Types of AIF Registration: Regulatory Compliance from SEBI Perspective

Types of AIF Registration: Regulatory Compliance from SEBI Perspective. Alternate Investment Funds are fast becoming an investment option for high net worth individuals and a source of debt for startups. For risky ventures, Alternate Investment Funds offer capital when banks and traditional lenders may be unwilling. In this post, Compliance Calendar breaks down the regulatory framework and compliance procedures around investing and operating an Alternate Investment Fund in India.
What is an Alternative Investment Fund?
The closest analogy to what an Alternative Investment Fund does, can be thought of as that of rain. Think of it as air evaporating moisture from varied lands and soils, to become a large heavy cloud that brings a spell of rain. An Alternative Investment Fund pools investments from a group of investors, who could be Indian or foreign, and then invests the quantum of funds in a defined investment policy. However, an AIF cannot make an invitation to the public at large to subscribe its units and can raise funds from investors only via private placement.
Exclusions from definition of AIF
In this context, it is important to understand the exclusions from the definition of AIF. The following are not included:

Mutual Funds
Collective Investment Schemes
Family Trusts
Employee Stock Options Trusts
Employee Welfare Trusts
Gratuity Trust
Holding companies
Funds managed by a securitization company or reconstruction company, Securitization Trust or any such pool of funds which are directly regulated by any other regulator in India are excluded from the definition of AIF.

Understanding Regulations applicable to Alternative Investment Funds (AIF) in India
The primary regulator for capital markets in India, the Securities and Exchange Board of India is currently investigating several AIFs for violating legal principles applicable to AIFs, including evergreening of loans and lack of requisite disclosure to market regulators like SEBI and RBI.
SEBI’s Master Circular dated July 31, 2023 is a crucial document for Alternate Investment Funds to comply with. In addition, the SEBI (Alternative Investment Funds) Regulations, 2012 and the SEBI Act, 1992 also hold relevance.
Master circular by RBI dated December 19, 2023 - Banks to not invest in AIFs In order to curb the practice of evergreening of loans, on 19 December 2023, the Reserve Bank of India issued a circular regarding “Investments in Alternative Investment Funds” to prohibit banks and regulated entities (regulated banks, financial institutions, and non-banking financial companies) from investing in AIF schemes that have direct or indirect investment in a company to which the banks have given loans in the last 12 months.
Open and close-ended AIFs - The open ended schemes by an AIF offer units to investors on a continuous basis and do not carry a fixed maturity period. Thus, the corpus of the fund is flexible and variable. Close ended funds on the other hand are offered to investors for a limited period only. Based on an informal guidance note issued by SEBI in 2018, an open ended scheme cannot be converted into close-ended and vice versa.
New SEBI circular - All fresh investments after September 2024 to be in Demat form
In November, 2023, SEBI issued a new notification mandating that any fresh investment made by an AIF, beyond September 2024, shall be held in the dematerialized form. However, schemes whose tenures end within a year are exempted from this.
Moreover, appointment of custodians has been extended to all categories of AIFs.
Types of Alternative Investment Funds in India
Category I AIF: Invests in start-ups, early-stage ventures, social ventures, small and medium-sized enterprises (SMEs), or infrastructure funds. These are usually the funds investing in high risk categories and help with bootstrapping capital since companies are at an early stage.
Category II AIF: The category II is a residual category and includes all those funds that do not fall under Category I or III. This category of AIF does not undertake leverage or borrowing other than that needed to meet day-to-day operational requirements.
Category III AIF: The category III included trades with a view to making short-term returns. Thus, it includes hedge funds, funds of funds. This AIF is also engaged in leveraging through investment in listed or unlisted derivatives. For this category, both open and close ended funds are allowed. For a close-ended fund, the minimum tenure is three years and minimum investment size is 1 crore. The overall compliance requirements for Category III AIF are much higher than the other two categories.
AIFs specified under Regulation 19 of the AIF Regulations – This is a recently introduced category and includes a “Corporate Debt Market Development Fund” that

Invests in liquid and low-risk debt instruments and undertakes any other activity related to the corporate debt market;

During periods of market dislocation, this category of AIF purchases corporate debt securities from specified debt-oriented schemes of mutual funds which meet the eligibility criteria prescribed in the AIF Regulations.

Conditions and Regulations - Category I and Category II Alternative Investment Funds
For the ease of understanding, we have clubbed Category I and II AIF due to certain similarities in the conditions and applicable regulations. 
These similarities between Category I and II AIFs are -

Both of these AIFs are not allowed to borrow funds directly or indirectly, other than for meeting temporary funding requirements, in which case it is allowable only for upto 10% of investable funds.

Both of these categories can only issue close ended schemes.

Not more than 25% of the investible funds can be invested in a single portfolio entity

The continuing interest of the sponsor or manager must be lower of the two amounts - 2.5% of the corpus or 5 crores, whichever lower.

Compliance Requirements
Registration as an Alternate Investment Fund
The process of registration of AIF is digitized, and all applicants are required to submit their applications only online, through the SEBI Intermediary Portal at https://siportal.sebi.gov.in.
Disclosures required in Private Placement Memorandum by an AIF
A private placement memorandum has to compulsorily be filed with mandatory disclosure of the scheme of investments. This requires disclosing the name of the scheme, the number of years of investment, details of manager/trustee/sponsors and advisors, risk factors, distribution of waterfall and history of any disciplinary proceedings. Any changes to the private placement memorandum should be intimated to investors within one month of the end of the financial year.
Launch of a scheme by AIF
An AIF may launch schemes subject to filing of placement memorandum with SEBI. Further, it may be noted that prior to launch of scheme, an AIF is required to pay Rs. 1 lakh as scheme fees to SEBI while filing the placement memorandum. Such fee shall be paid at least 30 days prior to launch of scheme.
Minimum corpus for launch of a scheme
Each scheme floated by an Alternative Investment Fund shall have a corpus of at least 20 crores. In case of an angel fund, it shall have a corpus of at least 10 crores.
Minimum amount of funds to be raised from each investor
Every investor undertaking the risk to invest in an Alternative Investment Fund has to make an investment of at least 1 crore. In case of investors who are employees or directors of the AIF or employees or directors of the Manager, the minimum value of investment shall be 25 lacs.
Disclosure of Investment Strategy
All Alternative Investment Funds shall state investment strategy, investment purpose and its investment methodology in its placement memorandum to the investors. Any material alteration to the fund strategy shall be made with the consent of at least two-thirds of unit holders by value of their investment in the Alternative Investment Fund.
Requirements of Compliance Test Report (CTR) for an Alternative Investment Funds

At the end of the financial year, the manager of an AIF shall prepare a compliance test report on compliance with AIF Regulations and circulars issued thereunder in the specified format.

In case the AIF is a trust, the CTR shall be submitted to the trustee and sponsor within 30 days from the end of the financial year. In case of other AIFs, the CTR should be submitted to the sponsor within 30 days from the end of the financial year.

In case of any observations/comments on the CTR, the trustee/sponsor shall intimate the same to the manager within 30 days from the receipt of the CTR. Within 15 days from the date of receipt of such observations/comments, the manager shall make necessary changes in the CTR, as may be required, and submit its reply to the trustee/sponsor.

In case any violation of AIF Regulations or circulars issued thereunder is observed by the trustee/sponsor, the same shall be intimated to SEBI as soon as possible.

Reporting Requirements with SEBI
As per circular No.CIR/IMD/DF/10/2013 dated 29th July, 2013, Category I and II AIFs and the Category III AIFs which do not undertake leverage are required to submit report to SEBI on a quarterly basis while Category III AIFs which undertake leverage are required to submit the reports on a monthly basis. The formats for such reports are provided as a part of the said circular. All AIFs shall submit the report irrespective of whether or not the AIF has started activity.
What is the maximum limit prescribed for Overseas Investment by Alternative Investment Funds?
Overseas investments by AIFs investments shall not exceed 25% of the investible funds of the scheme of the AIF subject to overall limit of USD 500 million (combined limit for AIFs and Venture Capital Funds registered under the SEBI (Venture Capital Funds) Regulations, 1996).
Moreover, AIF shall have a time limit of 6 months from the date of approval from SEBI for making investments in offshore venture capital undertakings.
Additional risk management and compliance for Category III AIFs
Since Category III AIFs are allowed greater flexibility in investing in equity markets, there is additional requirement of meeting the following:

Comprehensive risk management - Category III AIFs must have a comprehensive risk management framework supported by an independent risk management function, appropriate to the size, complexity and risk profile of the fund.

Strong and independent compliance function - Must have a strong and independent compliance function appropriate to the size, complexity and risk profile of the fund supported by sound and controlled operations and infrastructure, adequate resources and checks and balances in operations.

Record keeping - They are also required to maintain appropriate records of the trades/transactions performed and such information should be available to SEBI, whenever sought.

Disclosure of conflict of interest - Complete disclosure and transparency about conflicts of interest and how they manage them from time to time, to investors, in accordance with Regulation 21 of the AIF Regulations and any other guidelines as may be specified by SEBI from time to time.

Overseas investment reporting by AIFs
An AIF is allowed to invest in securities of companies incorporated outside India, subject to the following conditions:

AIFs may invest in equity and equity linked instruments only of off-shore venture capital undertakings, subject to overall limit of USD 1500 million

Such investment shall not exceed 25% of the investable funds of the scheme of the AIF

The securities market regulator of the country of incorporation of the potential investor, must be a signatory to the International Organization of Securities Commissions Multilateral Memorandum of Understanding (Appendix A Signatories) or a signatory to the bilateral Memorandum of Understanding with SEBI. Moreover, the investee company should not be incorporated in a country deemed by the FATF as having deficiencies in anti-money laundering or anti terror financing.

Investments are subject to Foreign Exchange Management (Overseas Investment) Regulations, 2022 and FEMA, 1999 and accompanying rules.

Overseas Investment cannot be made in joint ventures or wholly owned subsidiaries.

A report on utilization of overseas limits has to be filed on the SEBI intermediary portal within 5 working days of such utilization.

Investor Charter and Complaint Disclose by AIFs
The Investor Charter is a brief document, required to be published by all AIFs. It contains details of services provided to investors, details of grievance redressal mechanism, responsibilities of the investors etc., at one single place, in easy language for ease of reference. Additionally, AIFs shall maintain data on investor complaints as per Annexure 18, which shall be compiled latest within 7 days from the end of quarter.
Taxation of Alternative Investment Funds

Category I and II AIFs - Through the Finance Act, 2015, Category I and II AIFs have been given a special ‘pass through’ status under Section 115 UB of the Income Tax Act, 1961. Under this, income earned by SEBI registered AIFs of Category I and II are exempt from tax in the hands of the AIF.

Such income is taxable in the hands of the investor.

No Dividend Distribution Tax is payable.

However, the fund must deduct 10% TDS for income distributed (other than business income) under section 194 LBB

Category III AIFs - The special pass through status is not available to Category III AIFs. Thus, income of such AIFs will be taxable at the investment fund level and the tax obligation for the same will not pass to the unit holders.

Frequently Asked Questions

Does an AIF always have to be set up in the form of a company?

No, an AIF in India can assume varied forms. It can be incorporated as a company, a trust or a Limited Liability Partnership.

Is registration of AIF mandatory?

Yes, as per SEBI Rules registration of an Alternative Investment Fund is mandatory. All existing unregistered funds have to compulsorily register within six months. Moreover, raising funds for unregistered funds is barred till registration is obtained.

How many investors can an AIF have?

Additionally, if an AIF is incorporated as a company, the Companies Act, 2013 and applicable rules are also required to be complied with.
In conclusion, compliance with SEBI and RBI norms, commercial and corporate laws in India are the foundational elements of setting up a successful Alternate Investment Fund in India. Having assisted niche corporate clientele in drafting initial agreements, private placement memorandums and routine compliance with SEBI, Compliance Calendar’s bouquet of services can make setting up and operating your AIF venture hassle-free.

Alternate Investment Funds are fast becoming an investment option for high net worth individuals and a source of debt for startups. For risky ventures, Alternate Investment Funds offer capital when banks and traditional lenders may be unwilling. In this post, Compliance Calendar breaks down the regulatory framework and compliance procedures around investing and operating an Alternate Investment Fund in India.

What is an Alternative Investment Fund?

The closest analogy to what an Alternative Investment Fund does, can be thought of as that of rain. Think of it as air evaporating moisture from varied lands and soils, to become a large heavy cloud that brings a spell of rain. An Alternative Investment Fund pools investments from a group of investors, who could be Indian or foreign, and then invests the quantum of funds in a defined investment policy. However, an AIF cannot make an invitation to the public at large to subscribe its units and can raise funds from investors only via private placement.

Exclusions from definition of AIF

In this context, it is important to understand the exclusions from the definition of AIF. The following are not included:

Mutual Funds
Collective Investment Schemes
Family Trusts
Employee Stock Options Trusts
Employee Welfare Trusts
Gratuity Trust
Holding companies
Funds managed by a securitization company or reconstruction company, Securitization Trust or any such pool of funds which are directly regulated by any other regulator in India are excluded from the definition of AIF.

Understanding Regulations applicable to Alternative Investment Funds (AIF) in India

The primary regulator for capital markets in India, the Securities and Exchange Board of India is currently investigating several AIFs for violating legal principles applicable to AIFs, including evergreening of loans and lack of requisite disclosure to market regulators like SEBI and RBI.

SEBI’s Master Circular dated July 31, 2023 is a crucial document for Alternate Investment Funds to comply with. In addition, the SEBI (Alternative Investment Funds) Regulations, 2012 and the SEBI Act, 1992 also hold relevance.

Master circular by RBI dated December 19, 2023 - Banks to not invest in AIFs In order to curb the practice of evergreening of loans, on 19 December 2023, the Reserve Bank of India issued a circular regarding “Investments in Alternative Investment Funds” to prohibit banks and regulated entities (regulated banks, financial institutions, and non-banking financial companies) from investing in AIF schemes that have direct or indirect investment in a company to which the banks have given loans in the last 12 months.

Open and close-ended AIFs - The open ended schemes by an AIF offer units to investors on a continuous basis and do not carry a fixed maturity period. Thus, the corpus of the fund is flexible and variable. Close ended funds on the other hand are offered to investors for a limited period only. Based on an informal guidance note issued by SEBI in 2018, an open ended scheme cannot be converted into close-ended and vice versa.

New SEBI circular - All fresh investments after September 2024 to be in Demat form

In November, 2023, SEBI issued a new notification mandating that any fresh investment made by an AIF, beyond September 2024, shall be held in the dematerialized form. However, schemes whose tenures end within a year are exempted from this.

Moreover, appointment of custodians has been extended to all categories of AIFs.

Types of Alternative Investment Funds in India

Category I AIF: Invests in start-ups, early-stage ventures, social ventures, small and medium-sized enterprises (SMEs), or infrastructure funds. These are usually the funds investing in high risk categories and help with bootstrapping capital since companies are at an early stage.

Category II AIF: The category II is a residual category and includes all those funds that do not fall under Category I or III. This category of AIF does not undertake leverage or borrowing other than that needed to meet day-to-day operational requirements.

Category III AIF: The category III included trades with a view to making short-term returns. Thus, it includes hedge funds, funds of funds. This AIF is also engaged in leveraging through investment in listed or unlisted derivatives. For this category, both open and close ended funds are allowed. For a close-ended fund, the minimum tenure is three years and minimum investment size is 1 crore. The overall compliance requirements for Category III AIF are much higher than the other two categories.

AIFs specified under Regulation 19 of the AIF Regulations – This is a recently introduced category and includes a “Corporate Debt Market Development Fund” that

Invests in liquid and low-risk debt instruments and undertakes any other activity related to the corporate debt market;
During periods of market dislocation, this category of AIF purchases corporate debt securities from specified debt-oriented schemes of mutual funds which meet the eligibility criteria prescribed in the AIF Regulations.

Conditions and Regulations - Category I and Category II Alternative Investment Funds

For the ease of understanding, we have clubbed Category I and II AIF due to certain similarities in the conditions and applicable regulations.

These similarities between Category I and II AIFs are -

Both of these AIFs are not allowed to borrow funds directly or indirectly, other than for meeting temporary funding requirements, in which case it is allowable only for upto 10% of investable funds.
Both of these categories can only issue close ended schemes.
Not more than 25% of the investible funds can be invested in a single portfolio entity
The continuing interest of the sponsor or manager must be lower of the two amounts - 2.5% of the corpus or 5 crores, whichever lower.

Compliance Requirements

Registration as an Alternate Investment Fund

The process of registration of AIF is digitized, and all applicants are required to submit their applications only online, through the SEBI Intermediary Portal at https://siportal.sebi.gov.in.

Disclosures required in Private Placement Memorandum by an AIF

A private placement memorandum has to compulsorily be filed with mandatory disclosure of the scheme of investments. This requires disclosing the name of the scheme, the number of years of investment, details of manager/trustee/sponsors and advisors, risk factors, distribution of waterfall and history of any disciplinary proceedings. Any changes to the private placement memorandum should be intimated to investors within one month of the end of the financial year.

Launch of a scheme by AIF

An AIF may launch schemes subject to filing of placement memorandum with SEBI. Further, it may be noted that prior to launch of scheme, an AIF is required to pay Rs. 1 lakh as scheme fees to SEBI while filing the placement memorandum. Such fee shall be paid at least 30 days prior to launch of scheme.

Minimum corpus for launch of a scheme

Each scheme floated by an Alternative Investment Fund shall have a corpus of at least 20 crores. In case of an angel fund, it shall have a corpus of at least 10 crores.

Minimum amount of funds to be raised from each investor

Every investor undertaking the risk to invest in an Alternative Investment Fund has to make an investment of at least 1 crore. In case of investors who are employees or directors of the AIF or employees or directors of the Manager, the minimum value of investment shall be 25 lacs.

Disclosure of Investment Strategy

All Alternative Investment Funds shall state investment strategy, investment purpose and its investment methodology in its placement memorandum to the investors. Any material alteration to the fund strategy shall be made with the consent of at least two-thirds of unit holders by value of their investment in the Alternative Investment Fund.

Requirements of Compliance Test Report (CTR) for an Alternative Investment Funds

At the end of the financial year, the manager of an AIF shall prepare a compliance test report on compliance with AIF Regulations and circulars issued thereunder in the specified format.
In case the AIF is a trust, the CTR shall be submitted to the trustee and sponsor within 30 days from the end of the financial year. In case of other AIFs, the CTR should be submitted to the sponsor within 30 days from the end of the financial year.
In case of any observations/comments on the CTR, the trustee/sponsor shall intimate the same to the manager within 30 days from the receipt of the CTR. Within 15 days from the date of receipt of such observations/comments, the manager shall make necessary changes in the CTR, as may be required, and submit its reply to the trustee/sponsor.
In case any violation of AIF Regulations or circulars issued thereunder is observed by the trustee/sponsor, the same shall be intimated to SEBI as soon as possible.

Reporting Requirements with SEBI

As per circular No.CIR/IMD/DF/10/2013 dated 29th July, 2013, Category I and II AIFs and the Category III AIFs which do not undertake leverage are required to submit report to SEBI on a quarterly basis while Category III AIFs which undertake leverage are required to submit the reports on a monthly basis. The formats for such reports are provided as a part of the said circular. All AIFs shall submit the report irrespective of whether or not the AIF has started activity.

What is the maximum limit prescribed for Overseas Investment by Alternative Investment Funds?

Overseas investments by AIFs investments shall not exceed 25% of the investible funds of the scheme of the AIF subject to overall limit of USD 500 million (combined limit for AIFs and Venture Capital Funds registered under the SEBI (Venture Capital Funds) Regulations, 1996).

Moreover, AIF shall have a time limit of 6 months from the date of approval from SEBI for making investments in offshore venture capital undertakings.

Additional risk management and compliance for Category III AIFs

Since Category III AIFs are allowed greater flexibility in investing in equity markets, there is additional requirement of meeting the following:

Comprehensive risk management - Category III AIFs must have a comprehensive risk management framework supported by an independent risk management function, appropriate to the size, complexity and risk profile of the fund.
Strong and independent compliance function - Must have a strong and independent compliance function appropriate to the size, complexity and risk profile of the fund supported by sound and controlled operations and infrastructure, adequate resources and checks and balances in operations.
Record keeping - They are also required to maintain appropriate records of the trades/transactions performed and such information should be available to SEBI, whenever sought.
Disclosure of conflict of interest - Complete disclosure and transparency about conflicts of interest and how they manage them from time to time, to investors, in accordance with Regulation 21 of the AIF Regulations and any other guidelines as may be specified by SEBI from time to time.

Overseas investment reporting by AIFs

An AIF is allowed to invest in securities of companies incorporated outside India, subject to the following conditions:

AIFs may invest in equity and equity linked instruments only of off-shore venture capital undertakings, subject to overall limit of USD 1500 million
Such investment shall not exceed 25% of the investable funds of the scheme of the AIF
The securities market regulator of the country of incorporation of the potential investor, must be a signatory to the International Organization of Securities Commissions Multilateral Memorandum of Understanding (Appendix A Signatories) or a signatory to the bilateral Memorandum of Understanding with SEBI. Moreover, the investee company should not be incorporated in a country deemed by the FATF as having deficiencies in anti-money laundering or anti terror financing.
Investments are subject to Foreign Exchange Management (Overseas Investment) Regulations, 2022 and FEMA, 1999 and accompanying rules.
Overseas Investment cannot be made in joint ventures or wholly owned subsidiaries.
A report on utilization of overseas limits has to be filed on the SEBI intermediary portal within 5 working days of such utilization.

Investor Charter and Complaint Disclose by AIFs

The Investor Charter is a brief document, required to be published by all AIFs. It contains details of services provided to investors, details of grievance redressal mechanism, responsibilities of the investors etc., at one single place, in easy language for ease of reference. Additionally, AIFs shall maintain data on investor complaints as per Annexure 18, which shall be compiled latest within 7 days from the end of quarter.

Taxation of Alternative Investment Funds

Category I and II AIFs - Through the Finance Act, 2015, Category I and II AIFs have been given a special ‘pass through’ status under Section 115 UB of the Income Tax Act, 1961. Under this, income earned by SEBI registered AIFs of Category I and II are exempt from tax in the hands of the AIF.
Such income is taxable in the hands of the investor.
No Dividend Distribution Tax is payable.
However, the fund must deduct 10% TDS for income distributed (other than business income) under section 194 LBB
Category III AIFs - The special pass through status is not available to Category III AIFs. Thus, income of such AIFs will be taxable at the investment fund level and the tax obligation for the same will not pass to the unit holders.

Frequently Asked Questions

Does an AIF always have to be set up in the form of a company?

No, an AIF in India can assume varied forms. It can be incorporated as a company, a trust or a Limited Liability Partnership.

Is registration of AIF mandatory?

How many investors can an AIF have?

Additionally, if an AIF is incorporated as a company, the Companies Act, 2013 and applicable rules are also required to be complied with.

In conclusion, compliance with SEBI and RBI norms, commercial and corporate laws in India are the foundational elements of setting up a successful Alternate Investment Fund in India. Having assisted niche corporate clientele in drafting initial agreements, private placement memorandums and routine compliance with SEBI, Compliance Calendar’s bouquet of services can make setting up and operating your AIF venture hassle-free.