CHAPTER 6: ALTERNATIVE INVESTMENT FUND STRUCTURING — STUDY NOTES (PART 3)
This section focuses on Section 6.4: Common Fund Structures of AIF, specifically detailing Open-ended vs. Closed-ended structures and Onshore vs. Offshore structures, including relevant FEMA and RBI regulations.
ALTERNATIVE INVESTMENT FUND STRUCTURING: ONSHORE/OFFSHORE & OPEN/CLOSED STRUCTURES
An AIF's operational flexibility, liquidity profile, and capital-raising potential are defined by two primary structural decisions: whether the fund operates as an open-ended or closed-ended scheme, and whether it is domiciled as an onshore or offshore vehicle.
1. OPEN-ENDED VS. CLOSED-ENDED FUND STRUCTURES
Under SEBI regulations, the choice between open-ended and closed-ended designs is a key regulatory differentiator between AIF categories. While Category I and Category II AIFs are strictly mandated to be closed-ended, Category III AIFs have the unique flexibility to be structured as either open-ended or closed-ended schemes.
| Feature | Open-Ended AIF | Closed-Ended AIF |
|---|---|---|
| Issuance | Continuous issuance of units | No continuous issuance |
| Unit Capital | Variable unit capital | Generally fixed/committed capital |
| Redemption | Periodic redemptions available | Capital generally locked in until exit/tenure |
| Capital Deployment | Flexible investment and redemption | Drawdowns made through capital calls |
| NAV | Typically calculated daily/monthly | NAV calculated periodically as required |
| Tenure | No predetermined fixed tenure | Predetermined tenure |
| Listing | Generally not a defining feature | Optional listing |
A. Open-Ended AIF Structure
Open-ended AIFs resemble traditional mutual funds in their operational liquidity, but maintain the sophisticated investment strategies and high entry barriers characteristic of alternative assets.
- Continuous Issuance: Investors can enter the fund and subscribe to units on an ongoing basis after the Initial Offer Period.
- Variable Unit Capital: Because the fund continuously issues new units for subscriptions and cancels units upon redemptions, the overall corpus of an open-ended scheme is variable.
- Periodic Redemptions: Unlike mutual funds that allow daily exits, open-ended AIFs permit redemptions only at pre-defined regular intervals (e.g., monthly, quarterly, or semi-annually) as specified in the Private Placement Memorandum (PPM).
- Redemption Gates: To prevent sudden cash drains that could disrupt underlying trading strategies, fund managers employ redemption gates [77 in previous turn]. These gates cap the maximum percentage of the fund’s total assets that can be redeemed during any single redemption window [77 in previous turn].
- Minimum Investment Limits:
- The first single lump-sum investment by an investor in an open-ended Category III AIF must be at least INR 1 Crore.
- While subsequent top-up contributions have no specified floor, any partial redemption is permitted only if the residual investment value retained in the fund does not fall below the INR 1 Crore limit.
- For employees or directors of the AIF or its Investment Manager, a concessional minimum investment floor of INR 25 Lakhs applies.
- Corpus Breach Protocols: Every AIF scheme is legally required to maintain a minimum corpus of INR 20 Crore. For open-ended Category III schemes, a breach of this limit triggers strict statutory timelines:
- The AIF must notify SEBI within 2 days of receiving a redemption request that causes the corpus to fall below INR 20 Crore.
- The investment manager is granted a maximum of 3 months to restore the scheme's corpus to the mandatory INR 20 Crore threshold.
- If the manager fails to restore the minimum corpus within 3 months, the fund must redeem the entire units of all investors and wind up the scheme.
B. Closed-Ended AIF Structure
Closed-ended structures are designed to lock in investor capital, allowing fund managers to execute long-term, complex, or relatively illiquid investment strategies without the threat of redemption-driven liquidations.
- Capital Commitments & Drawdowns: Investors commit a specific capital sum during the fundraising period. Instead of depositing the entire amount upfront, the investment manager calls for capital incrementally through capital calls (drawdowns) as investment opportunities arise.
- Predetermined Tenure: Closed-ended schemes are launched with a fixed maturity period (tenure). The tenure of the scheme is computed from the date on which its First Close is declared.
- Tenure Extensions: Under SEBI regulations, the tenure of a closed-ended Category III AIF can be extended by a maximum of 2 years (typically executed as two individual extensions of 1 year each). Any such extension is subject to the formal approval of at least two-thirds (66.67%) of the unit holders by value of their investment in the fund. If investor consent is not obtained, the fund must liquidate its assets and wind up.
- Lock-in Periods & Exit Loads: Closed-ended AIFs do not permit redemptions prior to the expiration of the fund's tenure. However, schemes may offer premature exit options after the expiry of a specified lock-in period (typically 1 to 2 years) subject to the payment of an exit load (ranging between 0% and 5% of the NAV).
- Voluntary Exchange Listing: Units of a closed-ended AIF are eligible for listing on recognized stock exchanges to provide secondary market liquidity.
- Timing: Listing is permitted only after the fund has declared its Final Close.
- Tradable Lot: To prevent retail retail participation, the minimum tradable lot size on the exchange is set at INR 1 Crore.
- Exclusions: Units issued by Angel Funds are strictly prohibited from being listed.
2. ONSHORE VS. OFFSHORE FUND STRUCTURES
AIF structuring must facilitate the seamless routing of both domestic and international capital into Indian securities markets.
| Feature | Onshore AIF | Offshore AIF |
|---|---|---|
| Domicile | Domiciled in India | Domiciled outside India |
| Capital Pooling | Pools Resident & FPI capital | Pools Global Capital |
| Regulatory Registration | Registered with SEBI | Relies on applicable FDI / FPI / FVCI frameworks |
| Ownership / Management | Subject to Indian owner/manager test | May benefit from applicable treaty protection |
| Primary Use | Investment routing through an India-based AIF structure | Cross-border investment and global capital pooling |
A. Onshore Fund Structure
- Domicile: The pooling vehicle (almost exclusively structured as a private trust) is domiciled and registered in India under the SEBI AIF Regulations.
- Capital Sourcing: The onshore AIF accepts capital commitments from resident Indian investors as well as foreign/non-resident investors (such as Foreign Portfolio Investors - FPIs).
- The "Owner/Manager" Downstream Test: Under RBI and FEMA guidelines, if an onshore AIF accepts foreign capital, the downstream investments made by the AIF into Indian portfolio companies are subject to characterisation.
- Indirect Foreign Investment: Downstream investments are classified as indirect foreign investments (and must comply with sectoral caps, foreign entry routes, and pricing guidelines) if either the Sponsor or the Investment Manager of the AIF is foreign-owned or foreign-controlled.
- Domestic Investment Status: If both the sponsor and the manager are owned and controlled by resident Indian citizens, the downstream investments are treated as purely domestic investments, regardless of the quantum of foreign capital residing within the AIF's pooled corpus.
B. Offshore Fund Structure
- Domicile: The pooling vehicle is domiciled in an offshore jurisdiction (historically treaty-friendly hubs such as Mauritius, Singapore, Luxembourg, or Delaware) [106, 380, 109-110 in previous turn].
- Capital Sourcing: The vehicle pools capital exclusively from international investors (institutions, sovereign wealth funds, and foreign HNIs) with no intent to pool domestic Indian capital.
- Investment Routing: The offshore fund routes its capital directly into Indian investee companies using designated foreign investment routes: Foreign Direct Investment (FDI), Foreign Portfolio Investment (FPI), or the Foreign Venture Capital Investor (FVCI) route [528, 529, 75 in this turn].
- Bilateral Investment Promotion Agreements (BIPA): Offshore pooling is strategically executed in jurisdictions that have signed BIPAs with India. This provides international investors with critical international law protections, including:
- Protection against arbitrary state expropriation of assets.
- Guarantees for the unrestricted repatriation of capital and investment returns.
- Access to neutral, institutionalized dispute resolution frameworks.
- Resident Indian Outbound Investing (LRS Limit): If resident Indian individuals wish to invest in an offshore fund, their contributions are strictly governed by the RBI's Liberalised Remittance Scheme (LRS) under FEMA. Resident individuals are permitted to remit a maximum of USD 2,50,000 per person per financial year for permissible current or capital account transactions abroad.
3. COMPARATIVE ANALYSIS: PURE DOMESTIC VS. PURE OFFSHORE STRUCTURES
The table below outlines the core operational and legal differences between a Pure Domestic AIF structure and a Pure Offshore structure (adapted from Table 6.1 of the NISM Workbook):
Comparative Matrix of Pure Domestic vs. Pure Offshore Structuring
| Feature | Pure Domestic Structure | Pure Offshore Structure |
|---|---|---|
| Pooling Vehicle Domicile | Domiciled in India (Trust, LLP, or Company). | Domiciled in a foreign jurisdiction (e.g., Mauritius, Singapore). |
| Number of Pooling Vehicles | One (Onshore Fund). | One (Offshore Fund). |
| Primary Regulatory Oversight | SEBI (AIF) Regulations, 2012. | SEBI (FPI) or SEBI (FVCI) Regulations [392, 529, 75 in this turn]. |
| Eligible Investors | Exclusively Resident Indians, NRIs, and registered FPIs. | Strictly offshore/foreign institutional and individual investors. |
| Investment Routing | The Onshore AIF invests directly into Indian investee companies. | The Offshore vehicle invests directly into Indian companies from abroad. |
| Feeder Fund Requirement | Not Applicable. | Possible, but not legally mandatory. |
| FEMA Compliance | Governed by domestic pooling rules; standard reporting via FIRMS/SMF for foreign capital. | Governed strictly by cross-border FDI/FPI sector caps and pricing guidelines. |
DEFINITIONS & IMPORTANT TERMS GLOSSARY
- Open-ended Scheme: An AIF scheme characterized by continuous unit issuance, a variable capital corpus, and periodic redemption windows.
- Closed-ended Scheme: An AIF scheme with a fixed capital commitment period, a predetermined maturity tenure, and a general prohibition on redemptions prior to liquidation.
- Redemption Gates: Restrictive thresholds set by the investment manager that limit the maximum volume of capital redemptions permissible during a single redemption interval to protect fund liquidity [77 in previous turn].
- Indirect Foreign Investment: Downstream investments made by an Indian AIF which are treated as foreign capital because the AIF's Sponsor or Manager is foreign-owned or foreign-controlled.
- Liberalised Remittance Scheme (LRS): An RBI foreign exchange liberalisation framework allowing resident Indian individuals to remit up to USD 2,50,000 per financial year abroad for capital or current account transactions.
- Sectoral Cap: The maximum percentage of foreign equity investment permitted in a specific Indian industry sector under the Foreign Exchange Management Act (FEMA).
KEY EXAM TAKEAWAYS
- Category III Flexibility: Category III AIFs are the only category under SEBI regulations permitted to launch both open-ended and closed-ended schemes.
- Open-Ended Corpus Cure Period: If an open-ended Category III AIF's corpus drops below INR 20 Crore, the manager has exactly 3 months to cure the breach, failing which the entire scheme must be liquidated.
- Pari-Passu Exchange Listing: Listing of close-ended schemes on an exchange is voluntary, requires a minimum tradable lot size of INR 1 Crore, and is permitted only after the Final Close of the fund.
- The Fiduciary Test for Indirect FDI: Downstream investments made by an Indian AIF are classified as "domestic" only if both the Sponsor and the Manager are Indian-owned and controlled.
- LRS Outbound Barrier: Resident Indian individuals cannot bypass the USD 2,50,000 annual LRS ceiling when deploying capital into offshore alternative funds.
NISM AIF Practice Questions — Open/Closed-Ended AIF & Investment Routing
Question 1: Open-Ended AIF
Which AIF Category is permitted under SEBI Regulations to structure its schemes as open-ended funds?
A) Category I AIFs only
B) Category II AIFs only
C) Category III AIFs only
D) Both Category II and Category III AIFs
Answer: C — Category III AIFs only
Explanation: Category III AIFs may be structured as open-ended or closed-ended schemes. Category I and Category II AIF schemes are generally required to be closed-ended. This is an important NISM AIF exam concept.
Question 2: Minimum Corpus of Open-Ended Category III AIF
If the corpus of an open-ended Category III AIF scheme falls below ₹20 crore due to redemptions, what is the maximum statutory period allowed to restore the corpus to the minimum mandated size?
A) 30 Days
B) 60 Days
C) 3 Months
D) 6 Months
Answer: C — 3 Months
Explanation: If the corpus of an open-ended Category III AIF falls below the prescribed minimum corpus of ₹20 crore, the AIF is required to restore the corpus to the minimum level within 3 months.
Question 3: Onshore AIF with Foreign Investors
An onshore AIF registered with SEBI receives 60% of its capital from European institutional investors. However, the Sponsor and Investment Manager are wholly owned and controlled by resident Indian citizens. How are the AIF's downstream investments in Indian companies classified?
A) Purely Domestic Investments
B) Indirect Foreign Investments
C) Foreign Portfolio Investments (FPI)
D) Foreign Venture Capital Investments (FVCI)
Answer: A — Purely Domestic Investments
Explanation: For the relevant downstream investment classification, an AIF with foreign capital does not automatically become a foreign-owned or foreign-controlled entity. Where the Sponsor and Investment Manager are Indian-owned and Indian-controlled, the downstream investments can be treated as domestic investments, subject to applicable FEMA and regulatory conditions.
Question 4: Listing of Closed-Ended AIF Units
Under SEBI guidelines, a closed-ended AIF scheme can voluntarily list its units on a recognized stock exchange, provided the minimum tradable lot size is:
A) ₹10 lakh
B) ₹25 lakh
C) ₹50 lakh
D) ₹1 crore
Answer: D — ₹1 crore
Explanation: Units of a closed-ended AIF scheme may be listed on a recognized stock exchange, subject to applicable SEBI conditions, including the prescribed minimum tradable lot size of ₹1 crore.
Question 5: RBI Liberalised Remittance Scheme (LRS)
A resident Indian individual wants to invest in a Mauritius-domiciled offshore hedge fund. Under the RBI Liberalised Remittance Scheme (LRS), what is the maximum amount that can generally be remitted per financial year?
A) USD 1,00,000
B) USD 2,50,000
C) USD 5,00,000
D) There is no limit on LRS remittances for alternative assets
Answer: B — USD 2,50,000
Explanation: Under the RBI's Liberalised Remittance Scheme (LRS), a resident individual can generally remit up to USD 2,50,000 per financial year for permitted current or capital account transactions, subject to applicable conditions and restrictions.