Chapter 5: Regulatory Framework (Part 3 of 6)

5.8 Dematerialisation of AIF Units and Investments

To enhance transparency, security, and ease of transaction, the Securities and Exchange Board of India (SEBI) mandates the dematerialisation of both the units issued by Alternative Investment Funds (AIFs) and the investments held by them.

5.8.1 Dematerialisation of Units

All schemes launched by an Alternative Investment Fund must issue their units in dematerialised form.

• Implementation Standards: The dematerialisation of units must be carried out in compliance with the conditions specified by SEBI and according to the operational standards formulated by the Standard Setting Forum for AIFs (SFA) on a pilot basis.
• Transfer Mechanism: The AIF is required to report the specific mechanism for the transfer of its dematerialised units in its Private Placement Memorandum (PPM).

5.8.2 Dematerialisation of Invested Assets

In addition to the units issued to investors, Category III AIFs are also required to hold their own investment portfolios in dematerialised form.

Mandatory Timeline

Any investment made by a Category III AIF on or after July 1, 2025, must compulsorily be held in dematerialised form. This requirement applies universally, regardless of whether the investment is made:

1. Directly in the investee company, or
2. Acquired from another entity in the secondary market.

Exceptions to Investment Dematerialisation

The condition to hold investments in dematerialised form does not apply in the following specific cases:

• Ineligible Instruments: Investments made by AIFs in instruments that are not legally or operationally eligible for dematerialisation under depository rules.
• Liquidation Schemes: Investments held by a dedicated liquidation scheme of the AIF that are not available in dematerialised form.
• Other Specified Exemptions: Any other investments or schemes that may be specifically exempted by SEBI from time to time.

5.9 Category III AIFs: Open-Ended vs. Close-Ended Structures

Unlike Category I and Category II AIFs, which are compulsorily close-ended with their tenures fixed at the time of registration, Category III AIFs offer flexibility in their structural design. They can be registered as either open-ended or close-ended structures.

5.9.1 Open-Ended Fund Structure

In an open-ended structure, the fund does not have a fixed maturity and allows continuous entry and exit for investors.

• Capital Contributions: Investors contribute capital upon admission or subscription to the fund during the Initial Offer Period. They are permitted to make additional capital contributions from time to time as required by the fund.
• Redemption Mechanism: Redemptions of capital are allowed at pre-defined regular intervals, such as quarterly, half-yearly, or yearly.
• Investment Thresholds:
  • The first single lump-sum investment made by an investor must not be less than Rs. 1 crore.
  • Any subsequent or additional contribution made by the same investor has no minimum limit.
• Partial Redemption Guard: In the event of a partial redemption request, the open-ended Category III AIF must ensure that the residual investment amount retained by the investor in the fund does not fall below the mandatory minimum limit of Rs. 1 crore.

5.9.2 Close-Ended Fund Structure

In a close-ended structure, the fund is established for a defined term and does not permit investors to redeem their capital at will before the fund's maturity.

• Capital Commitments: Investors make capital commitments, which are subsequently called down by the Investment Manager through Capital Calls during a specified Commitment Period.
• Commitment Period: The Commitment Period is typically restricted to the first 3 years of the fund's tenure.
• Redemption Restraints: Redemptions are generally not permitted prior to the winding-up of the fund, except under extraordinary circumstances. Investors seeking an early exit after the mandatory lock-in period (prevalent in the industry as 2 years) can do so only by paying an exit load as specified in the PPM.

5.10 Listing of Close-Ended Funds/Schemes

Listing close-ended schemes on a public platform provides an alternative liquidity route for investors who are otherwise locked into the fund.

5.10.1 Key Listing Conditions

• Voluntary Nature: Listing of close-ended Category III AIF schemes on a recognized stock exchange is voluntary.
• Minimum Tradable Lot: To prevent retail participation, the scheme must maintain a minimum tradable lot size of Rs. 1 crore on the exchange.
• Post-Final Close: Listing is permitted only after the Final Close of the fund or scheme has been formally declared.

5.10.2 Steps in the Listing Process

In order to list the units of a close-ended scheme, the AIF must systematically progress through the following regulatory steps:

Step 1: Exchange Application ➔ Step 2: In-Principle Approval ➔ Step 3: SEBI Approval ➔ Step 4: Final Listing

• Step 1: Application and Documentation: The AIF files a formal application with a recognized stock exchange, submits the required compliance documents, and pays the designated exchange fees based on the size of the scheme.
• Step 2: In-Principle Approval: The recognized stock exchange reviews the application and documentation, and subsequently grants an In-Principle Approval for listing the units on its trading platform.
• Step 3: SEBI Clearance: The Category III AIF then formally seeks approval from SEBI to list the close-ended units.
• Step 4: Final Approval & Trading: Upon receiving SEBI’s clearance, the recognized stock exchange issues its final listing approval, allowing the units of the close-ended scheme to commence active trading.

5.11 Category III AIFs: Direct Plans vs. Distributor Plans

To protect investor interests and minimize cost overheads, SEBI requires AIFs to offer choices in how investors access the fund, mirroring the mutual fund utility.

5.11.1 The Direct Plan Option

Every scheme launched by a Category III AIF must provide a "Direct Plan" option for investors.

• Zero Commission: The Direct Plan must not entail or charge any distribution fees, placement fees, or marketing commissions.
• Mandatory Direct On-Boarding: If an investor approaches the AIF through a SEBI-registered intermediary that is already charging the investor an independent fee (such as an investment advisory fee or portfolio management fee), the AIF must compulsorily on-board that investor via the Direct Plan only.

5.11.2 Distribution Commission Trail Model

For investors on-boarded through distributor plans, SEBI enforces strict guidelines regarding how commissions are structured and paid:

• No Upfront Commissions: AIFs are strictly prohibited from charging upfront distribution or placement fees, either directly or indirectly, to investors. All distribution commissions must be charged strictly on an equal trail basis over the investment period.
• Paid from Management Fees: Any distribution or placement fees paid to intermediaries must be funded solely out of the Management Fees received by the Investment Manager; they cannot be charged as an additional expense to the fund's pool.
• Disclosure: The exact distribution or placement fee structure must be transparently disclosed to investors at the time of on-boarding.

5.12 Conditions for Investments by a Category III AIF

A Category III AIF operates with a diverse investment mandate, allowing it to invest across primary and secondary markets, unlisted spaces, and derivatives, subject to strict regulatory conditions.

5.12.1 Permissible Investment Scope

A Category III AIF is permitted to invest in:

• Securities of listed and unlisted investee companies.
• Listed or unlisted derivatives.
• Units of other SEBI-registered Category I, II, or III AIFs.
• Complex or structured products.
• Physical settlement of commodity derivatives.

5.12.2 Key Operational Investment Conditions

1. Commodity Derivatives & Physical Settlement

Category III AIFs may participate in the commodity derivatives market. They are permitted to deal in goods received in delivery against the physical settlement of commodity contracts. Such physical settlements are permitted for commodities like precious metals, base metals, energy products, and agricultural products.

2. Corporate Bond Request for Quote (RFQ) Platform

To enhance secondary market transparency and pricing disclosures, SEBI mandates corporate bond trading on exchange RFQ platforms.

• 10% Mandate: Category III AIFs must execute at least 10% of their total monthly secondary market trades in Corporate Bonds by placing or seeking quotes on the recognized exchange RFQ platform.
• RFQ Trading Modes:
  • One-to-One Mode: Used for trades targeted at an identified counterparty. If an AIF acts as both the buyer and seller (on both sides of a corporate bond trade), the transaction must be executed in one-to-one mode.
  • One-to-Many Mode: Used when quotes are broadcast to all participants. If a trade is entered in one-to-many mode and ends up executing against another AIF, it will still count toward the "one-to-many" monthly quota.

3. Investment in Units of Other AIFs

An AIF may invest in other registered AIFs without needing to register or label itself as a "Fund of AIFs".

• Reciprocal Subscription Ban: A Category III AIF that is authorized by its PPM to invest in units of other AIFs is strictly prohibited from offering its own units for subscription to those other AIFs.
• Consent for Dual Investment: Existing Category III AIF schemes can invest simultaneously in investee company securities and units of other AIFs, provided this is disclosed in the PPM and has the consent of at least two-thirds (66.67%) of the unitholders by value.
• Mandatory PPM Disclosures for Inter-AIF Investments: The PPM of such a fund must specifically disclose:
  • The proposed allocation of investment in the units of other AIFs.
  • The portion of fees and expenses attributed to investing in other AIFs out of the total fees charged to investors.
  • The risk management process to ensure continuous compliance with investment restrictions and concentration limits.
  • Disclosures of any investments in units of AIFs managed/sponsored by the same manager, sponsor, or their associate entities, including the fee allocation details.

4. Co-Investments and Conflict Prevention

To prevent sponsors or managers from favoring proprietary accounts or other clients over the AIF unitholders, SEBI enforces strict co-investment rules:

• No Favourable Terms: The Investment Manager is prohibited from dealing in co-investment securities for other clients or proprietary accounts on terms more favorable than those offered to the Category III AIF.
• Identical Exit Terms: The timing and pricing terms of exit from co-invested securities must be completely identical for the Investment Manager and the AIF.

💡 Co-Investment Priority Allocation Example

Manager PQ plans to buy 50 lakh shares of unlisted MNC Ltd. at Rs. 8.00 per share for Fund ABC, and also wants to purchase 10 lakh shares of MNC Ltd. for three discretionary portfolio clients. Under SEBI rules, Manager PQ must prioritize Fund ABC. The manager must first secure the 50 lakh shares for Fund ABC at Rs. 8.00 per share. Only if additional shares are available at Rs. 8.00 per share can the manager purchase the shares for the other three discretionary clients.

5. Overseas Investments

Category III AIFs are permitted to invest in foreign offshore entities, subject to guidelines issued by RBI and SEBI.

• Exemptions and Limits: Offshore equity/equity-linked investments are subject to an overall industry-wide cap of USD 1,500 million across all registered AIFs on a first-come, first-served basis. Individual scheme investments cannot exceed 25% of the investible funds.
• Sanction Validity: Once SEBI allocates an overseas investment limit, the approval remains valid for 6 months, failing which it automatically lapses.
• Indian Connection: Investments can only be made in offshore entities that have a demonstrable "Indian Connection" (e.g., front office overseas with back-office operations in India).
• Sale/Divestment Timelines: If an AIF liquidates an overseas investment, it must report the transaction details to SEBI at [email protected] within 3 working days of the sale so the regulator can release the limit back to the industry pool.

6. Leverage and Borrowing Limits

• Prior Consent: Category III AIFs can employ leverage or borrow money only after taking the prior consent of the investors.
• Regulatory Cap: Total leverage taken must not exceed 2 times the Net Asset Value (NAV) of the fund. If the fund invests in units of other AIFs, the 2x leverage limit must exclude the value of those inter-AIF investments.

7. Temporary Investments of Surplus Cash

The un-invested portion of the investable funds, or divestment proceeds pending terminal distribution, can be temporarily parked in high-quality liquid assets. These permitted assets include:

• Liquid mutual funds
• Bank deposits
• Treasury bills (T-bills)
• Triparty Repo Dealing and Settlement (TREPS)
• Commercial Papers (CPs) and Certificates of Deposits (CDs)
• Note: If the scheme has Non-Resident Indian (NRI) unitholders, temporary investments are subject to additional FEMA/RBI restrictions.

8. Transactions with Associates

To prevent self-dealing, any transaction where a Category III AIF buys or sells securities from or to an Associate, or other schemes managed/sponsored by its own sponsor/manager, requires the prior approval of at least 75% of the investors by value of their investment.

• 50% Anchor Investor Exclusion: If a single anchor investor has committed 50% or more of the fund corpus, they are compulsorily excluded from the voting process to ensure unbiased decision-making.
• Definition of Associate: An associate entity is defined as a Company, LLP, or Body Corporate where a director, trustee, partner, sponsor, or manager of the AIF holds more than 15% of the paid-up equity share capital or partnership interest, individually or collectively.

5.13 Concentration Limits

Concentration limits are designed to prevent AIFs from over-exposing their pooled capital to a single company, thereby managing diversification risk.

5.13.1 Regulatory Investment Limits in a Single Investee Company

• Standard Category III AIFs: A standard Category III AIF can invest a maximum of 10% of its investible funds in a single investee company, whether directly or through units of other AIFs.
• Large Value Funds (LVFs): For Large Value Funds dedicated to Accredited Investors, the limit is relaxed to a maximum of 20% of the investible funds in a single investee company.
• Cost-Basis Principle: Crucially, the 10% (or 20%) concentration limit is calculated based on the cost of the investments made by the AIF, and not on the current market value of those assets.

5.13.2 Concentration Bases: Investible Funds vs. Net Asset Value (NAV)

At the time of launching a scheme, the Investment Manager has the flexibility to choose between two different calculation bases for monitoring concentration limits:

1. Investible Funds Basis:
   • Investible Funds = Fund Corpus - Estimated Administration & Management Expenses for the entire fund tenure.
   • Fund Corpus represents the total capital committed by all investors by way of a written contract as on a particular date.
2. Net Asset Value (NAV) Basis:
   • The concentration limit is calculated based on the NAV of the scheme on the business day immediately preceding the date of investment.
   • NAV = Value of all securities (Mark-to-Market) + Cash & Cash Equivalents - Borrowed Funds.
   • Passive Breach Rectification: If price movements or redemptions cause a "passive breach" of the concentration limit under the NAV basis, the Investment Manager must compulsorily rectify the breach within 30 days from the date of its occurrence.

• No Base Switching: The chosen basis for calculating the investment concentration limit must be transparently disclosed in the PPM and cannot be changed during the entire tenure of the scheme.

Key Terms and Concepts for Exam Prep

Standard Setting Forum for AIFs (SFA)

The industry-led standard-setting body responsible for formulating detailed operational guidelines, such as dematerialisation processes and compliance reporting for AIFs in India.

Request for Quote (RFQ) Platform

An electronic trading platform on stock exchanges designed to bring transparency to secondary market corporate bond transactions.

Investible Funds

The total corpus of an AIF scheme minus the estimated administrative and management expenses projected for the entire life cycle of the fund.

Passive Breach

A regulatory breach caused solely by market price fluctuations or portfolio valuations rather than active buying/selling decisions by the manager. Passive breaches of NAV-based concentration limits must be resolved within 30 days.

Associate Entity

A corporate or partnership entity where the AIF's key constituents (directors, partners, sponsor, or manager) control or hold more than 15% of the capital or interest.

💡 Quick Revision Nudge

• Demat Timelines: All investments made by a Category III AIF on or after July 1, 2025, must be held in dematerialised form.
• Direct Plan Rule: Direct plans must carry zero distribution commission, and trail commission on distributor plans can only be paid out of the manager's management fees.
• Concentration Limits: Maximum of 10% of investible funds (cost-basis) in a single investee company for standard schemes; 20% for Large Value Funds (LVFs).
• Associate Trading: Buying or selling assets from/to associates requires a 75% investor vote by value, excluding any anchor investor holding 50% or more of the corpus.