Introduction

An emerging market such as India, with its growing appetite for development, has an ever-increasing requirement for capital and a sound regulatory framework is key in enabling innovative financial instruments through which money can be channelled to India.

With the aid of the Indian regulators, new asset classes, in particular alternative investment funds (AIFs) have grown in the Indian market. Indian Private Equity Report, 2017, issued by Bain and Company highlights that registered AIFs in India have more than doubled over the past 2 years and stood at approximately 270 in 2016. AIFs have also been a significant contributor to overall fund-raising in the Indian market and contributed to 41% of the total India-focussed funds raised in 2016, compared with only 11% in 2014.

The brisk growth of AIFs in India raises an important question – where are Indian fund managers raising this capital from and what is the participation of Indian investors in these pooling vehicles?

The Alternative Investment Policy Advisory Committee (AIPAC) Report, 2016 states that in India, a mere 10-15% of equity capital required by start-ups, medium enterprises and large companies is funded from domestic sources. The remaining 85% – 90% is sourced from overseas. This is in contrast to the U.S. and China where domestic sources fund 90% and 50% respectively, of the venture capital and private equity needs of enterprises. Prequin report of November 2017 on Alternative Assets in India states that a significant proportion (approximately 40%) of India-based institutional investors do not invest in alternatives, reiterating the relative unfamiliarity of the alternatives market for investors in India. However, the report observes that as these institutions develop and mature, the proportion may shrink, as the demand for alternative investments to maximize portfolio diversification increases, as does their familiarity with the alternatives market.

Given the growing awareness amongst Indian institutions to participate in AIFs in particular, this article provides a snapshot of the key legal and regulatory aspects that Indian fund managers need to be cognizant of, while approaching and raising capital from: banks, insurance companies (life and non-life) and pension funds.

Challenges for each institution

The Reserve Bank of India (RBI) has permitted scheduled commercial banks (excluding regional rural banks and urban co-operative banks) in India to invest in category I and category II AIFs, albeit with certain conditions. Banks are permitted to invest not more than 10% of the paid-up capital/unit capital in a category I/category II AIF and if investment exceeds 10% of the paid-up capital/unit capital in a category I/category II AIF, the bank would require prior approval from the RBI. The regulatory maximum for investments in AIFs (category I and category II) has been capped at 20% of the bank’s net worth permitted for direct investments in shares, convertible bonds/debentures, units of equity oriented mutual funds and exposures to AIFs. Investments by banks in category III AIFs continues to be not permitted. Further, the requirement imposed on banks to maintain additional capital basis a risk assessment on account of investments in AIFs made either directly or through their subsidiaries is an added restriction imposed on banks in making investments in AIFs.

Overall, while a banks’ participation in AIFs has been restricted, it still has opened up a significant source of capital raise domestically. The need of the hour is to permit banks to invest in category III AIFs as well (albeit within limits) which will provide a capital source to such AIFs which are today heavily reliant on foreign capital and Indian retail fund raise.

With respect to insurance companies, Insurance Regulatory and Development Authority (IRDA) has permitted both general insurance and life insurance companies to invest in category I AIFs such as infrastructure funds, small and medium enterprise (SME) funds, venture capital funds and social venture funds (as defined under the SEBI (AIF) Regulations, 2012) and category II AIFs (which will invest at least 51% of the funds in infrastructure, SME, venture capital and/or social venture entities). The permission to invest in AIFs from IRDA however, comes with certain additional restrictions. For one, insurance companies are not permitted to invest in AIFs which seek to invest in securities of companies incorporated outside India, will take leverage and/or will be classified as fund of funds. In addition, any investment by the insurance company in AIFs is categorised as an ‘unapproved investment’ and requires approval of the board of directors in addition to the approval of the investment committee of the insurance company. Further, overall exposure to AIFs is capped at 3% of respective fund in case of life insurance companies and 5% of investment assets in case of general insurance companies. Vis-à-vis a single AIF, insurance companies (both life and general) are permitted to invest the lower of 10% of the AIF fund size and 20% of the overall exposure permitted, provided that in case of infrastructure funds, the limit is to be read as 20% of the AIF fund size. Further, insurance companies cannot invest in an AIF, the sponsor of which is a part of the promoter group of the insurer and/or the investment manager is either directly or indirectly controlled or managed by the insurer or its promoters. In light of the growing awareness and interest of insurance companies to invest in AIFs, further liberalisation of the investment conditions such as permission to invest in category III AIFs (which do not undertake leverage), AIFs which are fund of funds and AIFs which can invest in companies incorporated outside India, subject to compliance with SEBI prescribed conditions, would go a long way in mobilising funds from insurance companies in the AIF industry.

Pension Fund Regulatory and Development Authority (PFRDA) has recently permitted private sector national pension system scheme (NPS) subscribers to invest in category I and category II AIFs albeit with the condition that such category of investment has to be in listed instruments or fresh issues that are proposed to be listed. Given the lack of a definitive listing regime for AIFs, this peculiar condition has created a challenge for pension funds to invest in AIFs. Further, the guidelines prescribe that such NPS should invest into units of AIF which have minimum AA equivalent rating in the applicable rating scale from one credit rating agency registered with SEBI, albeit such credit rating would not be required in case of a government owned AIF.  Other conditions prescribed by PFRDA are similar to the conditions imposed by IRDA in respect of investment into AIFs by insurance companies, such as the 51% fund utilisation conditions for category II AIFs, exposure of 10% of the AIF size in a single AIF, restriction in respect of AIFs who would invest in companies incorporated outside India and the group sponsor and manager restrictions. In addition, the guidelines prescribe that pension funds should only invest in such AIFs whose corpus is equal to or more than INR 100 crores. Whilst the guidelines permitting investment by pension funds into AIFs has been a step in the right direction, much is left to be desired. Restrictions such as minimum corpus of AIF being an eligibility criterion for pension fund investment, credit rating for AIF units and requirement to only invest in listed AIFs, create a considerable road block for investment by NPS in AIFs.

Insurance companies and pension funds have long-term liabilities and given the time gap between the receipt of premium/investment and the payment of claims and returns, they have substantial pool of capital which can be deployed in long-term assets. While this fact has been recognised in foreign jurisdictions where insurance and pension funds are permitted to deploy capital in AIFs in India, the restrictions on insurance and pension companies in India have limited their participation in AIFs. As a first step, pension funds can be brought at par with insurance companies. This will ensure that we see increased participation by them in the AIF industry.

Conclusion

Given the restrictions, often onerous, imposed on fund managers accepting domestic capital from Indian institutions highlighted above, many fund managers first look to raise offshore capital and domestic capital from private institutions, family offices and high net worth individuals. If any meaningful capital raise is to happen from India, the financial institutions mentioned herein with significant capital at their disposal should be allowed more flexibility to invest in alternative assets, albeit with checks and balances. This will go a long way in giving much needed fillip to the ever growing AIF industry.

Authors

1.  Pallabi Ghosal, Partner
2. Ananya Sonthaliya, Senior Associate