Written by Ananya Sinha and Tirth Purani

I. Introduction

In the Indian investment environment, stocks, debentures and bonds have been major sources of investment for investors that can be exercised by the public at large. On the other hand, Alternative Investment Funds (“AIFs”) fall under a special investment category that is different from the conventional sources of investments and are regulated by the Securities and Exchange Board of India (“SEBI”) under the SEBI (Alternative Investment Funds) Regulations, 2012. AIFs are specialized investment vehicles that collect capital from high net worth individuals or institutional investors to invest in multiple non-conventional assets.

Due to higher returns and lesser volatility, the AIF industry is growing rapidly as compared to traditional portfolio management industries. This raises an alarm to safeguard investors from possible misuse of their funds invested in several investee companies. Since the quantum of fund invested is higher, any irregularity in managing these funds can impact the functioning of modern investment mechanisms such as AIF.

The piece analyses SEBI’s recent investor-protection measures for AIFs and the additional reforms that may be warranted.

II. Present Status of AIFs and Need for Regulation

The AIF industry has crossed INR 10 trillion after receiving its all-time high investment commitments. As per SEBI, AIFs have raised around INR 4.3 trillion. As the industry is booming, SEBI has raised several concerns about the funds invested. The regulator has found multiple cases of flouting of financial sector regulations. Further, AIFs are now structured to enable the evergreening of loans to avoid recognition of the Non-Performing Assets. Through evergreening, investors are kept in the dark without knowing the performance of their investment. Resultantly, the Reserve Bank of India advised certain regulated entities such as banks and other Non-Banking Financial Companies to stop investing in AIFs. Earlier, due to investor protection concerns, SEBI did not allow AIFs to use securities of the investee companies as collateral. However, in its Consultation Paper dated February 2, 2024, it proposed permitting Category 1 and 11 AIFs to keep securities of the infrastructure investee company to as collateral for facilitating infrastructural development. This proposal was further implemented through a circular dated April 26, 2024. Although such a step has been to foster infrastructural growth, SEBI’s amendment recognizes risk with pledging of securities. Thus, the proposal ensures a thorough safeguard for investors by limiting the use of encumbered use of securities for limited purposes.

III. Analyzing Key Protective Measures taken for AIF investors

In 2023, SEBI, to meet the objective of ease of monitoring and administration by stakeholders had mandated that AIFs that have a corpus of INR 500 crores should mandatorily dematerialize their units.  Further, in 2024, the bar on corpus was revoked as SEBI mandated dematerialization any investment in AIFs post October 1, 2024 with certain exemptions. Dematerialization ensures a safer place to hold securities where the risk of fake certificates, delays, bad delivery, and mutilation are eliminated. Additionally, investors will be rest assured that the securities of the fund are held safely in a demat account. Further, the process of dematerialization is not as cumbersome as it seems. An AIF wanting to open a demat account has to provide KYC details, investor manager agreement and other such documents and the entire process is completed within two to three days. Thus, dematerialization will ensure that securities are safe, the entire process is transparent, and investors are protected against operational risks.

Further, as per Regulation 20(11) of the AIF Regulations, the appointment of a custodians is mandated for safekeeping of the securities. However, before the amendment, appointment was mandated only for specific categories of AIF. The Manager or Sponsor of Category I and Category II AIFs were permitted to appoint a custodian if the corpus of the AIF was more than INR 500 crore. While in case of Category III AIFs, it was mandatory to appoint custodian irrespective of the corpus of the AIF. The recent amendment mandates the appointment of custodians for Category I and II AIFs having corpus less than or equal to INR 500 crore holding at least one investment. Thus, mandating all categories of AIFs to appoint custodians irrespective of the size of the corpus will bring parity across all the categories. Further, to avoid conflict-of-interest it is ensured that if the custodian appointed is an associate of the manager/sponsor/trustee of the AIF then he should be appointed only under specified circumstances. Extending the appointment of custodians for all categories will ensure that investments made by the investors are managed efficiently and in safe hands.

In 2021, SEBI introduced the framework for Accredited Investors (“AI”) who are considered to have a deeper understanding of the investment products. Further, SEBI introduced the concept of Large Value Funds (“LVF”) for AI, an AIF scheme under which an AI invests a minimum amount of INR seventy crores. AIs under LVF have been endowed with the flexibility of the extension of investment tenure. For close-ended AIFs, an extension of tenure to liquidate the funds is permitted for up to two years along with the necessary approval.

On the other hand, LVFs have been permitted to extend up to five years subject to the contribution agreement and other such prescribed conditions. In case the conditions mentioned in the placement memorandum, contribution agreement of LVF for extension of tenure beyond two years are not fulfilled, the LVF is required to fully liquidate the funds. LVFs already had the flexibility to extend the tenure indefinitely. However, having no upper limit for the extension of the term of an LVF may result in a close-ended fund turning into an ever-lasting fund wherein investments of investors may get locked in for an indefinite period which may result in delayed disclosure of true asset quality, liquidity, and inaccurate information about the AIF’s performance. Thus, to ensure that the investor’s money is not locked-in for an uncertain period and to get accurate information on AIF’s performance, the extension of tenure for LVFs was aligned with that of other schemes of AIFs. LVFs have been now permitted to extend their tenure up to five years and beyond this would require a mandatory approval of two-thirds of the unit holder by the value of their investments. Thus, a balance has been created giving LVFs flexibility of extending the tenure and protecting investors by limiting it up to years as they will get their money back in a reasonable timeframe, reducing the risk of getting locked in for a longer period.

IV. Recommendations

While the new amendment strengthens investor protection, there remains a pressing need for certain reforms. Applying identical compliance requirements for all funds may prove to be disproportionate for certain smaller funds thus demanding regulatory flexibility. As SEBI has mandated the appointment of custodians for all AIF categories to ensure that investments made by the investors are managed efficiently, it can prove to be financially burdensome to smaller AIFs. SEBI had also noted that an average cost of compliance of schemes availing custodial services was Rs 88, 000 per annum.  For smaller fund managers handling nascent AIFs, such a custodial cost can affect financial bandwidth considering their other compliance costs. Thus, this one-size-fit all approach may not be beneficial to some AIFs. In such a scenario, the regulator should consider giving some flexibility to AIFs having cost concern. As a policy suggestion, SEBI can consider allowing a group of smaller AIFs to engage a single custodian to minimize individual costs. However, there may be a possibility of conflict of interest and operational risks concerning independent decision making and segregation of assets by custodians. To address this, the role of custodians should be strictly limited to safekeeping and settlement with adequate instructions and compliances. Operational risks could be further addressed through strict account segregation and robust IT system. Such an approach will reduce their cost on appointing custodian while also allowing them to monitor themselves independently.

V. Conclusion

For India’s economy to prosper, it is pertinent that modern investment mechanisms such as AIF perform well. AIFs will only attract investors if they are protected from misappropriation of funds, flouting of rules and regulations, and violation of their rights. As the AIF industry is booming, instances of misuse of funds in the form of ever-greening loans threaten investors’ safety. SEBI has effectively addressed such issues by taking the necessary steps. The dematerialization of units will ensure transparency and security in the process. Appointing custodians will safeguard the investor’s fund and comply with regulatory requirements. Reducing the extension of tenure for AIs will ensure that their funds are not locked-in for an indefinite period and will portray the true performance of their invested money. The specific due diligence of investors and investments of AIFs as notified by the SEBI in its circular dated October 8, 2024, aims to prevent any circumvention of the laws.

The steps taken by SEBI are intended to address the above issue of evergreening of loans and other such possible misuse of funds. The outcome of these steps will depend on the future course. Till then, investors need to be assured that the measures taken are intended to address the lacunas.