Understanding: Can VC Firms Own AMCs in India & Where They Get Funds to Invest in Start-ups?

We received a few queries on our last post published on LinkedIn on Tuesday, 13 September, 2022; asking us to help explain mostly:

• How are investment funds regulated and operate in India; and
• How and when can a VC fund be considered as an asset management company.

In today’s newsletter, we aim to provide a broad overview of –

• How are investment funds regulated in India;
• How do these investment funds get funding from domestic and international markets to further invest in companies/start-ups in India;
• Can investment funds, registered with SEBI in India, own asset management companies, if approved; and
• What does all this mean for the start-up ecosystem.

A PE fund (similar to a hedge fund) is an unregistered investment vehicle in which investors pool money to invest further in inter alia companies.

The Securities and Exchange Board of India (“SEBI”) (AIF) Regulations, 2012 (“AIF Regulations”) governs alternative investment funds (“AIFs”) in India, more commonly known as VC funds.

Mutual funds, generally established as trust catering to retail investors, are governed under the SEBI (Mutual Funds) Regulations, 1996 (“MF Regulations”).

Offshore funds seeking to invest in India are permitted to participate in the listed and debt market in India as foreign portfolio investors (“FPIs”) under the SEBI (FPI) Regulations, 2019 (“FPI Regulations”).

Offshore funds i.e., the foreign venture capital investors (“FVCI”) seeking to invest in the unlisted market in India, are governed by the SEBI (FVCI) Regulations, 2000 (“FVCI Regulations”). Please note that currently an FVCI is permitted to invest certain limited sectors only in India.

Except the first one, all of other options above requires the ‘investor’ to be registered with SEBI; however, please note that any Foreign direct investment (“FDI”) i.e., an investment in an Indian entity through equity-related instruments by a person resident outside India, in an unlisted company in India, does not require any prior registration of the ‘investor’ with SEBI and offers investment in more sectors, than available to FVCIs.

As per SEBI AIF Regulations:

• Category-I AIF: This can only be a closed-ended fund that invests in start-up or early-stage ventures or social ventures or SMEs or infrastructure or other sectors or areas which the government or regulators consider as socially or economically desirable and shall include venture capital funds, SME funds, social venture funds, infrastructure funds and such other AIF as may be specified;
• Category-II AIF: It does not fall in Category-I and III and which does not undertake leverage or borrowing other than to meet day-to-day operational requirements. A Category-II AIF can only be a closed-ended fund.
• Category-III AIF: It employs diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives. A Category-III AIF can either be open or close ended.

VC funds in India are generally required to be registered as Category II AIFs with SEBI. As regards the offshore funds, these can invest in India through FDI and FVCI investment routes

With growing importance and need for a source of active capital provided by investment funds to companies/startups in India as financial investment.

As per the AIF Regulations, an AIF is a privately pooled investment vehicle set up in India, which raises funds from larger investors, whether Indian or foreign, and invests further, in accordance with a defined investment policy for the benefit of its investors.

Mutual funds are primarily targeted towards retail investors with prudential regulations seeking to regulate all kinds of risks with the assets being under management of a fund manager.

Most AMCs in India are currently owned by banks, non-banking financial companies, industrial houses and foreign mutual funds expanding its portfolio to include India.

The Finance Ministry has set up a high-level panel headed by former Sebi chairman M Damodaran to look into issues being faced by venture capital (VC) and private equity (PE) investors when investing in India.

On 8 April 2022, the SEBI also constituted a working group to recommend an alternative set of eligibility criteria for entities to act as a ‘sponsor’ – to review the existing eligibility requirements for being a sponsor; to recommend mechanisms for addressing conflict of interest that may arise if pooled investment vehicles/ private equity act as a sponsor and; to examine the need for sponsor to dilute its stake in asset management company

The SEBI press release further examines the obligations cast on ‘trustees’ by various provisions of MF Regulations – so as to determine whether certain obligations of operational nature can be delegated to AMCs; to identify those responsibilities for which Trustees can avail the services of professional assurance agencies; and to recommend required financial resources to be made available to trustees to independently discharge their obligations.

As VC firms have limited lifecycle and therefore, previously SEBI had not looked favourably to such funds (registered as Category II AIFs) acting as a sponsor to an AMC.

If SEBI permits AIFs to act as a ‘sponsor’ to an AMC, in a progressive move, it will:

• allow loss-making sponsors to invest in mutual fund businesses provided they fulfil the fit-and-proper criteria. This could possibly also mean that fintech companies can also enter the asset management business;
• Professional fund managers running AMCs can partner with VC funds in a regulated environment that will encourage entrepreneurship, competition and overall increase in M&A and investment activities in India, ultimately leading to regulated and consistent flow of funds in promising startups in India.
• This will also ensure price correction in startups with more players and regulations entering the space.
• further accelerate investments into startups and sunrise sector with forward looking measures and future ready regulatory practices.