The year-long ‘regulatory rumble’ against India’s alternate investment fund (AIF) industry is a textbook example of regulatory excess. The industry is at risk of suffering a slow death by a thousand circulars, starting with those issued by the Reserve Bank of India (RBI).
As a creation of Parliament, RBI ought to be answerable to lawmakers. But it seems to have weaponized its autonomy and seems accountable only to itself. It has gone against the spirit of liberalization to become excessively prescriptive, with fintech firms and AIFs at the receiving end.
In December 2023, RBI released ‘Investment in AIFs,’ an innocuously titled circular. It was akin to curing dandruff by decapitation. To resolve the issue of some AIFs being used by RBI regulated entities (REs) to evergreen loans, the regulator placed an effective ban on banks and non-bank finance companies (NBFCs) investing in AIFs with exposure to REs’ debtor companies.
If an AIF portfolio company had even a mere fixed deposit-backed credit card from a bank, the latter would need to write off its AIF investment. Over ₹12,000 crore has been written off by banks and NBFCs. The government- sponsored SWAMIH Fund, meant for affordable housing, is stuck because of this.
The AIF industry protested, but RBI did not relent. A small group that got a meeting with it was told that the chapter was closed. In March 2024, the regulator released a circular providing cosmetic relief: REs could invest in AIFs that invest in equity shares, not equity securities.
This marked a break from treating both the same way, and it must surely have been aware that private equity and venture capital funds invest mostly in equity securities. Concerns that these could be redeemed were far-fetched, as their redemption norms are the same as for equity shares, as accounting standards classify redeemable shares as debt.
Another example of RBI’s lack of consultation is the issue of partly paid units (PPUs). AIFs units are a ‘beneficial interest,’ an undefined term taken to mean the right to receive a defined portion of the income and assets of an AIF. The Securities and Exchange Board of India (Sebi) had permitted AIFs to issue units as partly or fully paid, with RBI’s Form INVI allowing the same.
But in early 2023, with no prior consultation or intimation, Form INVI was changed to bar PPUs. After a year of multiple representations, rules under India’s Foreign Exchange Management Act saw an ‘explanation’ inserted to state that AIF units can be either partly or fully paid.
This was meant to elucidate an existing position. Yet, RBI sent emails to AIFs demanding that they admit a fault and regularize their PPUs. Distributions to foreign investors are stuck on account of this issue, which RBI has been reluctant to resolve. With the penalty as high as the capital raised, this is patently unfair to AIFs.
Despite AIFs bringing in convertible currency funds, their $1.5 billion overseas investment allowance hasn’t been renewed in over 30 months, while mutual funds have had at least two renewals. Why the dichotomy?
Section 58 of the RBI Act states that RBI may make regulations “with the previous sanction of the Central Government.” But today, the regulator appears to play judge, jury, executioner and legislator. Making matters worse, it lacks an appellate authority to overrule arbitrary moves.
Sebi often claims that AIFs have a “light touch” regulatory regime. But a light touch by an iron hand can still deliver a heavy blow. At the 2023 Gatekeepers of Governance event in Mumbai, a Sebi official mentioned that it had issued 167 circulars in 12 months: that’s almost a circular every two days. Investors need regulatory stability, not incessant rule changes.
A slew of circulars and changes this year have left AIFs gasping for air, with many spending more time on compliance than on investment. For them, regulatory risk has come to exceed market risk, although sophisticated investors don’t need the same protections as their retail counterparts.
Category III AIFs in India have always received stepmotherly treatment from regulators. The industry joke is that “Mutual fund sahi hai kyunki AIF nahin hai” (Mutual funds are the right choice as AIFs aren’t there). Sebi’s new ‘specified investment fund’ regime lets mutual funds invest in nearly the same areas as Category III AIFs, with a minimum ticket size one-tenth that of AIFs.
Combined with the tax advantage of mutual funds and the dismal lack of clarity on Category III AIF taxation, it’ll be a miracle if AIFs see any investor interest in a few years.
It is for the government to step in and save the industry from regulatory overreach. A study by the Indian Venture and Alternate Capital Association concluded that every $10 million of alternative capital invested in companies creates $58 million in revenue and 470 direct jobs, while yielding $12 million in taxes.
Capital formation by AIFs drives foreign direct investment, increases tax revenue and spurs economic activity by bringing innovation to markets.
Yet, AIFs are consumed and confused by compliance. AIFs need three compliance executives for each investment team member. Capital raised by AIFs slowed drastically in 2024 over 2023. Overregulation has mutated India’s red carpet for investors into red tape.
The author is chairman, Aarin Capital Partners.
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