulator is a signatory to the International Organization of Securities Commissions (IOSCO) Multilateral Memorandum of Understanding (Appendix A Signatories) or a signatory to a bilateral MoU with SEBI.
• The FATF Prohibited List: AIFs are strictly prohibited from investing in overseas companies incorporated in countries identified in public statements by the Financial Action Task Force (FATF) as:
  • A jurisdiction having strategic Anti-Money Laundering (AML) or Combating the Financing of Terrorism (CFT) deficiencies to which countermeasures apply.
  • A jurisdiction that has not made sufficient progress in addressing deficiencies or has not committed to an action plan developed with the FATF to address these deficiencies.
• The "Indian Connection" Rule: Investments must be directed toward offshore entities that demonstrate a valid connection to India (e.g., an offshore venture with front-office operations overseas but core back-office/R&D facilities based in India).
• Self-Investment Prohibition: An AIF is strictly prohibited from investing in a Joint Venture (JV) or Wholly Owned Subsidiary (WOS) of itself when deploying capital overseas.

III. The Investor Exclusion Framework (Excusing/Excluding Investors)

An AIF Manager is empowered or required to exclude specific unitholders from participating in a particular portfolio investment under four defined circumstances:

1. Violation of Applicable Law: If, based on a formal written legal opinion, the investor confirms that participating in the investment would result in a direct violation of an applicable domestic or international law or regulation.
2. Contravention of Disclosed Internal Policy: If the investor has explicitly disclosed in their Contribution Agreement that participating in such an investment would violate their internal investment policies.
   • Compliance Window: The manager must ensure that the Contribution Agreement mandates the investor to report any changes to their internal policies within 15 days of such change.
3. Manager-Initiated Exclusion: If the AIF Manager is independently satisfied that the investor’s participation would cause the entire scheme to violate applicable regulations or would cause material adverse regulatory effects. The manager is obligated to record the detailed written rationale for this exclusion and preserve all supporting documents.
4. Feeder Fund Look-Through: If the subscribing investor is itself an investment pool (e.g., a Fund of Funds), the manager may partially exclude it to the extent of the capital contributed by those underlying investors who are subject to an exclusion trigger.

IV. Portfolio Concentration Limits

To prevent over-exposure to a single asset, SEBI mandates strict concentration limits on the capital pool:

• Standard Category I & II AIFs: May invest not more than 25 percent of their investable funds in a single investee company, whether directly or through units of other AIFs.
• Large Value Funds (LVFs) for Accredited Investors: Standard limits are relaxed to permit investment of up to 50 percent of their investable funds in a single investee company, whether directly or through units of other AIFs.
• Defining "Investable Funds":
  • Formula (Simple Line Format): Investable Funds = Corpus of the scheme - Estimated expenditure for administration and management of the fund for its entire registered tenure
• IFSC Exemption: These concentration limits do not apply to Category I or II AIFs domiciled within the International Financial Services Centre (IFSC - GIFT City), provided they make clear disclosures in their PPM and align their portfolios with investor risk appetites.

V. Dealing with Associates and Managed AIFs

To eliminate self-dealing and conflicts of interest, transactions with associates or in units of AIFs sponsored/managed by the same group are strictly controlled by the 75% Approval Rule:

• Investments in Associates: An AIF cannot invest in its associates, or in units of other AIFs managed or sponsored by its own Manager, Sponsor, or their associates, except with the prior approval of 75 percent of the unitholders by value of their investment in the AIF.
• Secondary Asset Transfers (Inter-Scheme Trades): An AIF scheme cannot buy or sell portfolio investments to/from its associates, or to/from other schemes managed or sponsored by its own Manager, Sponsor, or their associates, except with the prior approval of 75 percent of the unitholders by value.
• The 50% Shareholder Exclusion: If a secondary trade is proposed with an investor who has committed to invest at least 50 percent of the overall corpus of the scheme, that specific investor must be excluded from the voting process to ensure the integrity of the 75% approval threshold.
• Defining an "Associate":
  • Formula (Simple Line Format): Associate = An entity (Company, LLP, or Body Corporate) in which a Director, Trustee, Partner, Sponsor, or Manager of the AIF (or a Director/Partner of the Manager/Sponsor) holds, either individually or collectively, more than 15 percent of the paid-up equity share capital or partnership interest.

VI. Cash Management and Temporary Liquid Deployments

Any un-invested portion of the investable funds, or any divestment proceeds pending terminal distribution to investors, can only be placed in high-quality, liquid assets:

• Liquid mutual funds.
• Bank deposits.
• Treasury Bills (T-Bills).
• Triparty Repo Dealing and Settlement (TREPS).
• Commercial Papers (CPs) and Certificates of Deposit (CDs).

VII. Mandatory Dematerialisation of Portfolio Assets

• The July 1, 2024 Mandate: All registered AIFs must hold their portfolio investments in dematerialised (demat) form. This rule applies to all investments made by an AIF on or after July 1, 2024, regardless of whether the investment is sourced directly from the investee company or acquired via secondary transfers from another entity.
• Strict Exceptions: Dematerialisation is not mandatory for:
  1. Investments in instruments that are legally ineligible for dematerialisation under depository rules.
  2. Investments held by an active Liquidation Scheme of the AIF that are structurally unavailable in demat form.
  3. Other specific instruments explicitly excluded by SEBI.

2. Specific Investment Conditions: Category I AIFs

In addition to general conditions, Category I AIFs must adhere to specific limits depending on their sub-category:

I. Borrowing and Leverage Restrictions

• The Leverage Ban: Category I AIFs are prohibited from employing leverage or borrowing capital at the fund level, whether directly or indirectly.
• The Temporary Operating Exception: A Category I AIF is permitted to borrow funds solely to meet temporary, short-term funding requirements under three strict limits:
  1. The borrowing tenure cannot exceed 30 days.
  2. Borrowing can occur on not more than 4 occasions in a calendar year.
  3. The aggregate borrowed amount cannot exceed 10 percent of the scheme's investable funds.
• The Emergency Capital Call Shortfall Rule (August 2024 Circular): To prevent deal failures, SEBI allows Category I AIFs to borrow money as a last resort to bridge shortfalls caused by delaying investors:
  • Trigger condition: Sourced only during emergencies when an investment is imminent and drawdown cash is delayed despite the manager's best efforts.
  • Cost attribution: The entire interest and borrowing cost must be charged exclusively to the delaying investor(s).
  • Cooling-off Period: A strict 30-day cooling-off period must be maintained between any two borrowing runs, calculated from the date of full repayment of the previous loan.

II. SME Market Making and Insider Trading Exemption

• SME Underwriting: VCFs and SME Funds can partner with Merchant Bankers to subscribe to the unsubscribed portions of public issues on SME exchanges, or hold inventory for market making.
• The PIT Safe-Harbor: To facilitate deep-dive investor due diligence, VCFs and SME Funds are exempt from the standard Insider Trading restrictions (specifically Regulations 3(1), 3(2), and 4(1) of the SEBI (PIT) Regulations, 2015) when analyzing SME-listed targets, subject to two conditions:
  1. All trades executed post-due diligence must be disclosed to the stock exchange within 2 trading days.
  2. The acquired securities are subject to a strict 1-year lock-in from the date of investment.

3. Specific Investment Conditions: Category II AIFs

Category II AIFs serve as a broad investment tier:

• Primary Investment Scope: Category II AIFs must invest primarily in unlisted investee companies, directly or through units of other Category I or Category II AIFs, as disclosed in their PPM.
• Leverage and Borrowing Rules: Subject to the exact same restrictions as Category I: leverage is banned, temporary borrowing is restricted to 30 days, 4 times a year, at 10% of investable funds, and the emergency capital-call shortfall borrowing framework applies.
• SME Insider Trading Safe Harbor: Enjoys the identical PIT exemption (2-day disclosure, 1-year lock-in) when investing in SME-listed companies.

4. Special Dispensation for Angel Funds

Angel Funds are a specialized, highly flexible sub-category of Venture Capital Funds registered under Category I AIFs. They are designed to pool capital from verified angel investors to finance early-stage, bootstrapped start-ups.

I. High Net-Worth Angel Investor Definition

An "Angel Investor" must meet one of the following eligibility standards:

• Individual Investor: Must possess net tangible assets of at least INR 2 crore (excluding the valuation of their principal residential property) AND satisfy one of these experience pillars:
  • Prior early-stage investing experience.
  • Experience as a serial entrepreneur (promoted or co-promoted more than one start-up).
  • A senior management professional with at least 10 years of experience in the corporate sector.
• Institutional Investors: A body corporate with a net worth of at least INR 10 crore, or another registered SEBI AIF / legacy Venture Capital Fund.

II. Corpus and Ticket Sizes

• Minimum Corpus: An Angel Fund must maintain a minimum registered corpus of at least INR 5 crore.
• Minimum Commitments: The fund must accept commitments of not less than INR 25 lakh from an individual angel investor, which can be called up over a maximum period of 5 years.
• No Listing: Units of Angel Funds are strictly prohibited from listing on any stock exchange.
• Maximum Investors: No individual scheme launched by an Angel Fund can onboard more than 200 angel investors.

III. Strict Investment Restrictions for Angel Funds

1. Industrial Group Turnover Cap: Angel funds can only invest in start-ups that are not promoted, sponsored, or related to an industrial group whose group turnover exceeds INR 300 crore.
2. No Family Connections: The target start-up must have no family relationships with any of the angel investors participating in that specific investment scheme.
3. Deal-Level Concentration: An Angel Fund’s investment in a single start-up must be at least INR 25 lakh and is capped at INR 10 crore.
4. No Associate Investments: Angel Funds are strictly prohibited from investing in associates.
5. Fund-Level Diversification: An Angel Fund cannot deploy more than 25 percent of the total capital commitments under all its schemes into a single investee company. This compliance is evaluated at the end of the fund's tenure.
6. Sponsor "Skin-in-the-game" Limit: The Sponsor or Manager must maintain a continuing interest of at least 2.5 percent of the corpus or INR 50 lakh, whichever is lesser (which cannot be fulfilled via fee waivers).
7. The Prior Investor Consent Gate: Unlike blind-pool PE/VC funds, the manager of an Angel Fund must obtain prior, formal written approval from each participating angel investor before deploying capital into any target deal.

5. Special Dispensation for Special Situation Funds (SSFs)

Special Situation Funds (SSFs) are distressed debt and resolution vehicles structured as a sub-category under Category I AIFs. They are designed to clear bad loans and stressed corporate balance sheets.

I. Eligible Special Situation Assets

An SSF must invest its capital exclusively in "Special Situation Assets":

• Stressed loans available for acquisition under Clause 58 of the RBI (Transfer of Loan Exposure) Directions, 2021.
• Stressed assets and debt securities undergoing a formal resolution plan approved under the Insolvency and Bankruptcy Code (IBC), 2016.
• Security Receipts (SRs) issued by registered Asset Reconstruction Companies (ARCs).
• Stressed loans defaulted to banks/NBFCs for not less than 90 days.

II. Structural Timelines, Corpus, and Tickets

• Minimum Scheme Corpus: An SSF scheme must have a minimum corpus of at least INR 100 crore.
• Strict Access Limits: An SSF is prohibited from accepting investments from any other AIF, except from another registered SSF.
• Minimum Investment Tickets:
  • Standard Investor: INR 10 crore.
  • Accredited Investor: INR 5 crore.
  • Key Employees/Directors of the SSF/Manager: INR 25 lakh.

III. Key Restrictions on SSF Deployments

1. No Associate Investing: An SSF is strictly prohibited from investing in its associates, in units of other AIFs (except other SSFs), or in schemes managed by its own sponsor/manager/associates.
2. The 6-Month Loan Lock-in: Stressed loans acquired by an SSF from RBI-regulated lenders are subject to a minimum lock-in period of 6 months. This lock-in does not apply if the loan is fully recovered from the borrower during this period.
3. ARC Parallel Due Diligence: Any SSF acquiring stressed loans must comply with the identical initial and continuous due diligence and KYC standards mandated by the RBI for investors in Asset Reconstruction Companies (ARCs).

6. Participation in Credit Default Swaps (CDS)

SEBI allows Category I and II AIFs to transact in Credit Default Swaps (CDS) to manage credit risks, subject to clear limits:

• Hedging Constraint for Cat I and II: Category I and Category II AIFs can buy CDS on their underlying debt holdings solely for the purpose of hedging their exposure.
• Cat II CDS Selling Rules: Category II AIFs are permitted to sell CDS (act as protection sellers) by complying with these rules:
  • The exposure must be backed by earmarking unencumbered Government Securities or Treasury Bills equal to the total CDS exposure.
  • These earmarked assets can maintain margin requirements but shall not be counted toward the AIF's leverage calculation.
• Unhedged CDS Limits: If an AIF takes an unhedged position in CDS:
  • The gross unhedged position is capped at 25 percent of the investable funds of the scheme.
  • If the unhedged CDS exposure exceeds 25%, the manager must obtain prior consent from 100% of the unitholders in the fund.
• The 1-Day Custodianship Report: All executed CDS transactions must be reported to the scheme's SEBI-registered custodian by the next working day.

7. Practical Scenarios & Worked Case Studies

Scenario A: The Prohibited Overseas Asset

• The Situation: Zenith Global Ventures (a Category II AIF) identifies a high-growth fintech startup incorporated in Panama. The startup has robust operations in Europe and a development center in Bengaluru. The Panama regulator is a signatory to the IOSCO MoU. However, the manager notes that Panama is currently listed on the FATF grey list for AML/CFT deficiencies.
• The Regulatory Verdict: The investment is strictly prohibited. Even though the Panama regulator is an IOSCO signatory and the startup has a valid Indian connection, the AIF Regulations forbid investing in any offshore company incorporated in a jurisdiction identified by the FATF as having strategic AML/CFT deficiencies.

Scenario B: The Associate Transaction Conflict

• The Situation: Apex Real Estate Debt Fund (a Category II AIF) wants to purchase a distressed commercial mortgage asset from Apex Homes LLP. Apex Homes LLP is owned 18% by the sister of the fund's chief sponsor. The manager believes this is an arm's-length transaction and seeks to execute it.
• The Regulatory Verdict: Since the sponsor's relative holds more than 15% (18%) of Apex Homes LLP, the entity is classified as an Associate of the AIF. This transaction cannot be executed as a routine deal. Under the regulations, the AIF must secure the prior written approval of at least 75 percent of its investors by value of their investment before buying assets from an associate.

8. Key Takeaways & Exam-Relevant Terms

• Investable Funds: Scheme corpus net of all estimated administrative and management expenses for the entire tenure.
• Concentration Limit: Standard Cat I & II funds are restricted to investing a maximum of 25% of investable funds in a single target company.
• The 75% Rule: The mandatory investor approval threshold (by value) required to authorize transactions with associates or inter-scheme transfers.
• Emergency Shortfall Borrowing: Allowed for Cat I and II to cover drawdown defaults; must be charged only to the delaying investors, subject to a 30-day cooling-off period.
• Angel Investor Asset Exclusion: An individual angel investor must possess net tangible assets of INR 2 crore, strictly excluding their primary residence.
• Angel Fund Deal Ticket: Must be at least INR 25 lakh and is capped at INR 10 crore per start-up.
• Special Situation Assets: Distressed corporate instruments (defaulted >= 90 days, IBC resolution debt, ARC security receipts).
• SSF Minimum Ticket: Standard investors must commit at least INR 10 crore to participate in a Special Situation Fund.