[By Prayas Das]
The author is a student of National Law University, Odisha.
Introduction
The Securities and Exchange Board of India (the Board), in recent times, has provided numerous investment options for the people, such as Mutual Funds, which offer stable returns with less risk to investors, thanks to tighter regulations under SEBI’s supervision. As temporal tides advance with the growth in the economy and increasing number of High Net-worth Individuals (HNIs) who can afford to take more risk in terms of investment, SEBI introduced the SEBI (Alternative Investment Funds) Regulations, 2012 to cater to the requirements and needs of the HNIs who wanted to invest beyond the stock market to gain more profit by taking more risk with less regulations from the board.
The AIF is defined under Regulation 2(1)(b) as a privately pooled investment vehicle that collects funds from investors (Indian or Foreign). The minimum investment amount is Rs 1 Crore for investors, and for Directors, Employees, and Managers, the limit is Rs 25 Lakh. Recent SEBI investigations into HDFC Capital Affordable Real Estate Fund- I, which is a Category II AIF, sparked curiosity about the governance lapses, bias and influence of the sponsor, which can jeopardise the investors’ investment in the respective AIF. This article explores the structures of AIFs, SEBI’s governance rules, what went wrong in a recent case, and how the sponsor can influence the investment decision-making for its benefit at the expense of investors.
Structure and Types of Alternative Investment Funds
Under Regulation 3(1) of Chapter II, an AIF has to obtain a certificate of registration mandatorily from the Board, and only upon completion of that step can it perform as an AIF. Any entity shall seek registration as an AIF under three categories, which are given below: –
- Category I Alternative Investment Fund – This category is viewed as a nation builder, as it promotes socially and economically desirable sectors that the government or regulators want to encourage. The AIFs under this category are generally perceived to have a positive spillover effect on the economy, with the government considering providing such funds, incentives, or concessions. These funds include venture capital funds, social impact funds (SME Funds), etc.
- Category II Alternative Investment Fund – These types of funds do not fall under category I or III. They do not take on leverage or borrowing other than to meet daily operational requirements. These funds invest in long-term assets that offer good returns with manageable risks to knowledgeable investors. These consist of funds such as private equity funds (buying of shares in unlisted companies), debt funds (earning interest on capital, the funds used to buy bonds or debentures), etc. The funds registered under this category are ineligible to receive any specific concessions from the government.
- Category III Alternative Investment Funds – This type of fund is for those who want to employ diverse or complex trading strategies by employing leverage or borrowings. They are famous for their risk control strategies to make a profit during unstable market situations. One such fund is a hedge fund, which trades to make short-term returns with high risk. It also receives no specific concessions from the government.
SEBI permits an Alternative Investment Fund under SEBI (AIF) Regulations, 2012 to be established as a trust, a limited liability partnership (LLP), or as a company. In these three structures, we can find trust as the most common mode of formation of an AIF, and popular due to the tax pass-through benefits it offers, where the investors have to pay taxes on the profit, not the trust under which as AIF is legally formed.
Why AIFs Matter
An AIF has a diverse portfolio as it invests in assets beyond the stock market, such as investing in unlisted companies, venture capital and infrastructure, which are not available through mutual funds or direct stock investing. With a high risk, it offers a higher return than other investment options due to the large pooled amount and flexible investment options with fewer regulations. The system of investments allows a company or organisation to seek investments, even if it is an unlisted one. This system of investment allows the investee and investors to grow more efficiently with less regulation from the regulator.
The SEBI May 2025 Order: What Went Wrong
Being a Category-II AIF is significant because such funds typically invest in long-term unlisted assets like real estate and private equity, and are subject to specific restrictions on leverage and regulatory exemptions that shape both their risk profile and fiduciary obligations. In this context, HDFC Capital Advisors Limited (Applicant No. 1) acted as the Investment Manager for HDFC Capital Affordable Real Estate Fund – I (Applicant No. 2), which is categorized as a Category-II Alternative Investment Fund, with HDFC Bank Ltd. designated as its sponsor. Applicant No. 2 allocated Rs. 200 crores towards Non-Convertible Debentures (NCDs) of Acme Realties Pvt. Ltd (ARPL), in addition to Rs. 99 crores further invested in NCDs issued to ARPL by Ascent Construction Private Ltd. (ACPL).
Both ARPL and ACPL were subsidiaries of Acme Housing (India) Pvt. Ltd (AHIPL), with HDFC Bank Ltd., as a sponsor of Applicant No. 2 being an existing lender to both subsidiaries of AHIPL. To simplify, both ARPL and ACPL (both subsidiaries of AHIPL) received funds from the AIF managed by HDFC Capital, which was sponsored by HDFC Bank, a creditor to all three entities. The amount invested by Applicant No. 2 in the NCDs of ARPL was transferred to the loan accounts (credit lines) of ARPL and AHIPL with HDFC (sponsor). These funds were utilized not only for the construction projects but also to repay existing loans and interest owed to HDFC Bank. It violates Regulation 21 (1) of the SEBI (AIF) Regulations, 2012, which mandates that the sponsor and investment manager must act in the best interest of the investors and disclose conflicts of interest. Redirecting investor capital to settle sponsor dues breaches fiduciary obligations and raises governance concerns.
Why was this a governance failure as well as a fiduciary breach
This diversion of the investor funds for the benefit of the sponsor raises serious questions about the governance structure in an AIF. The sponsor’s (HDFC Bank) influence over the investment process is evident over the Investment Advisory Board and the Investment Manager. . Under this influence, the conflict of interest that was created by the violation of the fiduciary responsibility by the investment manager and sponsor towards the investors, the investment of the AIF (applicant no. 2) was not referred to the conflict resolution committee, which was acting as an independent body, rather the investment advisory board of the investment manager approved its investment.
The independence of the IAB can be questioned clearly from the very fact that the board consists entirely of senior personnel of HDFC Ltd. It was also revealed to them via a presentation that Rs. 60 crore and Rs. 55 crores, respectively, out of the investment of capital in the Acme group, were meant for repayment of the loan amount from the existing creditors. This direct influence of the sponsor over the approval process undermined the necessary separation between the investment manager and the sponsor’s interest, which is a critical component of AIF governance according to Regulation 21(1) of the SEBI(Alternative Investment Funds) Regulation, 2012, which talks about to act in a fiduciary capacity by the sponsor and the manager towards its investors, and to disclose all conflict of interest that is about benefiting the sponsor instead of the investors in the AIF. Here, the funds are diverted to address the investee’s obligations towards the sponsor rather than being deployed in the construction projects to maximize investor returns.
Why is Bypassing the Conflict Resolution Committee a Serious Matter
The Conflict Resolution Committee (CRC) is an independent gatekeeper as per the Conflict of Interest Policy terms. Its primary role was to evaluate the proposed investments that could create a conflict of interest and jeopardise the investors. Bypassing this mandatory layer of evaluation and instead allowing the Investment Advisory Board (IAB) to approve the transaction constituted a serious breach of the fiduciary duty by both the sponsor and the Investment Manager. It is a critical breach because it deprived the investors of the protections the governance structure was designed to offer.
If the CRC had the opportunity to review the investment, it may have either blocked it or imposed conditions that would have protected the investors from any unnatural risk. Although this matter was settled by SEBI with a settlement order dated May 6, 2025, by accepting the settlement application filed by the investment manager of the real estate fund, it poses a serious question about the governance structure of the AIF, particularly regarding the sufficiency and efficiency of the regulation. The ease with which key checks, such as the Conflict Resolution Committee were bypassed, despite clear regulations, highlights potential gaps in enforcement and oversight that merit closer regulatory introspection.
Conclusion
SEBI’s role in safeguarding investor interests in AIFs is critical as the sector rapidly expands. The board must continue to tighten governance frameworks to minimise sponsor interference and ensure truly independent investment decision-making. Regulations should reinforce the primacy of investor interests, mandate transparent disclosures, and require strict maintenance of truthful compliance records, under Regulations 21, 22, and 24 of the SEBI (AIF) Regulations, 2012. With committed investment in the AIF industry in India rising by over 378% in the past six years (from Rs. 2.82 lakh crore in FY19 to Rs. 13.5 lakh crore in Q4 FY25), ensuring governance discipline is now more important than ever. SEBI’s increasing scrutiny of governance lapses signals a move towards robust investor protection in these alternative investment funds. As we advance, empowering trustees, enforcing accountability upon the investment manager, and strengthening the internal fund management system can significantly improve the investors’ confidence and market integrity in the AIF space.