AIFs' large offshore investor base likely to face more restrictions

Regulators suggest change in FEMA rules to treat such funds as indirect foreign investment

Alternative investment funds (AIFs) where the majority of investors are non-resident or offshore could be treated as indirect foreign investments.

Market regulator Securities and Exchange Board of India (Sebi) and banking regulator the Reserve Bank of India (RBI) have recommended to the government to make the changes in the norms. This comes amid concerns over circumvention of regulations through use of the AIF structure.

Post the changes, such investments will be subject to sectoral caps and foreign investment guidelines.

At present, classification of investments made by an AIF is based on the domicile of ownership or control of the fund manager or sponsor of the AIF.

If the fund is owned and controlled in India, it is not classified as indirect foreign investment.

The market regulator is in favour of the RBI’s recommendation to the Centre that if more than 50 per cent of the units of an AIF is held by or issued to a resident outside India, then all the investments made by such an AIF will be treated as indirect foreign investment for investee entities, according to a draft document seen by Business Standard.

“A decision in this regard with respect to amendment to Foreign Exchange Management (non-debt instruments) Rules is awaited,” the document stated.

Certain AIFs with a limited number of investors — of which a majority were foreign — were found to be bypassing the regulations. They were investing predominantly in debt securities and sectoral limits under foreign direct investment (FDI) norms, such as the 74 per cent cap in banking.

“Many entities were trying to use this route to circumvent the foreign investment guidelines and eye a rupee benefit from this regulatory leverage. After the change, they will fall under the sectoral caps and many investors may not choose the same route,” said a legal expert.

In an earlier disclosure, Sebi said that over Rs 30,000 crore of investments were found to be in circumvention of regulations.

Experts feel a crackdown on such investors should be made prospectively.

"If such an amendment comes then it should be prospective, that is, should grandfather the existing investments. The regulators had intentionally provided this regulatory leverage to AIFs to promote onshoring of fund management in India. If the fund manager and sponsor were India owned and controlled then an AIF investment even with 100 per cent foreign LP (limited partnership) money was not considered indirect foreign investment,” said Nandini Pathak, leader, investment funds practice at Nishith Desai Associates.

“This amendment may result in rising popularity of parallel structures again, as funds with foreign capital may as well be set up overseas,” added Pathak.

Legal experts said the onshoring of fund management has fallen and such a change may reduce it further.

Emailed queries sent to Sebi and RBI remained unanswered.

In December 2023, the RBI had restricted banks and non-banking financial companies (NBFCs) from investing in AIFs with downstream link or portfolio investment to a debtor firm.

It directed them to make 100 per cent provisions for their entire investments in such AIFs.

After deliberations with the industry, the RBI gave a breather by mandating provisioning only to the amount invested by the AIF scheme in the debtor company instead of the entire investments along with a relief to fund of funds.

Sebi is also mulling changes in other norms like the one for qualified institutional buyers (QIBs) to address the concerns of circumvention of norms through AIFs.'

On the cards

> Sebi, RBI have recommended the amendment to the government

> Decision on the change in the Fema (NDI Rules) awaited

> This comes amid concerns of circumventing regulations

> Certain AIFs with offshore investors were found to be investing in debt securities, bypassing foreign investment norms