Author: V S Sambandan

Source: Hedge Funds Review | 09 Aug 2011

India has released draft regulations that could create a platform for the emergence of a domestic hedge fund industry.

In early August, India joined the list of countries reworking domestic rules to regulate hedge funds. A concept paper by the country’s regulator, the Securities and Exchange Board of India (Sebi), which includes the “indicative regulations”, has been released for comments.

The draft Securities and Exchange Board of India (Alternative Investment Funds) Regulations 2011 includes provisions that would drastically alter the way the Indian fund management industry is run. The document is open for comments until August 30.

India’s investment management regulation is currently limited to mutual funds, collective investment schemes, venture capital funds (VCFs) and portfolio managers. The proposed regulation widens the range of funds allowed to be marketed in India and also includes specific hedge funds under one of the nine categories to be governed by the proposed regulations.

There are few hedge fund managers operating in India. Most managers exploiting opportunities in the country are based outside in Singapore, Mauritius and Hong Kong as well as the UK and the US.

Given the rise of wealthy individuals as well as institutional investors interested in a broader range of investment choice in India, the proposed regulation could nurture the development of a domestic hedge fund industry.

A related issue India will have to address will be how it develops local service providers to support the emergence of hedge funds.

Under the proposed regulations Sebi will “register and regulate the formation of investment funds” that raise capital from institutional or high net worth individuals (HNWI) interested in investing “in accordance with a defined investment policy for the benefits of those investors”.

Hedge funds are not listed as a separate category in the discussion document but all under “strategy funds”. These are described as a “residual category including all varieties of funds such as hedge funds”.

Vik Mehrotra, fund manager at the US-based hedge fund Venus Capital which runs a number of India-focused strategies, welcomed the draft regulations. They will “increase the transparency in the alternative investment fund industry and will benefit all the stakeholders,” he told Hedge Funds Review.

Pointing out the need for long-term cost-effective funding sourced from private pools of capital, he said the draft was a “welcome beginning” as regulations would “evolve over a period of time because these are generally complex vehicles of investment”.

Akil Hirani, an Indian lawyer who has been calling for a more liberal approach from the country’s regulator with respect to hedge funds, also welcomed the draft regulations “as they seek to fill in some gaps in the current regulations”.

The current Sebi (Venture Capital Funds) Regulations 1996 “need a revamp because they were enacted in an era when venture capital was in its nascent stage globally. From this perspective, the new regulations are welcome as they seek to fill in some of the gaps in the current regulations,” commented Hirani, a managing partner in a Mumbai-based international law firm Majmudar.

According to the concept paper, “any fund operating as [a] hedge fund shall be required to be registered as a strategy fund”. The strategy funds would “be guided by the strategy it specifies at the time of registration with no other restrictions”, it added.

The proposed regulation defines a strategy fund as one that includes “all those private investment funds including any entity operating as a hedge fund, displaying any one or a combination of some of the following characteristics: pooling of capital from institutional or high net worth investors for investment in securities, derivatives and structured products; more diverse risks or complex underlying products are involved”.

In addition Sebi proposes to impose five conditions on strategy funds. A fund may “specify any strategy in any class of financial instruments” and invest in derivatives and complex structural products subject to requirement of suitability and disclosure to investors”.

A strategy (hedge fund) fund would be allowed to leverage long or short funds with consent from the investors subject to a maximum leverage “as may be specified” by Sebi.

Transparency is also highlighted in the paper. Funds employing leverage “shall disclose information regarding the overall level of leverage employed, the leverage arising from borrowing of cash or securities and the leverage arising from position held in derivatives, the reuse of assets and the main source of leverage in their fund”, the draft said.

Strategy funds will also need to “ensure that the leverage limits are reasonable and shall demonstrate how it complies at all times with those reasonable limits”.

The concept paper said the proposed regulations will make registration a mandatory requirement for funds intending to operate under nine specified categories: VCFs, Pipe (private investment in public equity) funds, private equity funds, debt funds, infrastructure equity funds, real estate funds, SME funds, social venture funds and strategy funds.

Such funds could be formed as companies, trusts or body corporates, including limited liability partnerships.

The proposed regulations detail disclosure of information that would be required. The fund manager, asset management company or trustees of the company would report specific information as well as any changes in structure or trading conditions directly to Sebi.

When registering with the regulator a fund would need to “specify the category under which it is seeking registration, the targeted size of the proposed fund, its life cycle and the target investor”.

The proposed regulations provide for reporting and disclosure norms that have to be followed strictly by funds.

In addition Sebi is also contemplating prescribing various investment conditions. “The draft regulations seem to be adequate, although with regard to strategy funds, under which hedge funds fall, some of the conditions may not be feasible,” said Hirani. He was referring to restrictions on the number of shareholders or partners to 50 and the mandatory requirement that funds be close-ended. Both these
conditions are contained in the consultation document.

Pawan Badhla, assistant fund manager at Venus Capital, said hedge funds could merit a separate category on their own. “We think hedge funds should have a separate category due to the variety and complexity of their investments.”

Some other grey areas in the draft regulations have also been highlighted. For instance, although Sebi proposes permitting leverage, it is unclear if the Indian banking system would support this. It is also unclear if foreign banks with prime brokerage facilities would be able to operate such services in India for locally based hedge funds.

Another unresolved issue is the provision under section 11 (1) of the draft regulations. This says “funds shall be close-ended and the duration of fund shall be determined at the time of registration”. Hedge funds are open-end structures.

Usually Sebi conducts an internal consultation after comments are received and before a decision is taken on whether to go ahead with
proposed regulations. If the regulatory body decides to implement the regulation, it could take anywhere between three to six months for
adoption, according to an informed source.

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