This article provides a step-by-step guide for first-time fund managers in India, outlining the process of setting up a private equity or venture capital fund.
Key Points:
- What is a Fund? A private pool of investments managed by professionals and registered with SEBI (Securities and Exchange Board of India).
- Fund Categories:
- Category I (Venture Capital Fund): Offers tax benefits and invests in unlisted companies.
- Category II Fund: More flexibility in investment strategies but no tax benefits.
- Steps to Setting Up a Fund:
- Choose a fund category (I or II).
- Understand investment conditions (minimum investment, investable funds, etc.).
- Decide on the fund structure (trust, company, etc.).
- Appoint and onboard key entities (investment team, custodian, etc.).
- Prepare the Private Placement Memorandum (PPM).
- Apply for registration with SEBI.
- Considerations for First-Time Managers:
- Category selection depends on investment goals and investor needs.
- The process can be complex, so understanding regulations is crucial.
WHAT IS A FUND AND WHO REGULATES IT?
Private Equity Funds and Venture Capital Funds in India are set up as Alternative Investment Funds (“AIF” or “Funds") which have to be registered under the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (“Fund Regulations”) to carry on their activities.
It is a privately pooled investment vehicle which collects funds from investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors. Funds may raise funds from any investor whether Indian, foreign or non-resident Indians by way of issue of units[1].
Funds can be established or incorporated in the form of a trust or a company or a limited liability partnership or a body corporate and are liable to also comply with the separate laws under which they are incorporated.
STEP-BY-STEP GUIDE TO SETTING UP AN FUND
STEP I: CHOOSING A CATEGORY OF FUND
The Fund Regulations specify three categories under which Funds can be registered.
- Category I Fund: Venture Capital Funds, small and medium enterprise funds, social venture funds, infrastructure funds and any funds as may be specified.
- Category II Fund: Funds which do not fall under category I and III and which do not undertake leverage or borrowing. PE Funds or debt funds for which no specific incentives or concessions are given by the government can be considered as category II Funds.
- Category III Fund: Funds that employ diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives
First time managers are often faced with the choice between a Category I (Venture Capital Fund) and a Category II Fund. The key differences between the two categories are mentioned below.
Category I (VCF)
- Investment Conditions: At least 75% of the investable funds have to be invested in unlisted equity shares or equity linked instruments of a venture capital undertaking[2] or in companies listed or proposed to be listed on a SME exchange or SME segment of an exchange.
- Target Investments: venture capital undertakings, special purpose vehicles, limited liability partnerships, units of other Category I Funds of the same sub category, units of Category II Funds.
- Registration Fee: INR 5,00,000
Category II Fund
- Investment Conditions: Primarily (at least 50.1%) in unlisted companies directly or through investment in units of other Funds.
- Target Investments: companies, units of Category I Funds, units of Category II Funds, up to 49.99% can technically be done in listed securities
- Registration Fee: INR 10,00,000
STEP II: UNDERSTANDING INVESTMENT CONDITIONS
The Fund Regulations place certain conditions and restrictions on the Funds with regards to investment. The investment restrictions and conditions differ across various categories of the Funds, however, the general conditions applicable to all Funds are mentioned below:
- A Fund shall not have more than 1000 investors in any one scheme and shall not accept an investment of less than Rs. 1 Crore from an investor. However, the minimum investment is Rs. 25 lakhs in case of employees/ directors of the Fund or the manager and does not apply in case of accredited investors.
- In case of angel funds (a sub-category of Category I Fund), the minimum investment is Rs. 25 lakhs and the maximum number of investors in one scheme is 200.
- Each scheme of a Fund shall have a minimum corpus of Rs. 20 crores.[3]
- A Fund can invest up to 25% of the investible funds in securities of companies incorporated outside India subject to guidelines as specified by RBI and SEBI[4].
- Category I and II Funds cannot invest more than 25% of the investable funds in an investee company directly or through investment in the units of other Funds.
- Funds may invest in units of other Funds provided that contribution is not accepted from other Funds.[5]
- Fund shall issue units in dematerialised form as prescribed by SEBI from time to time.
STEP III: STRUCTURING THE FUND
One of the most important decisions for forming an Fund is the structure in which it will be set up.As stated above, Funds can be formed as a trust, company, LLP or a body corporate. Each of the structure has its pros and cons, however, a trust is preferred choice for structuring Funds in India. Since, most of the Funds in India are formed as trust, an illustrative structure of an Fund set up as a trust is explained below.
For the purpose of the illustration below, it is assumed that the Trust has only one scheme. However, fund managers can launch multiple schemes under one trust.
From a legal and commercial perspective, it is advisable for a Manager to launch multiple schemes under a single trust as a cost effective mechanism.
- Trustee: The Registrar of Trusts is the primary regulatory authority responsible for the registration of trust in India. Their role involves maintaining a comprehensive database of all registered trusts in the country. The registration process for private trusts is governed by the Trusts Act of 1882.. A trust is created and administered through the trust deed which is executed between the settlor and the trustee. The settlor, being the author of the trust settles the trust with an initial amount, which is then transferred to the proposed trustee. While trusts usually have their own trustee/board of trustees, in case of Funds, the trustee is often an independent institutional trustee, who agrees to provide the trusteeship services to the Fund for a fee.
- Sponsor: The sponsor may be an individual/company or LLP. The choice of entity is often dictated by regulator or tax considerations. The role of the sponsor is to contribute the continuing interest in the fund. Such interest may be maintained pro-rata to the amount of funds raised (net) from other investors in the Fund.[6]
- Manager: The trustee of the Fund appoints a manager for managing the Fund by entering into an investment management agreement. The manager along with the investment committee (if constituted) and the key investment team takes the investment decisions of the Fund. The Manager charges management fee for the services provided to the Fund.
- Investors: The investors of the Fund enter into an agreement with the trustee and investment manager making a capital commitment to invest the minimum contribution by signing a Contribution Agreement.
Typically, the commitment amount is drawn down by the Fund over a period of four years.
STEP IV: APPOINTING & ONBOARDING ENTITIES FOR FUND
- Key Investment Team: Each member should be either employee, partner or director of the Investment Manager, where at least one personnel should have a professional qualification (such as CA, CFA, MBA) and hold the NISM Series-XIX-C: Alternative Investment Fund Managers Certification. These two requirements can be fulfilled by two different members or one.
- Merchant Banker: The Fund shall onboard a Merchant Banker to file the application for registration with SEBI.
- Custodian: The custodian for a scheme of an Fund shall be appointed prior to the date of first investment of the scheme.
- Registrar and Transfer Agent (RTA): RTA appointed by Funds shall collect the stamp duty on issue, transfer and sale of units of Funds.
- Legal Advisor: Legal Advisors assist the Manager in structuring and preparing the documentation, which includes the Private Placement Memorandum (PPM), Investment Management Agreement and the Contribution Agreement, for the registration and operation of Funds.
- Tax Advisor: The tax advisors can advise the Managers on the taxation and valuation for the Fund.
STEP V: PREPARING THE PRIVATE PLACEMENT MEMORANDUM (PPM)
A draft of the PPM has to be submitted along with the application Form A by the applicant. A PPM is a document which contains all the important information about the Fund. As per regulation 11 of the Fund Regulations, a PPM must contain all the important information about Fund, sponsor, manger, tenure, investment strategy, risk management tools and parameters employed, key service providers, conflict of interest, disciplinary history, manner of winding up etc. The PPM has to be filed with SEBI through a SEBI registered merchant banker, who independently exercises due diligence of all disclosures in the PPM. The due diligence certificate provided by the merchant banker has to be submitted at the time of registration.
APPLICATION PROCESS
The application is made online through the SEBI Intermediary (SI) portal.
FEE STRUCTURE
Application Fees: INR 1,00,000
Scheme Fees (to be paid for a new scheme under an existing Fund): INR 1,00,000
Registration Fees: INR 5,00,000 (Category I Fund); INR 10,00,000 (Category II Fund)
The specified fee can be paid through NEFT/RTGS/IMPS or online payment using SEBI Payment Gateway. Thereafter, subject to responses being provided to queries from SEBI, the certificate of registration is granted to the applicant. As per regulation 6(5) of the Fund Regulations, an Fund can accept money only after receiving certificate of registration from SEBI.
CONCLUSION
Setting up a fund in India can be a complex process, especially for first-time fund managers. Understanding the different categories of funds, the regulatory requirements, and the investment conditions is crucial for successful establishment.
While Category I (Venture Capital Fund) offers tax benefits and a more focused investment mandate, Category II provides greater flexibility in investment strategies. The choice between these categories ultimately depends on the fund manager's investment objectives, risk tolerance, and the specific needs of their investors.
By carefully considering the factors outlined in this guide, first-time fund managers can make informed decisions and navigate the regulatory landscape to establish a successful fund in India.
This post has been contributed by Ms. Vaneesa Agrawal, Founding Partner and Ms. Sanyukta Srivastav, Senior Associate.
[Disclaimer: This article is for academic purpose and is solely to provide readers with general information regarding developments in Indian law. For specific queries, please write to us at admin@thinkinglegal.in ]
[1] Regulation 10 (a), SEBI (Alternative Investment Funds) Regulations 2012
[2] “venture capital undertaking” means a domestic company which is not listed on a recognised stock exchange at the time of making investments.
[3] Regulation 10(b), SEBI (Alternative Investment Funds) Regulations 2012
[4] SEBI Circular no. CIR/IMD/DF/7/2015, dated October 01, 2015
[5] Regulation 15 (da), SEBI (Alternative Investment Funds) Regulations 2012
[6] SEBI Circular CIR/IMD/DF/14/2014 dated June 19, 2014
