By: Siddhanth Singhi and Aditya Belsare

INTRODUCTION

Alternate Investment Funds (“AIFs”) have recently garnered significant traction in the market, recording an impressive Rs. 5 trillion by Quarter 1 (2025). AIFs, as privately pooled investment vehicles, have the potential to yield high returns, but they have been under the heat of the Securities and Exchange Board of India (“SEBI”) and Reserve Bank of India (“RBI”) for their alleged misuse to circumvent foreign investment regulations and emergence as a mechanism for evergreening of the loans.

To address these concerns, SEBI issued a Consultation Paper (“Paper”) in January 2024, wherein it formulated requirements of due diligence to be carried out by the Manager and Key Management Personnel (“KMP”) of the AIFs.

This article aims to analyse the prevailing lacunas in the regulatory framework concerning foreign investment in light of the SEBI (AIF) (Second Amendment) Regulations, 2024 (“2024 Amendment”), which inserted certain provisions as recommended in the Paper. The authors have analysed the existing regulatory framework (Paper and the subsequent 2024 Amendment), navigating the regulatory ambiguities, along with suggestions to plug the loopholes of the current framework.

HARMONISATION OF REGULATIONS

RBI had earlier noticed that to avoid reflection of default by the borrowers in the Regulated Entities (“REs”) financial statements, the REs would engage in ‘evergreening of loans’ by making subordinate investments in an AIF, which subsequently invests in the same borrowers.  This financial setup allowed the stressed borrowers to repay the RE’s loan without indicating any financial stress in the books of the REs. This created challenges for the financial regulators, as this setup allowed REs to evade classifying such loans as stressed debts. The Paper also outlined how AIFs are structured for evergreening of loans by utilising them to benefit REs by evading bad debts from their financial statements.

To address evergreening of loans, SEBI released a Specific Due Diligence Circular (“DD Circular”), which laid down guidelines to be followed by the Manager and KMP of the AIFs while accepting investments. It specifies that any RE of RBI investing more than 25% of the corpus of any AIF is required to perform due diligence in accordance with the due diligence standards set by the Standard Setting Forum for AIFs (“SFA”). Consequently, if any RE tries to invest beyond the permissible limit, it will be under the obligation to carry out due diligence according to SFA standards. Complexities emerged when RBI issued RBI (Investment in AIF) Directions, 2025 (“Draft Directions”) pertaining to guidelines for investment by REs in an AIF in order to curb the evergreening of loans. The Draft Directions put a ceiling limit for total investment that an AIF can receive from all REs combined at 15%. This is not in line with SEBI’s DD Circular which triggers due diligence when the investment by RE in an AIF exceeds 25%.

The authors are of the view that the percentages prescribed by SEBI and RBI at 25% and 15% respectively creates regulatory ambiguity for investors as SEBI allows a larger percentage of investment in contrary to RBI’s smaller cap. Since RBI is the apex body for regulating REs, it is suggested that SEBI should harmonise its rate with the RBI to synchronise the regulations.

INTENT V IMPLEMENTATION: WHO WATCHES THE MANAGER?

Along with inserting sub-regulation 20 under clause 20 in the SEBI AIF Regulations, 2012 to provide for due diligence standard mechanism, the Paper also proposed inserting a proviso which stated: “Provided that, if participation of an investor of an AIF in an investment opportunity has been ascertained to result in facilitation of circumvention of any extant regulation, the manager of the AIF shall – (a) not make the investment; or (b) exclude the particular investor from the investment.” It imposed a specific obligation on the Manager and functioned as an enforcement mechanism for the general obligation cast upon the Manager of AIF to ensure the investment does not lead to circumvention.

However, the 2024 Amendment, which inserted the due diligence standards, was notified without the inclusion of this proviso, thereby keeping the new sub-regulation 20 without any specific enforcement obligation of the Manager. The proviso, which ensured that the investments could not be misused, was not added through the 2024 Amendment. The omission of the proviso from the Amendment indicates that the Paper had envisaged a broader scope than what the 2024 Amendment delivers. SEBI’s act of excluding the proviso from the Amendment triggers alarms regarding the need to mitigate the regulatory arbitrage. It is essential for SEBI to address this exclusion since it may encourage a lackadaisical attitude from the Manager or KMP who are aware that there is no specific obligation to act against any circumvention of due diligence.

BYPASSING THE FEMA NDI RULES

There are multiple regulatory loopholes available to foreign investors to circumvent the sectoral limits. Firstly, as per Rule 23 of the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (“NDI Rules”), the categorisation of downstream investment in AIF is based on the domicile of ownership and control of the manager of AIF. The Paper voiced concerns regarding the circumvention of NDI Rules, wherein the foreign investors follow a sophisticated approach to bypass the established law and invest beyond permissible sectoral limits. The Paper highlighted that if a foreign investor invests in an AIF with an Indian resident manager, then it will not be considered as an Indirect Foreign Investment (“IFI”) and would be considered as a domestic investment as per Schedule VIII of NDI Rules. This loophole is allegedly exploited by the foreign investors who specifically create AIFs with a resident Indian Manager to circumvent the downstream investment rules to categorise it as domestic investment.

Secondly, the Significant Beneficial Owner (“SBO”) of an AIF investment in an enterprise cannot be traced back beyond the AIF, as AIFs are exempted from notifying their ultimate unitholders under SBO Rules, 2018, enabling the foreign investors to hide their investment.

Thirdly, SEBI in its DD Circular stated that in a scheme of AIF, where 50% or more of its corpus is held by the investors who are “citizens of a country which shares borders with India”, such investment will be considered as IFI. The circular only provides for countries sharing a land border with India but deftly excludes nations that do not share any land border with India. This provision fails to provide for a due diligence mechanism for investments by foreign investors who are citizens of a country not sharing a land border with India.

One prominent example of such manoeuvring is Amazon and Samara AIF’s acquisition of Retail More, wherein Retail More was acquired by Witzig Advisory, whose 49% and 51% stake were later acquired by Amazon and Samara AIF, respectively. Through this acquisition structure, wherein Amazon acquired a 49% stake directly and further heavily invested in Samara AIF, it is alleged that it exceeded the sectoral limit of 51% in the multi-brand retail sector as per the 2020 Consolidated Foreign Direct Investment Policy.

While SEBI issued the Paper and later the 2024 amendment to address these concerns, it has failed to address such significant flaws, which could be potentially exploited by foreign investors.

THE WAY AHEAD

SEBI has been undertaking pivotal efforts to regulate the financial landscape to foster robust market growth while providing stakeholders with sufficient flexibility to engage in legitimate investments. The proposal in the Paper, which ultimately found its way into the 2024  amendment, envisions a multipronged approach to counter the prevalent circumvention of regulations within the country’s financial sector. Therefore, it is essential for SEBI to ensure that the financial manoeuvring is curtailed while simultaneously avoiding the creation of new means for circumvention. Along with harmonising of rates by SEBI and RBI for REs, the authors suggest that SEBI bring the foreign investors from countries not sharing a land border with India under the ambit of its due diligence framework.

Furthermore, it is recommended that SEBI’s authority to act against non-compliance with regulations by AIFs should be increased. Currently, Section 15EA of SEBI Act, 1992 provides limited power to SEBI for the imposition of penalties on AIFs for violation of regulations. The authors suggest that under Section 15EA, SEBI should be given the power to divest the investor’s investment in an AIF in case the investor has been found to engage in circumvention of regulations. It should be noted that this power should be used cautiously and only when the regulator has proved beyond reasonable doubt that the concerned AIF is engaged in any kind of circumvention of laws. SEBI must show that such a penalty is justified, considering the quantum and nature of the investment.

Such changes in the regulatory framework are required for a balanced approach that is in alignment with SEBI’s approach to restore trust in the AIF structure with a minimal impact on the legitimate AIF investments.

(Aditya Belsare is a fourth-year B.A. LL.B. (Hons.) student at the Gujarat National Law University, Gandhinagar. Siddhanth Singhi is a fourth-year B.A. LL.B. (Hons.) student at the Gujarat National Law University, Gandhinagar. The authors may be contacted via mail at siddhant1604@gmail.com and adityabelsare13@gmail.com, respectively.)