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GUEST POST: Applicability of FDI norms for AIFs – a regulatory conundrum

18 Jun 2024

By Vivaik Sharma, Partner at Cyril Amarchand Mangaldas and co-authored by Sagar Gaba, Senior Associate and Saumya Motwani, Associate at Cyril Amarchand Mangaldas

In 2015, the alternatives industry saw many significant changes. Major reforms and favorable policies were introduced that reshaped the regulatory landscape for alternative investment funds (AIFs). These changes encompassed regulatory enhancements, tax related incentives, and streamlined procedures to attract foreign investors in the AIF sector. The industry as a whole, saw innovation in fund structures, comparatively higher investments, and increased participation from both domestic and foreign investors. Moreover, streamlining the entry of foreign investment in AIFs has facilitated increased institutional participation which now forms a considerable chunk of the investors being targeted by AIFs.

In this article, we propose to discuss the current regulatory framework surrounding AIFs for foreign investment in India, with emphasis on the need for sectoral regulators to establish/revise rules to encourage active participation from foreign investors.

The existing norms under the Foreign Exchange Management (Non-debt instruments) Rules (NDI Rules) considers the Indian owned and control (IOCC) status of investment managers and sponsors of an AIF as a criterion to determine whether its downstream investments should be considered as ‘indirect foreign investments’ or not. The only conditions prescribed by NDI Rules in this respect are that (i) the investment manager/sponsor should control the AIF to the general exclusion of others; and (ii) Category III AIFs having any foreign capital should make investments only in such instruments where foreign portfolio investors (FPIs) are permitted to invest; and the extent of foreign investment in the AIF was not considered for this purpose.

Hence, if the sponsor or investment manager of an AIF is foreign owned and controlled (FOCC), then investment by such an AIF would be considered as an ‘indirect foreign investment’. NDI Rules had been intentionally established based on ownership principles to encourage onshore pooling of foreign capital by IOCC managers catering to a boost in the influx of foreign capital.

SEBI has put forth its observations, vide its consultation paper dated 19 January 2024 (Consultation Paper), stating that the current regulatory framework for AIFs in India has inadvertently facilitated scenarios wherein foreign investors are setting up AIFs with investment managers/sponsors who are IOCC, with the objective of circumventing the restrictions on investments thereby bypassing financial regulatory frameworks, particularly sectoral norms under the Foreign Exchange Management Act, 1999 (FEMA) and prohibited sectors in terms of the Foreign Direct Investment (FDI). This proposal was brought into force vide an amendment to SEBI’s regulations with effect from 24 April 2024.

Further, SEBI has, vide a Circular dated 26 April 2024 (New Circular), extended certain compliance related obligations otherwise applicable to pledge of Indian securities by non-resident persons to pledge created by AIFs if (a) the AIF (irrespective of the AIF being IOCC or FOCC) has more than 50% foreign investment; or (b) the AIF has a foreign sponsor/ manager; or (c) the AIF has persons other than resident Indian citizens as external members in its investment committee.

Pursuant to the issuance of the aforesaid circular, it is clear that an AIF having more than 50% foreign investment (irrespective of it being IOCC or FOCC) is required to comply with additional compliance requirements as envisaged in the RBI Master Direction (dated 4 January 2018) as though such AIF is a person resident outside India. This is a substantial departure in the policy of applicability of FDI norms to IOCC AIFs.

The objective of the NDI Rules is to attract foreign capital, which is crucial for economic growth. However, the proposed changes through the issuance of the New Circular may inadvertently deter investment managers from pooling foreign capital through Indian AIFs. The provisions outlined in the New Circular could lead to increased costs for investment managers, ultimately borne by investors due to additional compliance requirements. Consequently, the New Circular may prove to be counter-productive in fostering a conducive investment environment and in ease of doing business for both, the foreign investors, and Indian managers.

The FDI inflows in India have substantially declined by 16% in 2022-23 (from USD 84835 million in 2021-22 to USD 71355 in 2022-23) and by further 1% in 2023-24 (from USD 71355 in 2022-23 to USD 70954 in 2023-24). Considering the current trend of declining FDI in India and the significance of AIFs’ contribution in attracting FDI, it is crucial to recognise that a stable policy in terms of regulatory treatment of domestic pools of capital is critical in boosting investor confidence.

It is essential to strike a balance between regulatory oversight and ensuring a conducive environment for foreign investors to participate in the Indian market effectively. Therefore, in the interest of the AIF ecosystem’s growth, it is important to ensure that new provisions are aligned with existing well-defined frameworks of the NDI rules, and do not inadvertently impede the intended objectives of established guidelines.


The information contained in this article has been compiled by Cyril Amarchand Mangaldas and/or its affiliates from sources believed to be reliable, but no representation or warranty, express or implied is made to its accuracy, completeness, or correctness. All opinions and estimates contained in this report are judgements as of the date of publication and are provided in good faith but without legal responsibility.

This article is provided for information purposes only and is not intended, and should not be construed, as legal, tax, public accounting, auditing or other advice or opinions. Readers should consult their legal counsel, accountants, and/or tax advisors prior to making any decisions or taking any action (including refraining from certain actions) concerning the matters discussed in this communication. IQ-EQ does not accept any direct or consequential loss arising from the use of this document. IQ-EQ is not a law firm or a public accounting firm.

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