Table of Contents
Chapter 15: Regulatory Framework
Statutory Registration and Core Parameters for Category III AIFs
Category III Alternative Investment Funds in India operate under the statutory governance of the SEBI (Alternative Investment Funds) Regulations, 2012:
Statutory Operational Thresholds (Category III AIFs):
┌──────────────────────────────────────┬──────────────────────────────────────────┐
│ Parameter │ Statutory Mandate │
├──────────────────────────────────────┼──────────────────────────────────────────┤
│ Minimum Scheme Corpus │ ₹20 Crores │
│ Minimum Investor Commitment │ ₹1 Crore (₹25 Lakhs for Employees) │
│ Maximum Number of Investors │ 1,000 investors per scheme │
│ Sponsor / Manager Commitment │ 5% of corpus or ₹10 Crores (lower) │
│ Single Investee Concentration Cap │ Max 10% of investable funds │
│ Permitted Structure │ Close-Ended OR Open-Ended │
│ Mandatory Dematerialization │ All units must be in demat form │
│ Direct Plan Requirement │ Mandatory direct plan (zero commission) │
└──────────────────────────────────────┴──────────────────────────────────────────┘
Single Investee Concentration Cap: 10% Rule
Unlike Category I and II AIFs which are permitted to allocate up to 25% of their investable funds into a single investee company, Category III AIFs are strictly restricted to investing no more than 10% of investable funds in a single investee company.
- Rationale: Protects the fund against idiosyncratic corporate shocks and prevents concentration risk in liquid market strategies.
- Large Value Funds (LVFs): Can invest up to 20% of investable funds in a single investee company.
SEBI Operational Guidelines on Leverage and Prudential Limits
Under Regulation 18 of the SEBI AIF Regulations and the comprehensive SEBI Circular on Operational Guidelines for Category III AIFs, leverage deployment is rigorously bounded:
Gross Exposure / Leverage Formulation:
Gross Exposure = Total Long Positions + |Total Short Positions| + Derivative Notional Values
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Net Asset Value (NAV)
STATUTORY LEVERAGE LIMIT: Gross Exposure must NOT exceed 2 times Net Asset Value (200% of NAV)
1. The 2x NAV Leverage Limit
- A Category III AIF cannot take leverage (whether through physical borrowing or through the economic exposure of derivative contracts) exceeding 2 times its Net Asset Value (i.e., gross exposure $\le 200%$ of NAV).
- Calculation methodology: The gross exposure is calculated as the sum of the absolute value of all long positions, absolute value of all short positions, and the gross notional contract value of all derivative positions, divided by the fund’s Net Asset Value.
- Exception for LVFs: Large Value Funds for Accredited Investors can exceed 2x NAV leverage, provided the maximum leverage is explicitly specified in the PPM and approved by investors.
2. Risk Management Architecture Mandates
SEBI mandates that every Category III AIF employing leverage must establish:
- Comprehensive Risk Management Framework (RMF): Documented policies for market risk, credit risk, liquidity risk, operational risk, and legal risk.
- Independent Risk Management Function: A dedicated Risk Management Team independent from the front-office portfolio trading team.
- Stress Testing: Mandatory quarterly stress testing against historical and hypothetical market stress scenarios.
- Daily Leverage Reporting: Maintaining daily audit logs of gross and net exposure calculations, accessible to SEBI upon inspection.
The Multi-Regulatory Compliance Matrix
A Category III AIF manager navigates an overlapping matrix of federal statutes ensuring integrity, anti-money laundering, and systemic stability:
Regulatory Compliance Pillars:
┌─────────────────────────┐ ┌─────────────────────────┐ ┌─────────────────────────┐
│ FEMA NDI Rules 2019 │ │ PMLA & KYC Mandates │ │ SEBI (PIT) & SDD │
│ Downstream FOCC test; │ │ 10% UBO threshold; │ │ Structured Digital Data-│
│ Indirect foreign invest │ │ PEP screening; FIU-IND │ │ base; UPSI management │
└─────────────────────────┘ └─────────────────────────┘ └─────────────────────────┘
1. Foreign Exchange Management Act (FEMA Non-Debt Instruments Rules, 2019)
- Downstream Investments & The FOCC Test: If the Manager and the Sponsor of the Category III AIF are Indian Owned and Controlled (more than 50% equity ownership and management control held by resident Indian citizens), the downstream investments made by the AIF are considered domestic investments, regardless of the quantum of foreign capital contributed by offshore LPs.
- If the Manager or Sponsor is Foreign Owned or Controlled (FOCC), all downstream investments must comply with FDI sectoral caps, entry routes, and pricing guidelines.
2. Prevention of Money Laundering Act (PMLA, 2002)
- Strict Customer Due Diligence (CDD) procedures.
- Mandatory identification of the Ultimate Beneficial Owner (UBO) holding at least 10% interest in corporate or trust entities.
- Verification against Politically Exposed Persons (PEPs) lists and suspicious transaction reporting (STR) to FIU-IND.
3. SEBI Prohibition of Insider Trading (PIT) & Structured Digital Database (SDD)
- Maintaining an immutable, tamper-proof Structured Digital Database (SDD) recording the details of all Unpublished Price Sensitive Information (UPSI) handled by fund analysts and managers.
4. SEBI PFUTP Regulations & SMART ODR Dispute Resolution
- Complete prohibition on manipulative trading, circular transactions, painting the tape, or wash sales under the SEBI (PFUTP) Regulations.
- Integration with SEBI's SMART ODR Platform for online, independent dispute resolution between unit-holders and the fund.