Critical Update for Alternative Investment Funds (AIFs): SEBI Mandates New Due Diligence Framework (Circular dated October 8, 2024)

On October 8, 2024, SEBI issued Circular SEBI/HO/AFD/AFD-POD-1/P/CIR/2024/135, mandating rigorous due diligence (DD) requirements for AIFs. These measures are a significant step in enhancing financial integrity and addressing Regulatory concerns in areas like FEMA compliance, QIB/QB statuses, and AML-CFT standards. Here’s a closer look at the key aspects and implications for AIFs, managers, and investors:

?Understanding the Applicability of Due Diligence (DD):

?The DD requirements apply under specific conditions to mitigate SEBI’s concerns regarding the misuse of AIF structures. Here’s when DD is required:

1. ?Qualified Institutional Buyer (QIB) Benefits: Applies if investors or related entities contribute 50% or more to the corpus of an AIF scheme. The DD checks ensure only eligible investors benefit from QIB privileges, preventing regulatory arbitrage.
2. Qualified Buyers (QB) Benefits under the SARFAESI Act: DD is mandatory if 50% or more of an AIF scheme’s corpus is funded by investors who independently lack QB status, ensuring compliance.
3. RBI-Regulated Entities: DD applies when an AIF manager or sponsor is regulated by RBI—or if RBI-regulated investors contribute 25% or more and hold substantial influence over fund decisions, helping prevent circumvention of RBI prudential norms, especially in handling distressed assets.
4. Investors from Neighbouring Countries: Investments originating from countries sharing land borders with India (e.g., China, Pakistan) are subject to DD if contributions reach 50% or more of an AIF scheme’s corpus, in compliance with FEMA Non-Debt Instrument Rules.

Exemptions:

Certain scenarios offer exemptions from these DD requirements:

1. ?Non-significant Contributions: When no single investor or group contributes 50% or more, or, in the case of RBI-regulated entities, 25% or more of a scheme’s corpus, the DD requirement may not be triggered.
2. Fully Compliant Entities: Entities already compliant with regulatory norms, including certain sovereign wealth funds or government-controlled investors, may qualify for relaxed DD protocols.

Key Definitions - ‘Investors Under the Same Group’:

The term “investors from the same group” is defined by SEBI Listing Regulations, which classify investors as related parties or relatives. Contributions from related entities or relatives (holding 10% or more equity in each other or part of a promoter group) will be aggregated. This aggregation is critical to ensure transparency and prevent circumvention through fragmented investments.

Why Is Due Diligence Required? Targeted Risks & Key Areas:

SEBI’s DD mandate addresses several targeted risks to safeguard AIFs’ integrity. Here’s why these checks are crucial:

1. Regulatory Arbitrage: Without DD, AIFs could be used to secure benefits meant for QIBs or QBs, even if investors don’t independently qualify. DD prevents related entities from bypassing eligibility by concentrating investments within an AIF structure.
2. Loan Evergreening: To avoid the “evergreening” of stressed assets, SEBI requires thorough checks on RBI-regulated entities. The DD process ensures that investments address actual financial health, preventing NPAs from being concealed within AIF structures.
3. FEMA Compliance & Border Country Investments: DD requirements on contributions from land-bordering countries ensure adherence to India’s Foreign Exchange Management Act (FEMA), safeguarding national security interests and reducing risks tied to foreign influence.
4. AML-CFT Alignment: Enhanced DD protocols are integral to India’s Anti-Money Laundering and Combating the Financing of Terrorism (AML-CFT) measures. By mandating detailed checks, SEBI aids in deterring illicit financing, aligning with global AML-CFT efforts and ensuring that all funds meet strict compliance standards.

Reporting & Compliance Deadlines:

For Existing Investments (as of October 8, 2024): DD must be completed and findings reported to custodians by April 7, 2025.

For New/Prospective Investments: DD should be completed prior to accessing any QIB/QB benefits or formalizing investments from regulated entities to ensure initial compliance.

If DD Outcome is Satisfactory: Managers must submit an undertaking to the AIF’s custodian by April 7, 2025.

If DD Outcome is Unsatisfactory: Details of non-compliant investments must be reported, and either these investors are to be excluded or the investment itself abandoned.

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Can the Due Diligence work be outsourced?

Outsourcing DD – Accountability Remains with AIFs & Management:

?SEBI’s circular emphasizes that while AIFs can engage third-party providers to assist with DD, ultimate accountability remains with the AIF, its managers, and KMPs. This approach reinforces the responsibility of AIFs to ensure all investor activities align with SEBI’s compliance standards, supporting a secure, transparent investment ecosystem in India.

Balancing Compliance with Operational Demands:

While this SEBI circular undeniably strengthens India’s regulatory framework, aligning AIFs with AML-CFT standards and enhancing financial transparency, it also brings additional compliance responsibilities—and with them, heightened operational and financial burdens for AIFs. The expanding scope of due diligence requirements means that AIFs and their managers must allocate more resources to uphold these rigorous standards, impacting overall cost structures.

In adapting to these requirements, AIFs are not only supporting India’s financial integrity and regulatory aims but also fostering a trusted investment environment. Yet, as these mandates grow, it’s crucial to consider the cumulative compliance load on AIFs and seek ways to streamline these processes to ensure sustainable operations within the sector.