Chapter 5: Regulatory Framework (Part 2 of 6)
5.3 Accredited Investors, Accreditation Agencies, and the Accredited Investor Framework
The Accredited Investor Framework (AI Framework) is a regulatory regime introduced by SEBI to offer greater operational flexibility and regulatory concessions to sophisticated investors who have the financial capacity and capability to evaluate complex investment products.
5.3.1 Definition and Eligibility Criteria for Accreditation
An Accredited Investor (AI) is an investor who is accredited by a registered Accreditation Agency based on their financial standing. The eligibility criteria for different categories of investors are as follows:
- Partnership Firms: In the case of a partnership firm set up under the Indian Partnership Act, 1932, each partner must independently meet the eligibility criteria for accreditation.
- Body Corporates: A body corporate is eligible if its net worth is at least Rs. 50 crore.
- Formula for Body Corporate Net Worth: Net Worth = (Capital + Free Reserves) - (Accumulated Losses + Deferred Expenditure not written-off)
- Trusts (other than family trusts): A trust (excluding family trusts) is eligible if its net worth is at least Rs. 50 crore.
- Formula for Trust Net Worth: Net Worth = (Book Value of all Assets, other than intangible assets) - (Book Value of all Liabilities)
5.3.2 Accreditation Agencies and Process
- Role of Accreditation Agencies: Accreditation is carried out by specialized Accreditation Agencies or KYC Registration Agencies (KRAs). These agencies are authorized to access the applicant’s Know Your Customer (KYC) documents and financial records to verify eligibility.
- Fit and Proper Criteria: The applicant must be a "fit and proper" person to participate in the securities market, meaning they must not be a wilful defaulter, have any regulatory convictions, or be subject to restraint orders by financial regulators.
- Accreditation Certificate: Upon successful verification, the agency issues an Accreditation Certificate which contains a unique accreditation number, the name of the agency, the PAN of the investor, and the validity period (with a clear start and end date). The certificate is granted solely based on KYC and verified financial information.
5.3.3 Obligations of Category III AIFs under the AI Framework
- Independent Verification: A Category III AIF cannot blindly accept a certificate; it is solely responsible for independently verifying the status of accreditation of any prospective investor with the concerned Accreditation Agency.
- Disclosures of Concessions: Prior to entering into any agreement, the AIF must clearly disclose to the Accredited Investor the specific regulatory concessions agreed upon and the conditions for availing them.
- Client Agreement Disclosures: The final client agreement must incorporate:
- The exact details of the regulatory concessions.
- The consequences if the investor loses their "Accredited Investor" status during the tenure of the agreement.
- The modalities and consequences of withdrawal of consent by the investor to discontinue the benefits linked to accreditation.
- Withdrawal of Consent and Consequences:
- If an Accredited Investor withdraws consent after availing a lower investment ticket size, they are responsible for increasing their investment to the standard minimum amount (e.g., Rs. 1 crore) within the timeline specified in the client agreement.
- If the investor withdraws consent after availing other regulatory concessions, their existing investments are "grandfathered" and continue to be treated as accredited investments, but all future transactions must comply with standard AIF regulations.
- Accredited Investors who invest in a Large Value Fund (LVF) are not allowed to withdraw their consent once given.
5.4 Conditions for Investment in a Category III AIF
To safeguard the interest of investors and ensure system-wide stability, SEBI imposes strict operational limits and conditions on both the fund and its investors.
5.4.1 General Investment Conditions and Restrictions
- Minimum Scheme Corpus: Every Category III AIF scheme must have a minimum corpus of Rs. 20 crore.
- Breach of Corpus in Open-ended Schemes: If the corpus of an open-ended scheme falls below Rs. 20 crore:
- The AIF must take corrective action to bring the corpus back to Rs. 20 crore within 3 months of the breach.
- The AIF must intimate SEBI within 2 days of receiving a redemption request that causes the breach.
- If the AIF fails to restore the corpus within 3 months, it must compulsorily redeem the entire units of all investors.
- Breach of Corpus in Open-ended Schemes: If the corpus of an open-ended scheme falls below Rs. 20 crore:
- Minimum Investment Threshold:
- Standard Investors: The minimum investment amount is Rs. 1 crore.
- Employees/Directors: For employees or directors of the AIF or its Investment Manager, the minimum threshold is reduced to Rs. 25 lakh.
- Joint Investment Rules: An AIF can accept joint investments only between:
- An investor and their spouse.
- An investor and their parent.
- An investor and their son/daughter.
- Rule of Two: No more than 2 persons can act as joint investors. For any other combination, each investor must independently meet the minimum investment threshold of Rs. 1 crore.
- Maximum Number of Investors: Every scheme launched by a Category III AIF is capped at a maximum of 1000 investors.
- Private Placement Only: AIFs are strictly prohibited from making any public invitations. Funds must be raised solely through a private placement mechanism.
- Dematerialisation: AIFs must issue units in dematerialised form only, subject to SEBI conditions.
5.4.2 Sponsor/Manager Continuing Interest ("Skin-in-the-Game")
- Continuing Interest: The Sponsor or Investment Manager must maintain a continuing interest (skin-in-the-game) of at least 5% of the fund corpus or Rs. 10 crore, whichever is lower. This interest must not be reduced, withdrawn, or transferred after the first close is declared.
- Disclosure: The Sponsor/Manager must fully disclose their investment and continuing interest in the fund to all other investors.
5.4.3 Investment Strategy and Approval of Changes
- PPM Disclosures: All Category III AIFs must disclose their Investment Strategy, Investment Objective, and Investment Methodology in the PPM. This strategy must be followed consistently during the entire life of the fund.
- Approvals for Changes: Any material change in the Investment Strategy at a later stage requires the prior approval of at least two-thirds (66.67%) of the investors by value of their investment in the fund.
5.4.4 Investor Excuse and Exclusion Framework
An Investment Manager may excuse or exclude an investor from participating in a particular investment under the following conditions:
- Violation of Law: If, based on a formal legal opinion, the investor confirms that participating in the investment would violate an applicable law or regulation.
- Internal Policy Conflict: If the investor has disclosed in the Contribution Agreement that such an investment would violate their internal policy.
- Note: The Contribution Agreement must mandate that the investor reports any change in their internal policy to the fund manager within 15 days of such a change.
- Regulatory Violation: If the Investment Manager determines that the investor's participation would lead to the scheme violating a regulation, they can record the rationale and exclude the investor.
- Investment Vehicle Excuses: If the investor is itself an investment pool/fund, they can be partially excused to the extent of their underlying investors who are excused.
5.5 Fund-Raising Process and Regulatory Requirements
The fund-raising process of a Category III AIF involves a series of sequential, highly regulated steps to ensure full compliance:
| Step | Stage | Key Action |
|---|---|---|
| 1 | Fund Formation | Establish the AIF's legal structure and prepare foundational documents |
| 2 | Apply to SEBI | Submit the AIF registration application to SEBI |
| 3 | In-Principle Approval | Obtain SEBI's in-principle approval |
| 4 | Seek Commitments | Approach eligible investors and obtain investment commitments |
| 5 | Final Certificate | Obtain the final AIF registration certificate |
| 6 | First Close | Complete the first closing of the fund |
| 7 | Drawdown Calls | Call committed capital from investors as required |
| 8 | Final Close | Complete the final closing of the fund |
Table 5.1: The Fund-Raising Process of a Category III AIF
| Step | Action | Description & Key Regulatory Requirements |
|---|---|---|
| Step 1 | Fund Formation & Constituents | The Sponsor/Manager forms a legal entity (typically a Trust) and appoints the Trustee, Custodian, Registrar & Transfer Agent (RTA), Auditor, Legal Advisors, and Fund Accountants. |
| Step 2 | SEBI Application (Form A) | The applicant files a draft Private Placement Memorandum (PPM) along with the application in Form A to SEBI through a registered Merchant Banker. |
| Step 3 | In-Principle Approval | SEBI reviews the application and grants an In-Principle Approval. This allows the fund to set up bank/custody accounts, demat accounts, register on the SEBI SCORES platform, and obtain SEBI login credentials. |
| Step 4 | Approaching Investors | Armed with the In-Principle Approval, the fund can appoint distributors and approach prospective investors to accept capital commitments, but no actual money can be drawn down. |
| Step 5 | Final Certificate of Registration | The applicant registers its final Trust Deed/LLP Deed (within 6 months of in-principle approval), pays the registration fees (Rs. 15 lakhs), and receives the Certificate of Registration in Form B. |
| Step 6 | First Close | The fund achieves its target first close (not less than Rs. 20 crore), calls down initial capital from investors, issues demat units, and starts investing and declaring NAV. |
| Step 7 | Capital Calls and Drawdown | During the commitment period, the Investment Manager issues drawdown notices to investors on an as-needed basis to finance investments. |
| Step 8 | Final Close | The fund reaches its final targeted corpus and closes the fund-raising window for close-ended schemes. Open-ended schemes can continue to accept new subscriptions. |
5.6 Private Placement Memorandum (PPM)
The Private Placement Memorandum (PPM) is the core offering document of a Category III AIF. It details all the material disclosures required by sophisticated and institutional investors to make informed decisions.
5.6.1 Key PPM Disclosure Sections (SEBI Template)
To ensure standardisation, SEBI mandates a common template for Category III AIF PPMs, which includes the following sections:
- Executive Summary: Contains AIF name, registration number, details of Sponsor/Manager, investment objective, leverage strategy, target corpus, classes of units, minimum commitment, and fee structures.
- Investment Objective, Strategy, and Process: Details on fund structure, target securities/sectors, exposure limits, use of leverage, and offshore allocations.
- Fund/Scheme Structure: Brief profiles of key team members, constituents (Trustee, Manager, Custodian, Advisor), and their inter-relationships.
- Governance Structure: Constitution, roles, fees, and responsibilities of key committees like the Valuation Committee, Investment Committee, and Advisory Boards.
- Track Record of the Manager: Historical investment performance, previous exits, and disclosure on whether the manager is a "first-time" or "experienced" manager.
- Principal Terms of the Scheme: Information on the target corpus, tenure, minimum investment size, hurdle rate, benchmark, distribution waterfall, and potential conflicts of interest.
- Determination of Net Asset Value (NAV): Explains the valuation policies, frequency of valuation, and details of the independent Valuer entity.
- Taxation and Legal Considerations: Applicable laws (Trust Act, Companies Act, FEMA) and specific tax regimes (direct taxes, capital gains characterisation, STT, GST, and GAAR).
- Illustrations of Fees, Expenses, and Charges: A comprehensive year-wise table illustrating the net amount invested after deducting all management fees, setup costs, and operating expenses.
5.6.2 Key PPM Compliance Policies
- Absolute Accuracy: It is the sole responsibility of the Investment Manager to ensure that all information in the PPM is true, accurate, and completely free of material omissions. SEBI only provides its observations on the PPM and does not formally "approve" the document.
- Mandatory Yearly Audit: AIFs must carry out an annual audit of the PPM at the end of each financial year to ensure compliance with its terms. The audit findings and corrective actions must be reported to investors and SEBI within 6 months from the end of the financial year.
- Prohibition of Priority Distribution: Category III AIFs must share losses on a pro-rata basis. No scheme can adopt a "priority distribution model" where a particular class of investors absorbs losses disproportionately higher than their pro-rata holding. Schemes with such structures are barred from accepting fresh commitments.
5.7 First Close, Final Close, and Fund Tenure
The timelines surrounding First Close, Final Close, and Fund Tenure are strictly monitored by SEBI to prevent open-ended fundraising by close-ended schemes.
5.7.1 Timelines for First Close and Final Close
- Standard Schemes: The First Close must be declared within 12 months from the date SEBI takes the PPM on record.
- Failure to Declare: If the First Close is not achieved within 12 months, the scheme is cancelled, and the AIF must file a fresh application by paying the fees again.
- Large Value Funds (LVFs): For LVFs, the 12-month period for declaring the First Close starts from either the date of registration or the date the scheme’s PPM is filed, whichever is later.
- Investor Entry Post-Close:
- Close-ended Schemes: Cannot accept any fresh commitments or new investors after the Final Close is declared.
- Open-ended Schemes: Can continuously accept money from new and existing investors even after the Final Close.
5.7.2 Calculation and Extension of Fund Tenure
- Tenure Start Date: For close-ended Category III AIFs, the tenure of the fund starts from the date of declaration of the First Close. Prior to the First Close, investors have the right to withdraw or reduce their commitments.
- Standard Extension Limits: Close-ended Category III AIFs can extend their tenure for a maximum of 2 years (divided into two separate extensions of 1 year each).
- Investor Approval: Any extension requires the consent of at least two-thirds (66.67%) of the investors by value of their investment in the scheme.
- Compulsory Liquidation: If the required consent is not obtained, or the extended tenure expires, the fund must immediately enter compulsory winding-up.
- Large Value Fund (LVF) Extension Limits: LVFs for Accredited Investors are permitted to extend their tenure up to a maximum of 5 years, subject to two-thirds unitholder approval by value.
- Realignment of Tenure: LVFs that did not specify a clear extension period or exceeded 5 years were mandated to realign their PPMs to the 5-year limit by November 18, 2024.
- Compliance Reporting: The trustee must confirm compliance with these realignment circulars in the Compliance Test Report (CTR) submitted to SEBI.
Key Terms and Concepts for Exam Prep
Accredited Investor (AI)
A sophisticated investor certified by an Accreditation Agency based on net worth or income, qualifying for relaxed investment ticket sizes and regulatory concessions.
Large Value Fund for Accredited Investors (LVF)
An AIF scheme dedicated entirely to Accredited Investors where each investor (except fund managers/employees) commits a minimum of Rs. 70 crore.
Skin-in-the-Game
The regulatory requirement for Sponsors or Managers to maintain a continuing financial interest of 5% of the corpus or Rs. 10 crore (whichever is lower) in Category III AIFs to align their incentives with those of the investors.
First Close
The milestone when a scheme achieves its target minimum corpus (at least Rs. 20 crore) and can begin drawdown, investment, and NAV calculations.
Priority Distribution Model
An illegal distribution structure where certain classes of investors are protected from losses by shifting them disproportionately to another class of investors.
💡 Quick Revision Nudge
- Accredited Investor Net Worth (Non-Individuals): Both Body Corporates and Non-Family Trusts require a net worth of Rs. 50 crore.
- Minimum Investment Size: Rs. 1 crore for standard investors; Rs. 25 lakhs for employees/directors of the AIF or Manager.
- Standard AIF Tenure Extension: Maximum of 2 years (1+1) with 2/3rd investor approval by value.
- Large Value Fund (LVF) Extension: Maximum of 5 years with 2/3rd investor approval by value.