AIF norms may let in foreign funds even in no-go sectors like e-commerce, defence machinery

MUMBAI:In its zeal to lure foreign capital, the government may have done a rushed job with the rules.

A closer look at the gazette notification released last week shows that an Alternative Investment Fund (AIF) — a pooled investment vehicle — in India can have majority or even almost the entire money from offshore investors and still buy into businesses where foreign ownership is restricted.

How? The new rules say that a fund will be considered as ‘domestic’ in nature as long as its sponsors and managers, who control the fund, are Indian. Thus, a Rs 500-crore AIF having Rs 495 crore of foreign investment can directly buy as much as it wants into companies carrying out ecommerce, or holding farm land or making defence machinery — entities where foreign ownership is either capped or barred.

While a more liberal AIF regime is aimed at attracting long-term capital and encouraging fund management in India, certain anomalies may have, perhaps unwittingly, crept into the notification. If foreign investment into AIFs is construed as local money, then AIFs can be used to sidestep hurdles in foreign direct investment (FDI) regulations.

“The new measures promote the ‘manage in India’ proposition and attempt to minimise flight of talent from India. But while this would enable all sectors in India to access foreign capital without any restrictions under this route, it is important to consider its compatibility with the existing FDI regime,” said Punit Shah, partner at Dhruva Advisors, a tax advisory firm.

It is unclear whether the anomaly is a drafting error or a subtle move to reduce the significance of FDI restrictions. The particular sentence in the notification which has raised doubts reads thus: “The extent of foreign investment in the corpus of the investment vehicle will not be a factor to determine as to whether downstream investment of the investment vehicle concerned is foreign investment or not.”

Indeed, this can even go against some of the local institutions. For instance, an AIF set up by an Indian financial institution which has 74% foreign shareholding would be considered a foreign AIF. However, an AIF whose asset management company is controlled by an Indian professional holding 51% and the balance by 49% by a Wall Street bank would be considered a local AIF.

“To maximise the ease of doing business, the new schedule seems to be a complete code stating the complete policy on allowing foreign contribution into AIFs. The position to link downstream investments (by) funds based on control and ownership of the manager may have been to encourage India-focussed funds to adopt onshore fund structures. However, making the extent of foreign investment in the corpus of the fund as a non-factor may lead to unintended consequences,” said Richie Sancheti, head of investment funds at the law firm Nishith Desai Associates.

The notification also says that as ownership and control cannot be determined in LLPs (limited liability partnerships), a LLP shall not act as a sponsor or manager. Financial market professionals said this condition may also need a relook as several AIFs have structured the asset management entity as an LLP


This post first appeared in The Economic Times on Nov 25, 2015

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