AIFs provide safety in numbers for FDI

Foreign Direct Investment (FDI) is significant for the global economy and is also critical to India’s economic advancement. Defying worldwide sluggish performance, India has seen sustainable macro-level growth. This has offered various investor classes attractive investment opportunities. In the financial year 2022-23, India has attracted FDI of nearly USD71 billion.

An increasingly popular foreign investment method is through alternative investment funds (AIF). These, structured as privately pooled investment vehicles and regulated under AIF regulations, have become popular with foreign investors.

The AIFs pool funds from investors and buy into specific asset classes. These are wide ranging and include private equity, hedge funds, angel funds and venture capital funds. The AIFs have predefined investment policies designed to safeguard investors’ interests.

Exchange control regulations are crucial to the treatment of AIF investments. If both the manager and sponsor of the AIF are at least 50% resident-owned and controlled, the investments comply with India’s exchange controls.

However, if either the manager or the sponsor is not owned and controlled by resident Indian citizens or is owned or controlled by persons resident outside India, investments by the AIF are categorised as downstream investments or indirect foreign investments. The distinction depends on the ownership and control of these entities. The nature of the sponsor and investment manager is critical in determining the nature of AIF investments.

Not all investments are classified as downstream investments. However, the AIF investments in equity shares, compulsorily convertible preference shares, and debentures are so recognised. These trigger sector restrictions and impose pricing requirements for investments and exits. By contrast, investments made by the AIFs in non-convertible or optionally convertible debentures are not affected by exchange controls, even if the manager or the sponsor are not domestically owned or controlled.

Investors using the AIFs must comply with Securities and Exchange Board of India (SEBI) guidelines. These include the affiliations of their countries’ securities regulators and complying with sanctions and anti-money laundering provisions. The SEBI requires that at the time of on-boarding foreign investors, the AIF manager ensures that the foreign investor is a resident of a country whose securities regulator is a signatory to the International Organisation of Securities Commission’s Multilateral Memorandum of Understanding or has a bilateral memorandum of understanding with the SEBI. The investor and its underlying investors must not be on the UN Security Council sanctions list. They must not be residents of countries identified by the Financial Action Task Force as having strategic anti-money laundering or terrorism financing deficiencies, or not making sufficient progress in remedying them.

By understanding the regulatory framework, investors can benefit from the AIFs. These strategic and efficient vehicles offer advantages to both domestic and foreign investors. These include ease of investment. The AIFs offer a more straightforward and organised way for foreign investors to enter the local market. They can invest in these funds without direct registration or approval, making them relatively problem-free investment routes.

The AIFs can improve financial performance and achieve long-term capital appreciation. The size of funds enables managers to tap into broader capital markets. Investors benefit from alternative securities providing higher returns than traditional investment instruments. AIF flexibility allows managers to adopt different market strategies and investment approaches, leading to greater portfolio diversification.

The large amounts the AIFs invest give investors greater negotiating power. Direct investments may give investors only nominal ownership. Lastly, the AIFs often have defined exit provisions, allowing investors to divest at specified intervals or under specific conditions. The AIFs are attractive, offering flexibility, diversification, and professional management of investments across asset classes. Understanding exchange controls, however, is critical for foreign investors entering the Indian market. The AIFs are a unique way of investing in a diverse and growing economy, but regulatory compliance is essential.

Rohit Jain (left) is the managing partner and Roopal Bajaj is a partner at Singhania & Co.