Who 'controls' PE, VC funds? Asks Sebi

Mumbai: Who really pulls the strings in Indian private equity and venture capital funds? Do many of them masquerade as desi funds and benefit from local laws though the actual powers lie with foreigners and non-residents? These are questions that seem to have cropped up in the regulatory sphere.

A few weeks ago, the capital market regulator Securities and Exchange Board of India (Sebi) asked these pooled investment vehicles, which raise money from domestic as well as foreign investors, to specifically spell out whether their 'manager' is "owned and controlled by persons who are residents" of India or are based outside the country, two persons aware of the query from the regulator told ET.

The August 23 email from Sebi to alternative investment funds (AIFs) - the regulatory term for PE and VC funds - also directs the funds to disclose whether their respective 'sponsor' is a domestic or overseas entity.

While the nature of the questions - coming a decade after the first set of AIF regulations - has baffled many fund officials and regulatory professionals, the issue raised by the regulator can have deeper implications.

Even though an AIF is free to raise as much money as it wants from foreign investors, the fund's investment in a company in India is not considered foreign direct investment (FDI). This is because, unlike international, offshore PE funds, AIFs are formed in India. However, investments by funds with non-resident managers and sponsors would be construed as FDI and such funds are required to follow the do's and don'ts of FDI regulations and the Foreign Exchange Management Act (FEMA).

It is unclear why Sebi has raised the subject - whether it's simply information collection or the regulator is trying to find out if some of the funds are sidestepping rules and violating the spirit of the AIF regulations.

Typically, the manager of an AIF is a local entity - a company or a limited liability partnership. This manager (who must have at least one employee with certain qualifications) enters into an investment management agreement with the trustee (on behalf of the fund) and is authorised to manage the fund's investments. The sponsor chips in money and has to contribute 2.5% of the fund corpus or ₹5 crore, whichever is lower. (The manager can also double up as a sponsor).

Now, if more than 50% of the manager entity is owned by foreigners or non-resident Indians (NRIs), the AIF no longer retains its local character.

According to Tejesh Chitlangi, senior partner, IC Universal Legal, "If the ownership as well as control of both, the investment manager as well as the sponsor of an AIF, are not with resident Indian citizens or if an AIF has a foreign sponsor, then the concerned AIF has to follow downstream FDI norms whilst making investments. Whilst Sebi may be carrying out an analysis of Indian-owned and controlled versus foreign-owned or controlled AIF manager/sponsor structures, what needs to be urgently addressed is a long-term unresolved issue wherein pending RBI clarification, Sebi has been holding back approvals for those AIF applications proposing external non-resident member (s) on its decision making/investment approving committee."

Thus, a fund which is foreign-owned and controls the manager and sponsor is well within the rules as long as its investments are FDI compliant. But funds which did not follow FDI rules and FEMA despite having non-resident managers - either because they were ill-advised or chose to disregard regulations - may have to explain their position to regulators.

Richie Sancheti, founder partner of law firm Richie Sancheti Associates, said the law is clear that investments by an AIF are reckoned as an 'indirect foreign investment' if the sponsor and the investment manager are not Indian 'owned' and 'controlled'.

"For such indirect foreign investment, the AIF will have to comply with sectoral caps, capitalisation norms, valuation rules, restrictions on optionality clauses, etc., in respect of its equity investments. The determination is, accordingly, quite critical... But Sebi and regulators at times seek data, to identify information gaps or address situations that could benefit from additional information," said Sancheti. The information gathering precedes a detailed questionnaire on the valuation methodology and practice followed by funds.