Addressing Regulatory Arbitrage: Foreign Investment Compliance Recommendations for AIFs

[Harit Gandhi and Mukund Arora are fourth-year law students at National Law School of India University, Bangalore and Symbiosis Law School, Pune, respectively]

Recently, commitments in alternative investment funds (‘AIF’) crossed INR 10 trillion for the first time amid rising demand from high net-worth individuals. As of December 2023, the investment commitments amounted to INR 10.84 trillion, showing a quarterly increase of 13.6% and a yearly surge of over 40%. Currently, foreign investors play a dominant role in India’s AIF industry, with foreign investments constituting a significant portion of the capital involved. This reflects a growing trend of international investment in sectors like infrastructure, technology, and retail, prompting regulatory measures to manage foreign investment inflows, attracting regulatory restrictions for foreign investments. Rising foreign investments through AIFs require effective compliance with foreign investment laws.

The Securities and Exchange Board of India (‘SEBI’), in its January 19, 2024 consultation paper, identified multiple cases of AIFs structured to bypass financial regulatory frameworks, particularly sectoral norms under the Foreign Exchange Management Act, 1999 (FEMA) and prohibited sectors in terms of the Foreign Direct Investment (‘FDI’). This development casts a shadow on the legitimacy of AIF investments.

This post will begin by analyzing the operation of AIFs and identifying the loopholes that facilitate regulatory arbitrage. It will then move on to review SEBI’s policy recommendations and explore methods to enhance protection with the twin aims of sustaining capital formation and ensuring regulatory compliance.

AIFs and Sectoral Caps: Navigating Regulatory Restrictions

Rule 23(7)(g) of the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (the ‘NDI Rules’) defines downstream investment as one made by an Indian entity that possesses significant foreign investment, or by an investment vehicle, into the capital instruments or capital, as applicable, of another Indian entity. In essence, this provision contemplates that an Indian entity, subject to foreign investment exceeding the threshold of 50%, or an Indian company or limited liability partnership (‘LLP’) that is either owned or controlled by non-residents or foreign citizens to the extent of 50% or more, is categorized as an indirect foreign investor. When an Indian entity is deemed an indirect foreign investor, any investment it undertakes is classified in its entirety as indirect foreign investment (‘IFI’), disregarding any notion of proportionality. For instance, should an Indian company be the recipient of 60% foreign investment, any downstream investment executed by this company will be wholly regarded as IFI. Once categorized as downstream investment, then under rule 23 of the NDI Rules the Indian entity is subject to the entry route, sectoral caps, pricing guidelines, and as mandated by the 2020 Consolidated Foreign Direct Investment (FDI) Policy.

However, in terms of Schedule VIII of the NDI Rules, an exception is made to investments made by investment vehicles such as AIF. Investment made by an investment vehicle depends only on the domicile of its manager or sponsor rather than the quantum of foreign investment in the fund. An investment made by a foreign-funded AIF into an Indian entity shall be reckoned as a domestic investment if it is owned and controlled by a manager or sponsor who is a resident Indian citizen or a person resident outside India (‘PROI’). In such cases, the investment need not comply with the restrictions outlined in rule 23. Definitions of ‘ownership’ and ‘control’ can be derived from the 2020 Consolidated FDI Policy. Ownership refers to owning or beneficially owning more than 50% of the capital in the company; whereas ‘control’ includes the right to appoint the majority of the directors or to control the management or policy decisions.

The current regulatory framework for AIFs has inadvertently facilitated scenarios where foreign investors set up domestically managed AIFs, aiming to circumvent restrictions or sectoral caps on investments. This practice has garnered attention from SEBI, with the investment by Amazon and SAMARA AIF (domestically owned and controlled by SAMARA Capital) in Witzig Advisory Limited serving as a prominent example. The Consolidated FDI Policy restricts foreign investment in the multi-brand retail sector to a maximum of 51%, following the government-approved route and subject to other conditions. In its pursuit of entry into the Indian retail market, Amazon navigated these constraints by securing a substantial stake in Witzig Advisory, a company engaged in facility management, support, and property services. In 2018, Witzig acquired More Retail Ltd., the fourth-largest supermarket chain in India, from the Aditya Birla Group. The following year, Amazon and SAMARA AIF acquired stakes of 49% and 51%, respectively, in Witzig Advisory. The Confederation of All India Traders (‘CAIT’) raised allegations that by investing in SAMARA AIF, though not publicly disclosed, Amazon effectively exceeded the 51% investment ceiling in the retail sector. They argued that Amazon’s 49% stake in Witzig, combined with a major investment in SAMARA AIF, would aggregate to an indirect ownership well above the permitted limit. However, such aggregate calculations are futile given SAMARA AIF is domestically owned and controlled by SAMARA capital. Similar to SAMARA AIF, there might be other AIFs structured to invest in prohibited or restricted sectors.


In all SEBI identified over 40 transactions with a combined value of approximately INR 30,000 crores, accounting for about 3% of the AIF market. The 40 cases are inclusive of other regulatory breaches such as evergreening, which suggest a minor proportion of FDI sectoral violations, likely under 3%. The majority of the AIF are deployed in real estate (20.1%), followed by IT/ ITeS (6.3%), financial services (6.1%), non-banking financial services (5.3%), banks (4.0%), and pharmaceuticals (3.7%). The top six sectors accounted for around 46%  of total deployment of funds by AIFs as of the end of March 2023. These sectors normally have relaxed sectoral norms, while other sectors contribute minimally to the overall AIF market. Furthermore, no significant investments in prohibited sectors have been observed according to data in the SEBI annual report. Although the regulatory arbitrage through bypassing sectoral caps may not be a substantial concern, the possibility of a large-scale circumvention cannot be neglected. This highlights the need for vigilance to prevent widespread abuse of the regulatory framework.

To address the problem, the SEBI Consultation Paper suggests that where an investment by an AIF may result in a sectoral breach for an investor, the AIF may choose to excuse the investor’s participation in the investment. According to the SEBI Circular titled ‘Guidelines with respect to excusing or excluding an investor from an investment of AIF’, the AIF may exclude an investor’s participation if the investment manager (IM) is satisfied that the participation of such investor in the investment opportunity would lead to the scheme of the AIF being in violation of applicable law or would result in a material adverse effect on the scheme of the AIF. The suggestion is a welcome move. However, there is no clarity on how to identify an investment that would breach sectoral norms. This method would theoretically require determining the pro-rata share of an AIF investor in the particular investment, calculated based on the investor’s pre-existing investments in the sector or investment, to find the total investment in the sector. Furthermore, given the high number of investments made by AIFs, a complex calculation for pro-rata share in each investment seems unviable. This approach may also lead to subjectivity in determining sectoral breach.

Enhancing Transparency and Compliance

The Consultation Paper notes that most instances of circumvention involve a sole investor or a group of closely connected investors who exercise control over the AIF. Presently, under section 90 of the Companies Act, 2013, the significant beneficial owner (‘SBO’) may only be traced back to an AIF without considering the ultimate beneficiaries or unit holders of the AIF. Consequently, if a single investor primarily owns an AIF, and that AIF holds a controlling interest in a company, the true beneficiary could effectively hide their status as an SBO.

As a solution, it is proposed that the SEBI (Alternative Investment Funds) Regulations, 2012 (the ‘AIF Regulations’) delineate a requisite minimum number of unrelated investors within each AIF structure. Regulation 10(f) specifies the maximum number of investors in an AIF as one thousand. A minimum number of unrelated investors could prevent a dominant control in an AIF and consequent circumvention of sectoral breach. Alternatively, SEBI may mandate reporting details of a ‘single beneficial investor’ of an AIF. This requirement, similar to the one recently mandated by the Ministry of Corporate Affairs through the Limited Liability Partnership (Significant Beneficial Owners) Rules, 2023, aims to enhance transparency.

According to the AIF Regulations, SEBI also requires several declarations from the applicant aimed at piercing the corporate veil at the point of registration. These declarations encompass fit and proper criteria, information regarding controlling entities/persons, key management personnel (‘KMPs’), the key investment team, and the like, and require specification of the shareholding structure of the sponsors and managers. Therefore, ownership and control of the applicant are always disclosed to SEBI, which can indicate whether the fund is controlled by a foreign entity.

As another viable solution, SEBI may further require disclosure on foreign portfolio investments (FPI) and FDI investments of foreign controlling entities and demand a declaration ensuring that no provisions of these regulations are violated by investments through the AIF. In furtherance of AIF obligations recommended in the Consultation Paper, this will enhance the due diligence of the AIF for its investors, even when the entity is not foreign-controlled. From the fund’s perspective, it may seek to limit its liability by requiring representations from the investors regarding compliance with applicable law and, consequently, indemnifications through their contribution/investment agreements.


Enhancing transparency and compliance within the AIF regulatory framework is necessary not only for preserving investor confidence but also for maintaining the stability and integrity of India’s financial markets. By fostering a regulatory environment for investment funds that promotes adherence to international investment regulations, SEBI can facilitate sustainable growth and development in the AIF industry while mitigating risks associated with regulatory arbitrage.

Harit Gandhi & Mukund Arora

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