Foundation — Pooling, and the three ways to build an AIF

What "structuring" actually means

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.

Two questions, then. What legal body is the fund? — trust, LLP or company. And how does an investor's money reach the investee company? — directly, through a feeder, through a parallel offshore vehicle, or pooled together in India. This chapter answers both.

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.

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. 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. For domestic investors, the AIF regime provides an effective platform to avail the expertise of alternate fund managers.

Notice the policy intent stated openly: promoting home-grown investment managers. Every structural rule in this chapter — the unified structure, the automatic route, the fee earned at onshore level — makes more sense once you see that India wants the manager, and the management fee, to sit in India.

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8.1 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. 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

Under the former structure, 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.

Either way, 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.

That last line is the whole distinction in one sentence. Hundred PMS clients, hundred different portfolios, hundred different returns.

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. Thus, it is also known as 'blind pool investment'.

The benefits, exactly as the workbook lists 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.

The tax and compliance benefit of pooling

Pooling also has regulatory efficiency in effective compliance management. In the case of offshore investors with an India focus, if the funds are pooled outside India, the requirement to obtain a Permanent Account Number (PAN) and filing of domestic tax returns in India will only be on the offshore Fund, as opposed to each of the offshore investors (in case of their direct participation in an onshore pooling vehicle or taking direct investments in Indian investee companies through the FDI policy).

Picture forty Singapore family offices wanting Indian exposure. Without an offshore pool, forty PAN applications and forty Indian tax returns. With one, exactly one. That single administrative fact is why feeder funds exist, and it comes back in section 8.5.3.

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8.2 General Pooling Considerations — the six tests

1. 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. Under SEBI AIF regulations, 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
• (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

Learn the three Acts with their years: Indian Trusts Act 1882, LLP Act 2008, Companies Act 2013.

2. 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 give limited liability. That is not a differentiator — do not pick an option that says only one of them does.

3. 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. 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. 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.

Tax neutrality is a comparison, not an exemption. It does not mean the fund pays no tax. It means investing through the fund should not cost you more tax than investing directly. The classic problem is a pension fund that is tax-exempt in its own right but whose income becomes taxable once it flows through a fund that is itself a taxable entity.

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

5. 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.

GAAR are a set of rules to ensure that assessees do not 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 1, 2017.

Two facts to keep: GAAR effective 1 April 2017, and the trigger phrase is lack of commercial substance.

6. 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.

Notice the extra reason given for tax optimisation: it partly offsets the currency loss they may incur on Indian rupee depreciation. A foreign investor earning 15 per cent in rupees may earn far less in dollars after the rupee slides; saving tax is one of the few levers he controls.

(b) A Bilateral Investment Promotion Agreement

Many a time, a jurisdiction is also chosen if it has a good Bilateral Investment Promotion 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 = tax. BIPA = protection of the investment itself. Keep them apart.

(c) A 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, DIFC, ADGM or Gift City 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) 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.

(f) Disclosure and fiduciary norms

As the rigor of the SEBI (AIF) Regulations increases, an investment manager must contend with greater supervision and accountability to both the regulator and the investors. While creating pooling and co-investment structures within the AIF or outside of it, given the way the thinking of regulators is being shaped in developed jurisdictions, enough consideration is to be given to disclosure norms and fiduciary driven rules that are now statutorily mandated.

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8.4 Anatomy of AIF Constitution

As discussed earlier, there are primarily three constitutional options to incorporate the AIF pool.

Alternative 1 — Trust Structure

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 SEBI (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 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.

An oddity worth remembering: 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 four trust classifications

The Indian Trusts Act allows different kinds of trusts.

And the combination the exam always asks for:

For AIF purposes, 'irrevocably settled, determinate trust' is considered more appropriate primarily from a clear tax treatment perspective. 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.

That is the neat link back to Chapter 7. Units exist because determinacy is required, and determinacy is required because it gives clean tax treatment.

Alternative 2 — LLP Structure

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.

Partners will be the contributing investors, the sponsor/ investment manager. While the investors act as non-managing or passive partners who contribute capital, they do not participate in day-to-day management. The investment manager will be appointed through an investment management agreement (entered into between the fund and the manager). Every LLP must have at least two 'designated partners', who are responsible for the conduct and compliances of the LLP.

Minimum two designated partners — a number that shows up in questions.

The trade-off:

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 LLP deed and needs to be updated on Ministry of corporate affairs (MCA) website. Secondly, as LLPs are also regulated by the Ministry of Corporate Affairs, the details of investors come under public domain. The secrecy which is maintained under Trust level is lost under LLP/company level.

Three LLP drawbacks: higher compliance, cumbersome investor entry and exit requiring MCA updates, and loss of investor confidentiality. For an HNI who does not want the world to know he holds INR 20 crore in a fund, that last one alone settles the choice.

Alternative 3 — Company Structure

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 cumbersome management and compliance requirements. Companies are subject to numerous governance and compliance requirements under the Companies Act, especially if there are public limited companies.

And the fatal practical limit:

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 (accredited investors are excluded from the count).

200 versus 1000. A company caps you at a fifth of what the AIF Regulations would allow. Note the parenthesis too: accredited investors are excluded from the count.

Why the trust wins

Majority of 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. In addition, trust structure allows for bespoke investment arrangements between investment managers and the beneficiaries which prove advantageous in attracting private capital.

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8.5 The fund structure, party by party

As per the SEBI (Alternative Investment Funds) Regulations, an AIF can be registered as a Trust or a Company or a Limited Liability Partnership (LLP) or a Body Corporate.

The AIF is formed by a Sponsor, with a minimum contribution and adequate skin-in-the-game. The footnote defines the phrase: Skin-in-the-game is a phrase used to ensure that the Manager also bears financial risk by investing in the AIF, along-with other investors, and managing the fund to achieve a common risk-return objective.

The chain of formation, in order:

An AIF formed as a trust requires a 'settlor' to settle the trust, who in turn appoints the Trustee by executing the trust deed. The trustee then enters into an Investment Management Agreement with the Manager to delegate its powers in respect of management and administration of the AIF. Once the Fund is formed, it applies for registration with SEBI through a Merchant Banker and seeks for capital commitments from investors, domestic or foreign investors. After receiving the investment contribution and identifying suitable investments for the fund, the Fund can invest directly in the investee companies.

Trace it once: settlor → trustee (via trust deed) → manager (via Investment Management Agreement) → SEBI registration through a merchant banker → capital commitments → investments. The settlor is a party you have not met before; it exists only in the trust route.

The Manager or Sponsor appoints the service providers, such as: Custodian for the purpose of safekeeping the securities on behalf of the investors, Fund Administrator for maintenance of accounts and investor reporting, Registrar and Transfer Agents for recording the buying and selling of units of the funds by investors, other professionals, such as Auditors, Tax Advisors, Legal Professionals, Registered Valuers and Investment Advisors etc.

In a limited liability partnership structure (LLP), the sponsor of the fund is the Designated Partner and is responsible in respect of all statutory compliances stipulated for the LLP. In most of the foreign jurisdictions, the manager of the fund is known as the General Partner (GP), while the investors subscribing to units in the fund are known as Limited Partners (LPs).

GP = manager. LP = investor. In an Indian LLP, the sponsor is the Designated Partner.

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Open-ended and closed-ended

As per SEBI (AIF) Regulations, a Category III AIF can be structured either as an open-ended fund or a closed-ended fund. However, the other two categories are mandatorily close ended funds only.

This is a single-line, high-frequency exam fact. Only Category III has the choice. Categories I and II are mandatorily closed-ended.

Open-ended Fund Structure

In an Open-ended fund structure, investors contribute capital at the time of subscription. The open-ended schemes offer units to investors on a continuous basis and do not have a fixed maturity period. Hence, investors can buy units or sell units from the AIF at any time, thereby making the corpus of the fund variable. Open-ended schemes permit investors to redeem capital at regular intervals, viz. monthly, quarterly or semi-annually.

Note the contrast with commitment-and-drawdown: in an open-ended fund investors contribute capital at the time of subscription — the money goes in at once, not in tranches.

Closed-ended Fund Structure

Closed-ended funds are offered to investors for a limited time period, as specified by the Manager of the fund, in the Placement Memorandum. Closed-ended funds require investors to make a capital commitment from time to time, within the specified commitment period. Commitment periods for closed-end funds typically range from 3-5 years from the final closing date.

Closed-end funds do not permit redemptions of capital at any time prior to the expiration of the fund, except in extraordinary circumstances. Most AIFs in industry would have a lock-in period of 1-2 years, post which investors would be permitted to redeem their capital by paying an exit load, for redemption/exits between periods of 2-3 years from the completion of the lock-in period.

Example: An AIF launches a closed-ended scheme for 5 years, with an option given to investors to exit from the scheme after expiry of a lock-in period of 2 years, by paying an Exit Load. For exits made after the completion of lock-in period, till the end of the fund tenure, exit load will be paid by the investor, as specified by the Manager in the Private Placement Memorandum.