AIFs face risk of large investors moving away as Sebi tightens rules

AIFs include private equity, venture capital and hedge funds, besides other privately pooled instruments that invest in real estate to commodities. Such investments usually carry higher risk and are targeted at high-net-worth or wealthy investors.

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The Securities and Exchange Board of India (Sebi) in its 8 October circular introduced stricter due diligence requirements for AIFs, their managers and key management personnel, and to prevent the circumvention of regulations and tighten oversight over such funds.

Benefits to qualified buyers

Sebi’s circular 8 directs AIFs to ensure their investors and investments comply with various laws, especially to prevent ineligible investors from accessing benefits meant for qualified institutional buyers (QIBs) and qualified buyers (QBs). These are large, sophisticated investors like banks, mutual funds, pension funds, HNIs, family offices, venture capital firms and AIFs.

AIFs are designated as QIBs under Sebi’s (Issue of Capital and Disclosure Requirements) Regulations and as QBs under the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act (Sarfaesi Act), making them eligible to invest in specific financial instruments like security receipts issued by asset reconstruction companies (ARCs).

Under the new circular, AIFs must now conduct thorough due diligence when any investor contributes 50% or more to the corpus of a scheme, ensuring compliance with Sebi and Sarfaesi regulations.

Evergreening of stressed loans

The circular addressed concerns about RBI-regulated lenders using AIFs to “evergreen" stressed loans or bypass asset classification and provisioning rules. 

Last year, in a speech to bank directors, the Reserve Bank of India (RBI) governor had cautioned against the evergreening of loans. Earlier this year, RBI issued a circular prohibiting regulated entities from investing in AIF units having downstream investments, either directly or indirectly, in a ‘debtor company’ to curb structures which could be used by such entities, including non-banking financial companies (NBFCs), for ‘evergreening’ of loans. Sebi's current circular also tackles the same concern.

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AIFs will be required to perform due diligence if 25% or more of the scheme’s corpus is contributed by RBI-regulated investors or if they exert significant influence over investment decisions. This aims to prevent AIF managers from indirectly allowing RBI-regulated lenders to gain ownership or control of investee companies beyond what is permitted. Sebi directed AIFs to apply these standards to existing investments by April 2025.

While due diligence for QIBs and QBs won’t be overly burdensome, monitoring RBI-regulated lenders for “evergreening" could be more complex, according to Puneet Sharma, chief executive officer of Whitespace Alpha. “The onus is on the investor or group entities to inform the manager if they belong to the same group structure, which may not always happen in a timely manner."

Sharma elaborated that due diligence checks whenever an AIF’s investor group exceeds 25% or 50% of the scheme’s assets under management (AUM) could extend the onboarding timeline, requiring additional verification steps.

Foreign investments in India

According to the October 8 circular, due diligence must align with standards set by the Standard Setting Forum for AIFs (SFA), which was set up by Sebi. For foreign investors or funds based outside India, this must be done on a look-through basis by assessing the overall profitability of the investment structure. An investor failing these checks must be excluded from the scheme.

Sharma said the rigorous internal processes required could add complexity to monitoring and reporting. “Managers will need to evaluate whether they should accept investments from other AIFs or funds based in IFSC or outside India," he said. “This decision hinges on the operational capacity of the fund to carry out the necessary due diligence and manage the additional compliance burden."

Cross-border investments

The Sebi circular also mandates entities from countries sharing a land border with India to obtain government approval before investing in Indian companies.

In any AIF scheme where 50% or more of the corpus is contributed by such entities, due diligence must be conducted as per standards set by SSF. If an AIF holds 10% or more of the equity-linked securities of an investee company, it must report this to its custodian within 30 days of the investment. Custodians are required to report all relevant information to Sebi by 7 May 2025.

What experts say

While acknowledging the added compliance burden, Brijesh Damodaran, founding partner at Auxano Capital, emphasized the importance of maintaining integrity in the regulatory ecosystem. "Not all money is welcome," he said, highlighting the need for prudent regulations to support sustainable investment growth.

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Some experts predicted that burden of compliance and reporting may discourage large investors of some AIFs. 

According to Sharma, for many AIFs, particularly those with a diversified investor base, these new regulations may not have a significant impact on day-to-day operations or investment decisions. However, AIFs with a focused, large-investor base will find themselves dedicating more resources to compliance and reporting. “These additional burdens could affect their attractiveness as an investment vehicle, particularly for high-net-worth investors or institutional clients seeking efficient and flexible structures."

AIFs focused on niche opportunities or those catering to large investors with higher risk appetites may find the additional diligence unappealing, he said. “This could drive such investors to consider alternative vehicles for their investments." 

According to Vivaik Sharma, partner at Cyril Amarchand Mangaldas, the circular is aimed preventing AIFs from being used to bypass regulations, particularly by RBI-regulated entities. “Non-compliance could be seen as a regulatory breach, reinforcing the importance of the new compliance standards."