PE funds | Venture capital funds: who “controls” venture capital funds? Sebi asks
A few weeks ago, the capital market regulator Securities and Exchange Board of India (Sebi) asked these pooled investment vehicles, which raise funds from domestic and foreign investors, to clarify precisely whether their ” manager” is “owned and controlled by persons who reside “in India or are based outside the country,” two people familiar with the regulator’s request told ET.
Sebi’s August 23 email to alternative investment funds (AIFs) – the regulatory term for private equity and venture capital funds – also orders the funds to disclose whether their respective “sponsor” is a domestic or foreign entity.
While the nature of the questions – coming a decade after the first round of AIF regulations – has baffled many fund managers and regulatory professionals, the issue raised by the regulator may have deeper implications.
Although an AIF is free to raise as much money as it wishes from foreign investors, the fund’s investment in a business in India is not considered foreign direct investment (FDI). This is because unlike international offshore private equity funds, OFIs are formed in India. However, investments by funds with non-resident managers and sponsors would be construed as FDI and such funds are required to follow the do’s and don’ts of FDI regulations and the Foreign Exchange Management Act. (FEMA).
It’s unclear why Sebi brought up the topic – whether it’s just information gathering or the regulator trying to find out if some of the funds are bending the rules and violating the spirit of the AIF regulations.
Typically, the manager of an AIF is a local entity – a corporation or a limited liability company. This manager (who must have at least one employee with certain qualifications) enters into an investment management agreement with the trustee (on behalf of the fund) and is authorized to manage the fund’s investments. The sponsor contributes cash and must contribute 2.5% of the fund’s corpus or ₹5 crore, whichever is lower. (The manager can also act as a sponsor).
Now, if more than 50% of the managing entity is owned by foreigners or non-resident Indians (NRIs), the AIF no longer retains its local character.
According to Tejesh Chitlangi, Senior Partner, IC Universal Legal, “If the ownership as well as the control of both, the investment manager as well as the sponsor of an AIF, is not with resident Indian citizens or if an AIF has a foreign sponsor, then the concerned AIF must follow the standards of downstream FDI while making investments. What needs to be addressed urgently is a long-term unresolved issue in which, pending clarification from RBI, Sebi has withheld approvals for FIA applications proposing non-resident external members within its investment decision/approval committee.
Thus, a fund owned by foreigners and controlling the manager and the sponsor is well within the rules as long as its investments are FDI compliant. But funds that didn’t follow FDI and FEMA rules despite having non-resident managers – either because they were misguided or because they chose not to abide by the regulations – may have to explain their position to regulators.
Richie Sancheti, founding partner of law firm Richie Sancheti Associates, said the law is clear that an AIF’s investments are considered “indirect foreign investment” if the sponsor and investment manager are not ” owned” and “controlled” by Indians.
“For such indirect foreign investments, the AIF will have to comply with sector caps, capitalization standards, valuation rules, restrictions on optionality clauses, etc., for its equity investments. The determination is so quite critical… But Sebi and regulators sometimes look for data, to identify information gaps or resolve situations that could benefit from additional information,” Sancheti said. details on the valuation methodology and practice followed by the funds.