Foundation — Pooling and the three ways to build the pool

What "structuring" actually means

The word "structuring" sounds like something only lawyers do. The workbook gives it a very practical definition:

The term 'alternative investment fund structuring' refers to both the constitutional aspects of the AIF and the investment routing options for investors in such funds.

So it is two questions, not one:

1. What legal box do we put the money in? A trust, an LLP, or a company.
2. By what road does each investor reach that box? Directly, if they are Indian. Through an offshore fund, an FVCI registration or the FDI route, if they are not.

And the reason the second question matters so much: Since AIFs have become an important investment route for foreign investors to invest in India, AIF structuring inter alia, should also consider the aspects related to how such offshore investors may invest in India.

The chapter is short — eleven printed pages — but it carries 10 marks out of 100, the same as the enormous Chapter 4. That tells you the examiner asks a lot of questions from very little text. Read every sentence here as if it were a question.

Why the AIF route grew

After the introduction of the SEBI (AIF) Regulations 2012, the regulatory slant has been towards promoting home-grown investment managers by allowing Indian managed and sponsored AIFs with a mix of foreign investors.

Read that as policy, not just description. Before 2012, an offshore fund wanting Indian exposure typically pooled abroad and hired an Indian adviser. The Indian professional was an employee of someone else's fund. The AIF Regulations invited that professional to run his own fund in India, and invited the foreign investor to come into it.

The AIF Regulations have thus revolutionised offshore interest in domestic AIF assets and it is presently perceived that the AIF route is the most convenient route for large offshore financial investors to tap alternative investments in India. Since Category II AIFs also have the flexibility to tap the listed market assets to a certain extent of their corpuses, it is a comprehensive investment route. For domestic investors, the AIF regime provides an effective platform to avail the expertise of alternate fund managers.

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5.2 The principle of pooling

The concept of 'pooling' is central to the formation of any investment management structure and it applies equally in the context of AIFs.

The workbook sets it up as a choice between two service models:

When a set of investors having common investment objectives require investment management services, there are primarily two methods of managing the same – (a) Individual Portfolio Management and (b) Pooled Asset Management.

Individual Portfolio Management: the individual investment corpus of each investor is kept distinct and managed under a portfolio management agreement with the manager. The portfolio manager either has discretion to take the investment decisions from time to time or every decision is advised to the investor who takes the call depending on whether the management terms are discretionary or non-discretionary.

And the defining sentence: the essential feature of portfolio management is that it is a customised service offered at individual investor level. Therefore, there would be as many investment management outcomes as there are investors.

Fifty PMS clients, fifty different portfolios, fifty different returns — even under one manager following one philosophy, because each account starts on a different day with a different amount.

Pooled Asset Management: In asset management services, there is no concept of an individual corpus. Instead the contributions provided by investors are 'pooled' together into a common corpus that would be managed by an investment manager.

Four benefits follow, and the exam has asked all of them:

• Pooling also helps to bring in economies of scale in investment management by combining individual corpuses into a large common fund.
• The investment manager can plan a better and broad-based investment strategy with a larger pool of underlying assets —
• to bring in the benefits of risk diversification.
• The risk-taking capability is also enhanced to bring in the possibility of better returns to the common fund that would be enjoyed by all individual investors participating in it.

In short, pooling helps in collective investment management and its attendant benefits. Pooled investment vehicles are therefore fundamental to fund structuring in the AIF industry as much as they are applicable to the mutual fund industry.

One outcome, shared by all. That is the whole difference. If the fund returns 18 per cent, every unit holder's units returned 18 per cent — a person who came in through the green shoe on the last day of the final close gets the same per-unit outcome as the anchor investor, because they own units in the same pool.

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5.3 The six general pooling considerations

These six are the most examinable list in the chapter. Learn them in order.

1. A distinct legal identity

In a pooled investment management structure, it becomes essential to provide a distinct legal identity to the pool, separate from its individual investors, the manager and the sponsor or other service providers associated with the pool.

Depending upon the available alternatives under law, there are primarily three possibilities – (a) formation of a trust under the Indian Trusts Act 1882, (b) a limited liability partnership (LLP) between the investors and the investment manager under the Limited Liability Partnership Act 2008 and (c) formation of a private or public limited company under the Companies Act 2013 with investors as shareholders and the representatives of the manager as directors in executive capacity.

Note the precise roles in the company option: investors as shareholders and representatives of the manager as directors in executive capacity.

2. Limited liability

The pool should have limited liability so that it does not end up taking higher level of risks than those underlying its investment objectives. All the three alternatives mentioned above provide the advantage of limited liability to the pooled vehicle.

All three provide limited liability. So limited liability is not a distinguishing factor between trust, LLP and company. If a question asks which structure gives limited liability, the honest answer is all of them — and the exam will be testing whether you remember that, not whether you can pick a favourite.

3. Tax neutrality

Pooling should also satisfy the principle of 'tax neutrality', i.e. it should not put an investor in a comparatively adverse position from taxation point of view as compared to investing at individual level.

Understand the standard being set. Tax neutrality does not mean the fund pays no tax, and it does not mean the investor gets a tax advantage. It means: investing through the pool should leave you no worse off than investing directly.

This is especially relevant when certain streams of income may be tax free at investor level due to the status of the investor, but taxable at fund level. Think of a provident fund or a charitable institution whose income is exempt. If the pool paid tax on that income before passing it on, the exempt investor would be worse off inside the fund than outside it — and would simply not invest.

Since this outcome depends on the provisions of the tax law, it would be necessary to optimise the structure as nearly as possible to achieving tax neutrality. Note the careful phrase as nearly as possible. Perfect neutrality is an aspiration, not a guarantee.

4. Regulatory compliance

Pooling should also be compliant with regulatory requirements of SEBI, foreign investment law and RBI regulations, corporate law and compliance requirements.

Four bodies of law in one sentence: SEBI, foreign investment law and RBI regulations, corporate law.

5. Not too complex — and the GAAR warning

The structure should not be too complex such that it is perceived to be exploiting regulatory and tax arbitrage and may come under the scrutiny and wrath of regulators. While taking advantage of available options under law, the structure should seem genuine and not to obfuscate the underlying objectives of creation of the pool.

From the Indian context, complicated structures are likely to be scrutinised under the General Anti-Avoidance Rules (GAAR) which allows Indian tax authorities to re-characterise transactions on grounds of lack of commercial substance among other things.

The footnote definition is worth learning verbatim: GAAR are a set of rules to ensure that assessees don't resort to tax avoidance/evasion by setting up complicated structures and practices that do not have any genuine business purpose. GAAR came into effect from April 01, 2017.

Two things to carry: the phrase lack of commercial substance, and the date April 01, 2017.

6. Jurisdiction choice for offshore pools — five criteria

From an offshore investor perspective, the general principles for deciding on the jurisdiction for pooling an India centric fund are the following:

(a) A good tax treaty. Since India is one of the high tax jurisdictions in comparison with several other countries, offshore investor prefers to optimise domestic taxation in India on their investment activity. This would partly offset the currency loss they may incur on Indian rupee (INR) depreciation during the investment horizon. Pooling the fund in a jurisdiction that has a good tax treaty with India which would avoid double taxation in India as well as in the investor's country is of primary importance. India has such Double Taxation Avoidance Agreements (DTAAs) with several countries.

Do not skip the currency point — it is often the reason a foreign investor cares about a percentage point of tax. A dollar investor in an Indian fund faces both Indian tax and rupee depreciation over a seven-year horizon. Tax efficiency partly offsets the currency loss. This is why the workbook calls a good treaty of primary importance.

(b) A BIPA. Sometimes, a jurisdiction is also chosen if it has a good Bilateral Investment Promotion and Protection Agreement (BIPA) with India (for e.g. Singapore). A BIPA also helps in protecting an investor's financial interests in India in the event of hostilities between the two countries or other repatriation risks. BIPA also generally provides investment incentives to promote mutual interests of both countries.

DTAA protects against double tax. BIPA protects against political and repatriation risk. Two different instruments doing two different jobs — a favourite exam confusion.

(c) A globally recognised capital market. Investors may also prefer in certain situations to set up their investment vehicle in a jurisdiction that has a globally recognised capital market such as Luxembourg, Singapore, Tokyo etc. Such a step would help to list the investment vehicle in the local stock market or to explore other such strategic opportunities involving the fund vehicle.

(d) Wealth preservation and security. From a wealth preservation and security perspective, foreign investors may select pooling jurisdictions that may have in addition to tax advantage, a political system, legal framework and enforcement and a stable currency that provide adequate protection for their wealth.

(e) An equivalent jurisdiction under AML and CFT law. Jurisdictional selection should also be based on 'equivalent jurisdiction' as per the local anti-money laundering law (AML) and combating the financing of terrorism (CFT) law. Many countries have passed such laws based on standards developed by the Financial Action Task Force (FATF). The FATF is an inter-governmental international agency to keep oversight on international money laundering and terror financing. Based on the laws created by respective countries, each country would create a list of equivalent jurisdictions that comply with acceptable FATF standards. In international investing, selecting a FATF compliant jurisdiction has become a necessity.

Note the word necessity in that last line. Criteria (a) to (d) are preferences that trade off against each other. FATF compliance is not a preference. A fund domiciled in a non-compliant jurisdiction will find banks unwilling to open accounts and counterparties unwilling to deal, whatever its tax position.

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5.4 Anatomy of AIF constitution — the three vehicles

Alternative 1 — the trust

Incorporation of a private trust to house the AIF pool is the most preferred option for a domestic fund structure. A trust is incorporated under the Indian Trusts Act 1882. Under the AIF Regulations, a body corporate set up under an Act of Parliament or State Legislature is also included for this purpose.

Apart from tax benefits which are enumerated in a subsequent Chapter, the Indian Trusts Act 1882 offers the management team the ability to incorporate specific terms of governance for an AIF which is set up as a trust, as may be agreed between the manager and the investors of the AIF.

That is the trust's great advantage: you write your own governance. A company must follow the Companies Act's meeting rules, board rules and disclosure rules. A trust deed can say what the parties agree it should say.

Then a quiet sentence that carries a full exam question:

Though the trust is a registered body, it does not have the ability to sue or be sued like other legal entities. It is represented by its trustee, which is primarily entitled to sue or be sued for and on behalf of the trust.

The trust does not go to court. The trustee goes to court on its behalf. This is the legal reason the trustee exists as a separate party — and it explains why the trustee, not the manager, signs so many documents.

The kinds of trust:

And the conclusion that is the single most asked fact in this chapter:

For AIF purposes, 'irrevocably settled, determinate trust' is considered more appropriate.

Three words, each doing work: private (not public/charitable), irrevocable (the settlor cannot take the money back), determinate (each investor's share is fixed and knowable).

Why determinacy matters, and how it is achieved:

The word 'determinate' implies that the share of each beneficiary is determinable distinctly. To achieve 'determinacy', the AIF needs to ensure that its investors and their respective beneficial interests are ascertainable as per the terms of the 'indenture of trust' or the 'trust deed' setting up the AIF as a trust, at all times during its existence. This is the reason why the corpus is divided into unit capital and investors are allotted specific number of units representing their determinate share in the trust corpus or a specific scheme.

Now you know why AIFs issue units at all. It is not a marketing convention borrowed from mutual funds. Units are the mechanism that makes the trust determinate, which in turn is what keeps the tax treatment workable. Note also the requirement at all times during its existence — determinacy is not a one-time test at launch.

Alternative 2 — the LLP

A limited liability partnership (LLP) firm incorporated under the Limited Liability Partnership Act 2008 to house the AIF pool provides a legal entity status with limited liability distinct from that of individual partners.

An LLP is liable to the full extent of its assets but liability of the partners is limited to their agreed contribution in the LLP. Since liability of the partners is limited to their agreed contribution in the LLP, it contains elements of both a corporate structure as well as a partnership firm structure.

There is no personal liability of a partner except in the case of a fraud. Moreover, a partner is not responsible or liable for another partner's misconduct or negligence as there is no joint and separate liability in the case of LLP as in the case of a normal partnership. The relationship between partners is governed by the LLP agreement.

Three protections, each with its limit: the LLP itself is liable to the full extent of its assets; a partner is liable only up to agreed contribution; there is no personal liability except in the case of fraud. Fraud pierces everything.

Who is who in an LLP fund:

Partners are the contributing investors, the sponsor/investment manager. The investors become the non-managing and passive partners who provide capital contributions to the firm's corpus but do not participate in day-to-day management of the fund. The investment manager is appointed through an Investment Management Agreement entered into between the fund and the manager who manage the firm's capital corpus. Every LLP must have at least two 'designated partners', who are responsible for the conduct and compliances of the LLP.

The number two designated partners and their role — responsible for the conduct and compliances of the LLP — are both examinable.

The verdict on the LLP:

The LLP structure is most popular in foreign countries for AIF management. In India the AIF Regulations allow an LLP structure for an AIF and the tax law also provides for treating an LLP as a taxable entity. However, the downside is that an LLP structure demands higher compliance requirements as compared to a trust. All investors become partners which makes their entry and exit a cumbersome process under the partnership deed. Secondly, LLPs are also regulated by the Ministry of Corporate Affairs. Therefore, details of investors come under public domain.

Three downsides, and the third is the one that kills it commercially: details of investors come under public domain. A family that has spent thirty years keeping its wealth quiet will not accept its name being searchable on the MCA portal. That single fact explains a great deal about why Indian AIFs are trusts.

Alternative 3 — the company

A company incorporated under the Companies Act 2013 is the third alternative to house the AIF corpus. This is the least preferred alternative due to its tax inefficiency (it does not provide tax neutrality). Moreover, are subject to numerous governance and compliance requirements under the Companies Act, 2013, especially if there are public limited companies.

Companies are also restricted in making private placements to not more than 200 investors though the AIF regulations permit the fund or a scheme to have up to 1000 investors.

That last sentence gives you a clean, arithmetical exam fact: 200 under the Companies Act versus 1000 under the AIF Regulations. A company-form AIF simply cannot use four-fifths of the investor capacity the AIF Regulations allow it. And this is consistent with what you learnt in Chapter 4: No scheme of the AIF shall have more than 1000 investors. In the case of a company, this limit is regulated by the Companies Act, 2013.

The verdict

Almost all AIFs formed in India follow the trust structure because of its operational advantages and favourable regulatory framework. It reduces the cost of compliance and provides flexibility for the AIF to form its own system of governance and reporting.

Two reasons, both worth quoting in an answer: reduces the cost of compliance and provides flexibility for the AIF to form its own system of governance and reporting.

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The three vehicles at a glance