[By Anirudh Vats]
The author is a student at the Rajiv Gandhi National University of Law, Patiala.
I. Introduction
The Securities and Exchange Board of India (“SEBI”), in a pertinent towards the development of the Alternative Investment Fund (“AIF”) regime in India, relaxed the stringent restrictions pertaining to overseas investments made by Indian AIFs, vide SEBI Circular dated 17 August 2022[1] (“SEBI 2022 Circular”).
This development comes as a partial relief to investors in the AIF industry who have been long demanding a more flexible and transparent route to overseas investments without tedious regulation and red-tapism. However, the circular does not go far enough in transforming the regulatory framework so as to accommodate the rapidly growing AIF industry. This circular comes as a welcome but sluggish step forward in the right direction, with much scope for further relaxations.
II. The Evolved Regime
i.) ‘Indian Connection’ Requirement
In accordance with SEBI Circular dated August 09, 2007[2] read with SEBI Circular dated October 01, 2015[3] regulating overseas investments, Indian AIFs investing in foreign portfolio entities were required to ensure that such entities have an Indian connection; they may operate a front office overseas but must have functioning back office operations in India. With the introduction of the SEBI 2022 circular, this requirement has been done away with.
While the erstwhile requirement was introduced to expand the local market, it placed an unjust obligation on investors by forcing them to limit the ambit of their overseas portfolio and discourage diversification. This caused the investment managers to have limited choices in the available avenues within his/her area of expertise which could potentially fetch lucrative returns for investors. Moreover, the requirement seemed redundant in light of the restriction requiring AIFs to invest 25% of their investible fund in overseas entities, while the overwhelming majority of the fund is mandatorily allocated for Indian companies.
Therefore, such an arbitrary requirement merely functioned as an embargo on the agility of the investment manager to procure sufficient returns for investors and diversify into more dynamic and flexible overseas investment strategies.
ii.) Jurisdiction Specific Requirements
In addition to the ‘Indian Connection’ requirement being removed, the SEBI 2022 Circular also prescribes jurisdiction specific guidelines prescribing the permitted jurisdictions which could attract investments from Indian AIFs. AIFs are restricted to investing only in portfolio entities overseas which are incorporated in countries where the securities market regulator is either:
- a signatory under Appendix A of the International Organization of Securities Commission’s (IOSCO) Multilateral Memorandum of Understanding (such as Luxembourg, Malaysia, and Netherlands); or
- a signatory to the bilateral Memorandum of Understanding (MOU) with SEBI (such as USA, Mauritius, Singapore, and Indonesia).
Moreover, the SEBI 2022 Circular also prohibits investments into the overseas companies in countries which have been identified in the public statement of Financial Action Task Force (FATF) as either having strategic anti-money laundering or lack of effort in combating terror financing.
However, certain jurisdictions fall in both the permitted and prohibited categories mentioned above (such as the UAE) and, hence, it is unclear whether overseas investments into these countries would be permitted under the new regime or not.
iii.) Permission for Reinvestment of Principal Amount from Liquidation or Disinvestment
The SEBI 2022 Circular has permitted AIFs to reinvest the principal amount of the proceeds procured from the liquidation of overseas investments, without the requirement of a prior approval from SEBI for allocation of investing limits. However, this would be subject to the fund documents providing for such a flexible model of investment.
This is a welcome change as it relaxes the tedious process for AIFs which employ a dynamic mode of overseas investment wherein investments can be repurposed to new portfolio entities according to the strategy of the investment manager. This is a significant step forward by SEBI to liberalize the overseas investment regime and provide the AIF industry the support it needs to continue its trajectory of rapid growth in India.
iv.,) Additional Compliances
The SEBI 2022 Circular also prescribes certain additional compliances for AIFs. These are, inter alia: –
- AIFs are mandated to furnish an application to SEBI for allocation of limit for overseas investments in the prescribed format.
- AIFs are required by SEBI to provide the modalities of sale or disinvestment of the overseas investments to SEBI in accordance with the prescribed format within a period of 3 working days of the disinvestment or sale.
Such compliances will ensure that SEBI can effectively monitor and update the allocated limits for overseas investments and ensure the overall limit is not exceeded. Moreover, these compliances will provide SEBI with valuable data that will assist in analysing market trends and updating the law in the future.
III. Unaddressed Issues pertaining to Overseas Investments
i.) No enhancement of the USD 1.5 billion overseas investment cap
Despite the AIF market size expanding exponentially in the past few years, this circular maintains the status quo regarding the USD 1.5 Billion overall limit for overseas investments by AIFs, despite calls for increasing the limit by investors. However, SEBI 2022 Circular falls short of increasing the aforesaid limit despite purporting to be an exhaustive overhaul of the overseas investments regime under AIFs.
The possible rationale behind not increasing the overall limit is possibly to protect the foreign exchange reserves of India in the face of a resurgent US dollar and the fall in the value of the INR. While this concern is valid, periodic review of the overall limit is crucial to ensure that the regulatory regime is in line with the rapidly growing industry, and incremental increase will not have any drastic effects on the foreign exchange reserves. Moreover, if this limit is viewed as a function of the overall industry size of AIFs, it is clear that the 1.5 billion cap is a miniscule percentage of the total industry size.
In the status quo, there exists a huge lag between the expanding industry size and the overall limits prescribed for investments. The regulatory framework is playing a losing game of catch up with the growing size of the AIF industry, which can be exemplified by the fact that over the past few years, while the AIF industry has been growing in size exponentially,[4] overseas investments as a percentage of the AIF industry size has been significantly decreasing. As a result, many AIFs are losing out on lucrative investment opportunities and suffer from a lack of flexibility, dynamism and freedom to diversify their portfolio to new entities.
ii.) Revisiting the 25% overseas investment requirement
Under the current regime, there is a blanket requirement for all AIFs of a maximum of 25% of their investible funds being allocated for overseas investment. However, this requirement is too simplistic and paints a broad brush stroke on all AIFs which are diverse in their strategy, size, and aim.
Rather than having a uniform percentage for all AIFs, SEBI could have explored a more flexible limit in which AIFs that are strategically inclined towards overseas investments are benefitted. AIFs that are hampered by the aforesaid limit can potentially approach SEBI and seek approval for enhancement of that limit. SEBI can then strategically raise the threshold in accordance with the appetite of these funds and serve their diverse interests.
Another option that SEBI can explore is raising the threshold in a phased manner wherein it could be raised by a certain percentage every year up to 49% in three years. This would allow the investment manage to build on the overseas investments which are proving to be lucrative and maximize returns to the investors.
With the disposal of the Indian connection requirement, many AIFs will diversify their investment into overseas portfolio entities, which would lead to frequent utilization and exhaustion of the 25% threshold. Therefore, a proportionate increase in that threshold is reasonable in accordance with the increased focus overseas.
IV. Conclusion: The Way Forward
While the circular is a major step towards achieving liberalization for overseas investments by AIFs, it is still silent on a myriad of crucial concerns surrounding the issue. While the delinking of the Indian connection requirement will attract much more diversification of investments by AIFs, it has not been coupled with proportionate change in the overall limit, tedious approval requirements and rigidity in utilization of the investible fund by AIFs.
Therefore, SEBI must follow this particular development with accompanying amendments to the regulatory regime to facilitate a complete overhaul in the overseas investment regime regarding AIFs. While the step forward may have been sluggish, if it is followed by a series of timely and well intentioned changes to the regulatory framework, may lead to immense and rapid growth in the AIF industry.
[1] Guidelines for overseas investment by Alternative Investment Funds (AIFs) / Venture Capital Funds (VCFs), SEBI Circular No. SEBI/HO/AFD-1/PoD/CIR/P/2022/108 available at https://www.sebi.gov.in/legal/circulars/aug-2022/guidelines-for-overseas-investment-by-alternative-investment-funds-aifs-venture-capital-funds-vcfs-_62020.html
[2] Guidelines for Overseas Investments by Venture Capital Funds, SEBI Circular No. SEBI/VCF/CIR no. 1/98645/2007 available at https://www.sebi.gov.in/legal/circulars/aug-2007/guidelines-for-overseas-investments-by-venture-capital-funds_8308.html
[3] Guidelines on overseas investments and other issues/clarifications for AIFs/VCFs, SEBI Circular No.CIR/IMD/DF/7/2015 available at https://www.sebi.gov.in/legal/circulars/oct-2015/guidelines-on-overseas-investments-and-other-issues-clarifications-for-aifs-vcfs_30772.html
[4] Data relating to activities of Alternative Investment Funds (AIFs), SECURITIES AND EXCHANGE BOARD OF INDIA available at https://www.sebi.gov.in/statistics/1392982252002.html