Funds Hotline
June 9, 2024
Indian LP investments in Overseas Funds - Rules Liberalised
Indian LPs now permitted
to invest in overseas funds regulated through
their manager Indian LP investment
not limited to only units issued by overseas
funds, but any instrument by whatever name
INTRODUCTION
On Friday, the Reserve Bank of India (“RBI”)
issued a highly anticipated circular introducing
two key amendments (“Circular”)1.
Firstly, it permits Indian LPs to invest in overseas
funds regulated through their managers, doing away
with the erstwhile condition that investment could
only be made in funds that were directly regulated
by the financial regulator of the host country.
Secondly, it removes the restriction limiting Indian
LP investment solely in units issued by overseas
funds, and now allows investments in any instrument,
regardless of its form.
Background
Indian LP investment in overseas funds is governed
by a combined reading of the Foreign Exchange Management
(Overseas Investment) Rules, 2022 (“OI
Rules”) and the
Foreign Exchange Management (Overseas Investment)
Directions, 2022 (“OI Directions”),
(together read as the “OI Framework”).
Barring a few specific exemptions,
the OI Framework provides that any investment into
unlisted equity capital of a foreign entity should
be treated as Overseas Direct Investment (“ODI”),
even if such investment does not afford the investor
control of the foreign entity and is less than 10%
of the foreign entity’s share capital.
Accordingly, on a plain reading
of the OI Rules, any LP portfolio investment into
an overseas fund (other than a fund set up in GIFT
City) may be treated as ODI and accordingly be subject
to certain key restrictions including pricing and
reporting requirements. Moreover, as the OI Rules
do not permit individuals to make ODI into financial
services, the provisions of the OI Rules read in
isolation seem to completely cut off individual
LP investment into overseas funds.
However, the OI Rules are not
read in isolation; they are read with the OI Directions.
Prior to the amendments introduced through the
Circular, Paragraph 1(ix)(e) of the OI Directions
clarified that investment (including
sponsor contribution) in units of any investment
fund overseas, duly regulated by the regulator for
the financial sector in the host jurisdiction, shall
be considered as Overseas Portfolio Investment (OPI).2
Accordingly, a route had been carved out for listed
Indian companies and resident individuals3
to make OPI into overseas funds; however, the permission
was subject to the following two conditions –
the investment had
to be made in ‘units’ of
the overseas fund; and the fund had to be
regulated in its home jurisdiction.
Investment in Units
Most offshore funds are typically set up as corporate
bodies issuing shares/stock or partnership/membership
interest, rather than as trusts issuing units. As
such, when the OI Framework was first released,
the limiting language created confusion amongst
Authorised Dealer Banks (“AD Banks”)
who were not sure whether OPI should be permitted
into securities other than units. More recently,
AD Banks have been taking a more pragmatic approach
and permitting investment in overseas funds as OPI
even if the instrument issued was not a unit.
Investment in regulated overseas
funds
Based on the erstwhile language
of Paragraph 1(ix)(e) of the OI Directions there
was a general consensus in the industry as well
as amongst AD Banks that OPI investment should not
be permitted unless the fund itself, and not the
manager, was regulated in the host jurisdiction.
However, there was some ambiguity as to whether
the scope of the phrase “duly regulated”
extended to funds which were in substance regulated,
but only through their managers. The approach
that AD Banks generally took was to only permit
remittance where the fund was directly regulated.
As a result, not only were Indian
LPs limited in their ability to make new overseas
investments, but LPs who had already committed capital
before the OI Framework was introduced encountered
difficulties in meeting their commitment obligations
where the fund was located in a jurisdiction whose
financial sector regulator did not directly regulate
the fund. Moreover, new funds had to be set up in
jurisdictions like the Cayman Islands, Mauritius
or GIFT City, to ensure that investment from Indian
LPs would be possible.
Analysis of New Regime:
Considering the diverse legal
and regulatory framework governing investment funds
across various jurisdictions, the Circular has now
amended paragraph 1(ix)(e) of the OI Directions
to do away with both of the above-mentioned conditions
Specifically, the original text
has been replaced with the following language - “The
investment (including sponsor contribution) in units
or any
other instrument (by whatever name called)issued
by an investment fund overseas, duly regulated by
the regulator for the financial sector in the host
jurisdiction, shall be treated as OPI…”
The following explanation has
also been added “Explanation: ‘investment
fund overseas, duly regulated’ for the purpose
of this para shall also include funds whose activities
are regulated by financial sector regulator of host
country or jurisdiction
through
a fund manager.”
By permitting OPI investments
in overseas funds regulated through their managers,
the RBI has granted GPs the flexibility to establish
their funds in commercially favorable jurisdictions
without having to worry about whether Indian investments
would be permitted. This flexibility was crucial,
as the financial services regulators in popular
fund jurisdictions like Singapore and the US (in
some cases), regulate the fund manager rather than
the fund itself. In such jurisdictions, the fund
is in substance still regulated to some extent,
but through its manager.
With the language of Paragraph
1(ix)(e) of the OI Directions amended, Indian resident
individuals as well as Indian listed companies should
now be able to make OPI without ambiguity –
neither with respect to whether the fund or its
manager is regulated nor with respect to the nature
of the instrument being issued. This will not only
re-open the door for LP investment in VCC funds
in Singapore as well as funds set up in Delaware,
subject to the manager being regulated, but will
also allow Indian employees of Indian advisory entities
to participate in overseas funds.
The amendment not only allows
flexibility with respect to jurisdiction, but also
with respect to the legal form of the fund. As OPI
is no longer limited to only investments made into
units of offshore funds, GPs now have the flexibility
to set up funds as Limited Partnerships, LLC, VCCs,
companies, etc.
It is interesting to note that
the move to allow OPI into funds regulated through
their managers is consistent with the treatment
of LP investment into funds established in GIFT
City. While the regulatory framework governing funds
in GIFT City (ie. the IFSCA (Fund Management) Regulations,
2022), regulates the manager and not the fund, Schedule
V of the OI Directions clearly permits LP investment
into such funds as OPI.4 In fact, when
the OI Framework was first introduced, the fact
that it was the only overseas jurisdiction in which
LP investment was permitted despite the funds not
being directly regulated was one of GIFT City’s
distinguishing features. That being said, while
the requirement that an overseas fund be directly
regulated has been done away with, GIFT City continues
to be the only overseas jurisdiction in which unlisted
Indian entities can still make OPI into investment
funds under Schedule V of the OI Directions.
Overall, the Circular offers
a great opportunity for Indian LPs to access a wider
range of investment options and aligns the OI Directions
with industry needs and international practices,
fostering a more dynamic investment environment
and positioning Indian LPs to seize opportunities
in the global markets.
Authors
Chandrashekar K,
Radhika Parikh and
Parul Jain
Funds Team
Nishith Desai, Global Strategy
Parul Jain, Fund Formation and International Tax
Radhika Parikh, Fund Formation and GIFT City
Prakhar Dua, Fund Formation and FSR
Chandrashekar K, Regulatory and Compliances
You can direct your queries or comments to the relevant member.
1A.P. (DIR Series) Circular No. 09, dated 07 June 2024 (RBI/2024-25/41)
2Paragraph 1(ix)(e) of the OI Directions
3The OI Directions did not extend
the ability to make OPI into overseas fund to unlisted
entities
4Rule 15, Paragraph 2(iii) of Schedule
V of OI Rules.
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