This article has been published by The Economic Times at: https://ciso.economictimes.indiatimes.com/news/navigating-carried-interest-and-compliance-overcoming-regulatory-and-cybersecurity-challenges/121575732

With access to sensitive financial data, ownership records, and compensation models across jurisdictions, the shift toward cloud-based administration and third-party platforms may expose the ecosystem to new cyber threats.

 Carried interest, or “carry”, has long served as a critical incentive mechanism in private capital markets aligning general partners (“GPs”) and limited partners (“LPs”) through performance-linked profit sharing. Fund managers typically receive a percentage of profits once a predefined hurdle rate is surpassed. To operationalize this, many funds typically issued profit-linked units in the GP entity to managers, facilitating downstream distribution once performance thresholds are met.

However, regulatory and compliance regarding such compensation structures have intensified in recent years. India’s overhaul of its overseas investment (“OI”) framework in August 2022- via the Foreign Exchange Management (Overseas Investment) Rules, Directions, and Regulations, 2022- has introduced a new layer of legal and operational complexity to carried interest payments to Indian fund managers by offshore funds. For Indian fund managers participating in offshore fund structures, legacy compensation arrangements now risk falling afoul of the law and require a rejig to align with the new regime.

Under the revised OI regime, Indian residents face significant restrictions when investing in foreign GP entities. Four key regulatory roadblocks stand out:

1. ODI Restrictions on Financial Sector Investments: The Overseas Direct Investment (“ODI”) route does not permit Indian individuals to invest in foreign entities involved in financial services under the ODI route. Since GP entities typically perform regulated fund management activities, they fall within this restricted category. Furthermore, only equity capital investments are permitted by Indian entities in foreign entities engaged in financial services sector —not the units traditionally used in carry structures.
2. ESOP Eligibility Gaps: The regime permits acquisitions under employee stock option plans (“ESOPs”) only if the individual is employed by an Indian branch, subsidiary, or qualifying affiliate of the foreign entity-and only if the scheme is offered on a globally uniform basis. Most fund structures fail to satisfy both requirements.
3. Sweat Equity Constraints: Sweat equity is permissible in principle but is restricted to issuance of equity shares (not fund units) and requires a similar employment linkage. As a result, this option offers little practical relief for carried interest design.
4. Clarified OPI Framework: The Overseas Portfolio Investment (“OPI”) route allows investment in regulated funds-but ambiguity lingered around whether funds, as opposed to managers (as is the case in certain key jurisdictions such as Singapore and United States of America), qualify as regulated. A June 2024 RBI clarification settled this, confirming that a fund managed by a regulated manager can qualify as regulated fund for OPI purposes, thereby permitting investment by resident individuals in units of such ‘regulated funds’ under the OPI route. This update addressed a major structural pain point for cross-border carry participation and allows scope for investment by Indian individuals in funds/ feeder fund structures offshore, subject to LRS limits.

The interplay between regulatory and operational risk has never been more dynamic. While the 2024 RBI clarification offers some relief for carry structures under the OPI route, which is subject to the LRS limits, the broader compliance and cybersecurity environment demands greater coordination among fund managers and legal advisors, and may require the stakeholders to go back to the drawing board to re-align the fund and compensation structures to align with the recent regulatory and compliance regime.

For Indian fund professionals engaging with offshore structures, this is not just a regulatory inflection point—it’s a governance reset. Achieving compliance will increasingly hinge on rethinking the legal eligibility and how such nuanced structures can fit within the contours of the framework.

Given the evolving regulatory regime, it will be interesting to witness how the structures across global jurisdictions evolve to achieve an equilibrium between the Indian regulatory requirements and commercial rationale for incentivizing Indian fund managers.