Private Equity & Venture Capital: Fund Formation in India

This FAQ has been prepared to address the most commonly asked questions by fund sponsors, promoters, investors, and intermediaries seeking to establish Private Equity (PE) or Venture Capital (VC) funds in India. It covers the regulatory framework, fund structures, tax treatment, foreign investment, and practical considerations under the SEBI Alternative Investment Funds (AIF) Regulations, 2012 and allied laws.

A. Fundamentals Of Fund Formation

Q1. What is an Alternative Investment Fund (AIF) in India?

An Alternative Investment Fund (AIF) is any fund established or incorporated in India that is a privately pooled investment vehicle. It collects funds from investors, whether Indian or foreign, for investing in accordance with a defined investment policy for the benefit of its investors.

AIFs are regulated by the Securities and Exchange Board of India (SEBI) under the SEBI (Alternative Investment Funds) Regulations, 2012 and are distinct from mutual funds, collective investment schemes, and other publicly offered vehicles.

KSK Note: PE and VC funds in India are overwhelmingly registered as Category I or Category II AIFs under the AIF Regulations.

Q2. Which SEBI AIF category is applicable to PE and VC funds?

SEBI classifies AIFs into three categories based on their investment focus and strategy:

• Category I AIF: Includes Venture Capital Funds (VCFs) and Angel Funds. Invests in start-ups, early-stage ventures, SMEs, and sectors considered economically or socially desirable.
• Category II AIF: Includes Private Equity Funds and Debt Funds. These do not fall under Category I or III and do not use leverage beyond day-to-day operational needs. Most mid-to-late-stage PE funds register as Category II.
• Category III AIF: Hedge funds and PIPE funds employing complex trading strategies and leverage. Not typical for PE/VC.

KSK Note: VC funds typically register as Category I; PE funds (buyout, growth equity) as Category II. The choice affects tax treatment, permissible investments, and reporting obligations.

Q3. Can a foreign entity sponsor or manage an AIF in India?

Yes, subject to conditions. A foreign entity or a foreign-owned and controlled entity may act as the Sponsor or Investment Manager of an AIF registered in India. However, where the Sponsor or Investment Manager is foreign-owned or foreign-controlled, downstream investments by the AIF into Indian portfolio companies will be characterised as indirect Foreign Direct Investment (FDI) and must comply with FEMA sectoral caps, entry routes, and pricing norms.

If the Sponsor and Investment Manager are Indian-owned and Indian-controlled, the foreign investment flowing into the AIF is not treated as indirect FDI, providing significantly greater investment flexibility.

KSK Note: Structuring the sponsor and manager as Indian-controlled entities is a commonly deployed strategy for global GPs seeking to deploy capital in India without FDI characterisation risk.

Q4. What is the minimum corpus and minimum investor commitment for an AIF?

The SEBI AIF Regulations prescribe the following minimums:

• Minimum Corpus per scheme: INR 20 crore (approximately USD 2.4 million).
• Minimum investment per investor: INR 1 crore (approximately USD 120,000), except for employees or directors of the AIF/Investment Manager where the minimum is INR 25 lakh.
• Sponsor / Manager continuing interest: The lower of 2.5% of the corpus or INR 5 crore, held throughout the life of the fund.
• Maximum number of investors per scheme: 1,000 (Category I & II); 1,000 for Category III (with up to 1,000 per sub-scheme).

B. Fund Structure And Legal Vehicles

Q5. What legal structure is typically used for an AIF in India?

An AIF may be established as a trust, a company, a body corporate, or a Limited Liability Partnership (LLP). In practice, the vast majority of AIFs including PE and VC funds, are structured as irrevocable private trusts under the Indian Trusts Act, 1882 or applicable state legislation.

The trust structure is preferred for its operational flexibility, pass-through tax treatment (for Category I and II AIFs), familiarity to institutional investors, and the ability to create multiple investment schemes under a single trust umbrella.

Q6. Who are the key parties in an AIF trust structure?

A typical AIF trust structure involves four key parties:

• Sponsor: The settlor of the trust who contributes the initial corpus (typically a nominal amount of INR 1 lakh or as agreed) and sets the trust in motion. The Sponsor must maintain its continuing interest throughout the life of the fund.
• Trustee: Holds the trust assets for the benefit of investors. Must be a SEBI-registered debenture trustee or a professionally managed trust company. The Trustee does not manage investments but provides governance oversight.
• Investment Manager (IM): Appointed by the Trustee to manage the corpus in accordance with the investment policy. The IM is responsible for deal sourcing, due diligence, investment decisions, and portfolio monitoring.
• Investors: Participate as beneficiaries of the trust, executing Contribution Agreements with the fund specifying their commitments, drawdown obligations, and rights.

Q7. Can a single AIF have multiple schemes?

Yes. An AIF may launch multiple schemes under the same registered trust entity, provided each scheme has a distinct investment strategy and corpus of at least INR 20 crore. Each scheme must be separately disclosed in the Private Placement Memorandum (PPM) filed with SEBI.

This structure allows fund managers to run parallel funds with different mandates (e.g., an early-stage VC scheme and a growth equity scheme) under a single registration, reducing administrative overhead.

KSK Note: Each scheme is treated as a separate pool for tax, reporting, and investor allocation purposes.

Q8. What is the typical tenure of a PE or VC fund in India?

The fund tenure is specified in the Trust Deed and PPM. Typical tenures are:

• Venture Capital Funds: 5-7 years (inclusive of investment period of 3–4 years), with one or two one-year extension options.
• Private Equity Funds: 7-10 years (inclusive of investment period of 4–5 years), with extension options of one or two years.

KSK Note: SEBI requires that the tenure be stated upfront, and extensions beyond the stated period require investor consent (typically majority/supermajority of LP commitments).

C. Sebi Registration And Documentation

Q9. What documents are required for SEBI AIF registration?

The principal documents required for SEBI registration include:

• Executed Trust Deed (or LLP Agreement / MoA for other structures)
• Draft Private Placement Memorandum (PPM) – the offer document for investors
• KYC documents and fit-and-proper declarations for the Trustee, Investment Manager, and Sponsor
• Details of key investment team members, including their qualifications and experience
• Proof of the net worth of the Investment Manager (minimum INR 5 crore for most categories)
• Application form (SEBI Form A) filed via the SEBI Intermediary Portal (SIP)
• Payment of prescribed registration fee (INR 5–15 lakh depending on category)
• Details of the continuing interest commitment of the Sponsor / Manager

Q10. How long does the SEBI AIF registration process take?

The typical timeline for SEBI AIF registration is as follows:

• Document preparation and filing: 4-8 weeks (depending on complexity of trust structure and PPM)
• SEBI initial review and queries: 21-30 working days from receipt of complete application
• Response to SEBI queries (1–3 rounds): 4-8 weeks
• Issuance of Registration Certificate: 2-4 weeks post final SEBI satisfaction
• Total typical timeline: 4-6 months from commencement of preparation

Q11. What must the Private Placement Memorandum (PPM) contain?

The PPM is the primary offering document presented to prospective investors and must be filed with SEBI. It must contain, at minimum:

• Investment objective, strategy, and focus sectors / stages
• Details of the Sponsor, Trustee, and Investment Manager
• Profiles of key investment professionals and their track record
• Fee structure: management fee, carried interest / performance fee, hurdle rate, and catch-up provisions
• Fund governance: LPAC / advisory committee composition, investor consent matters, and conflict of interest policies
• Risk factors specific to the fund’s strategy, sectors, and jurisdiction
• Drawdown and distribution mechanics, capital call procedures
• Valuation policy and auditor details
• Subscription and transfer restrictions
• Disclosure of material conflicts of interest and related-party transactions

D.  Tax Treatment Of PE and VC Funds

Q12. Do PE and VC AIFs enjoy tax pass-through status in India?

Yes. Category I and Category II AIFs (which include VC and most PE funds) enjoy a full pass-through tax regime under Sections 10(23FBA) and 115UB of the Income Tax Act, 1961. Under this regime:

Income (other than business income) accruing to the AIF is not taxed at the fund level. Instead, it is deemed to accrue directly in the hands of investors in proportion to their contributions in the year of accrual regardless of whether it is actually distributed.

Business income accruing to the AIF is taxed at the fund level at the maximum marginal rate applicable to trusts (approximately 42.74%), and thereafter distributed to investors tax-free.

KSK Note: Pass-through treatment means capital gains (short-term or long-term) retain their character in investors’ hands which is a significant advantage for tax-exempt investors such as sovereign wealth funds, pension funds, and charitable endowments.

Q13. What is the tax treatment of capital gains from AIF investments?

Capital gains from investments by a Category I or II AIF pass through to investors and are taxed as follows (post Finance Act 2024):

• Long-Term Capital Gains (LTCG) on listed equity / units (held > 12 months): 12.5% (without indexation) above INR 1.25 lakh exemption threshold
• Short-Term Capital Gains (STCG) on listed equity (held ≤ 12 months): 20%
• LTCG on unlisted shares (held > 24 months): 12.5% (without indexation)
• STCG on unlisted shares (held ≤ 24 months): Taxed at investor’s applicable slab rate

KSK Note: Foreign investors (e.g., FPIs or FVCIs) may benefit from lower treaty rates under applicable Double Taxation Avoidance Agreements (DTAAs), subject to satisfaction of Principal Purpose Test (PPT) and Limitation of Benefits (LOB) requirements.

Q14. How is carried interest / performance fee taxed in India?

The tax characterisation of carried interest in India depends on how it is structured:

• Profit-sharing / co-investment model: If the GP / manager holds a beneficial interest in the trust and receives distributions as a co-investor, the carried interest may be characterised as capital gains attracting lower rates.
• Fee-based model: If carried interest is paid as a contractual performance fee under the IMA, it is likely treated as business income (and subject to GST at 18%).

Q15. Is GST applicable to fund management services?

Yes. The management fee charged by the Investment Manager to the AIF is subject to Goods and Services Tax (GST) at 18% under the category of financial and management advisory services. The AIF (as the recipient of the service) bears the GST cost, which reduces the net corpus available for investment.

Carried interest paid as a fee (as opposed to a profit distribution to a co-investor) may also attract GST. Expense ratios in PPMs should clearly account for GST on management fees to ensure accurate cost disclosures to investors.

E. Foreign Investment And Fema Considerations

Q16. Can foreign investors (LPs) invest in Indian AIFs?

Yes. Foreign investors including foreign companies, foreign nationals, Non-Resident Indians (NRIs), Overseas Citizens of India (OCIs), and Foreign Venture Capital Investors (FVCIs) are permitted to invest in Indian AIFs. The inflow is governed by the Foreign Exchange Management Act, 1999 (FEMA) and the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019.

Foreign investment in Category I and Category II AIFs is permitted on a non-repatriation basis under the automatic route, subject to FEMA compliance and the AIF’s sectoral investment restrictions.

Q17. What is the FEMA ‘sponsor / manager test’ and why does it matter?

Under FEMA, the classification of AIF investment as direct FDI or indirect FDI depends on the ownership and control of the Sponsor and Investment Manager. If both the Sponsor and Investment Manager are Indian-owned and Indian-controlled, then foreign investment received by the AIF is not treated as indirect foreign investment, even if the majority of fund capital is foreign.

This is highly significant because:

• Investments in sectors with FDI caps (e.g., defence, media, insurance) are not restricted
• Pricing norms under FDI regulations (fair market value requirements) do not apply
• Investment approvals and FIPB/government route requirements are avoided

KSK Note: Structuring the Investment Manager as an Indian-controlled entity is a cornerstone of India-focused fund architecture for international GPs.

Q18. What are the FEMA reporting obligations for AIFs with foreign investors?

AIFs that receive foreign investment are required to comply with FEMA reporting obligations, including:

• Reporting of foreign capital inflows through the authorised dealer (AD) bank within prescribed timelines
• Annual return filings on the FIRMS (Foreign Investment Reporting and Management System) portal maintained by RBI
• Maintenance of records of all foreign investors and remittances for a minimum period of 5 years
• Compliance with KYC, AML, and FATF guidelines for each foreign investor
• FATCA and CRS reporting where the AIF has US persons or reportable account holders as investors

Q19. Can a Foreign Venture Capital Investor (FVCI) invest in Indian VC funds?

Yes. FVCIs registered with SEBI under the SEBI (Foreign Venture Capital Investors) Regulations, 2000 enjoy a more liberalised investment regime compared to ordinary FDI investors. Key advantages for FVCIs include:

• Exemption from FDI sectoral caps for investments in specified sectors (IT, pharma, biotech, infrastructure, etc.)
• Flexibility to purchase and sell securities at a price agreed with the counterparty (without being subject to standard FDI pricing norms in many cases)
• Long-term capital gains exemptions on specified securities (subject to applicable provisions)
• Simplified downstream investment characterisation rules

KSK Note: FVCI registration is particularly advantageous for offshore VC funds that are seeking concentrated exposure to India’s start-up ecosystem.

F. Fund Economics: Fees, Carry, And Hurdle Rates

Q20. What is the standard fee structure for a PE or VC fund in India?

While fee structures are commercially negotiated and vary across fund managers, typical market standards for Indian PE and VC funds are:

• Management Fee: 1.5% to 2.5% per annum on committed capital (during investment period) and 1.0% to 2.0% on invested capital (post investment period)
• Carried Interest / Performance Fee: 15% to 20% of distributable profits above the hurdle rate
• Preferred Return / Hurdle Rate: 8% to 10% per annum (compounded) on invested capital
• Catch-up Provision: Typically 100% catch-up once the hurdle is cleared, until the GP receives 15–20% of total profits
• Setup and Organisation Costs: Typically borne by the fund up to a capped amount (INR 50–75 lakh); excess borne by the Manager

Q21. What is the ‘waterfall’ in a fund distribution structure?

The waterfall refers to the order in which distributions from realised investments are made among the parties. A typical deal-by-deal or fund-level waterfall for an Indian PE/VC fund is:

• Return of capital: Investors receive return of their invested capital (cost basis of realised investments)
• Preferred return: Investors receive the preferred return (hurdle) on contributed capital (typically 8–10% p.a.)
• GP catch-up: The GP/Investment Manager receives 100% of distributions until it has received its carried interest percentage of total profits to date
• Carried interest split: Remaining profits are split between investors and the GP (typically 80:20 or 85:15)

KSK Note: European-style (whole-fund) waterfalls provide stronger LP protection and are increasingly common in Indian institutional PE; American-style (deal-by-deal) waterfalls are more prevalent among VC funds.

G. Ongoing Compliance And Reporting

Q22. What are the key ongoing compliance obligations of an AIF?

Registered AIFs are subject to the following key ongoing obligations under SEBI regulations:

• Quarterly reporting to SEBI on the SEBI AIF Reporting Module (fund performance, portfolio details, investor commitments)
• Annual report to SEBI within 180 days of year-end, including audited financial statements
• Annual audit by a SEBI-empanelled / qualified independent auditor
• SEBI PPM amendments: any material change to the fund strategy, team, or structure requires prior SEBI intimation or approval
• Maintenance of books of accounts and records for a minimum of 8 years
• KYC / AML compliance for all investors under the PMLA, 2002 and SEBI KYC norms
• Valuation of portfolio: at least semi-annual independent valuation as per SEBI guidelines (quarterly for Category III)
• Renewal of SEBI registration every 3 years (Category I & II: INR 3 lakh; Category III: INR 5 lakh)

Q23. Can an AIF invest in overseas securities?

Yes, subject to limits. SEBI permits AIFs to invest in offshore securities and overseas funds subject to an aggregate industry-wide limit (currently USD 1,500 million for Category I and II AIFs, and USD 500 million for Category III AIFs, as periodically revised by SEBI).

Individual AIFs may also invest in overseas securities up to 25% of their investable corpus, subject to the availability of the industry-wide window. Offshore investments must comply with applicable FEMA provisions and RBI guidelines.

Q24. What investor rights and protections are typically embedded in AIF documents?

AIF documentation particularly the Trust Deed and PPM provides for a range of investor protections, including:

• Key Man provisions: suspension of new investments if specified key investment personnel leave
• No-fault removal rights: ability to remove the Investment Manager with investor supermajority
• LP Advisory Committee (LPAC): an investor representative body with veto rights over conflicts, valuations, and extensions
• Most Favoured Nation (MFN) rights: ensuring investors receive the benefit of better terms granted in side letters
• Transfer restrictions and tag-along / drag-along rights at fund level
• Mandatory disclosure of conflicts of interest and related-party transactions
• Co-investment rights for qualifying investors on a deal-by-deal basis

H.  Gift City IFSC: Offshore-Equivalent Option

Q25. What is GIFT City and why is it relevant for fund formation?

GIFT City (Gujarat International Finance Tec-City) in Gandhinagar, Gujarat houses India’s International Financial Services Centre (IFSC), regulated by the International Financial Services Centres Authority (IFSCA). It operates as an offshore-equivalent financial jurisdiction within India’s sovereign territory.

For fund formation, the IFSC is regulated under the IFSCA (Fund Management) Regulations, 2022, which allow Fund Management Entities (FMEs) and investment funds to be established at GIFT City with a significantly more favourable tax and regulatory regime than onshore AIFs.

Q26. What are the key tax advantages of structuring a fund at GIFT City?

Funds and FMEs at the IFSC benefit from significant tax concessions under the Income Tax Act:

• Section 10(4D): 100% income tax exemption on income of Eligible Investment Funds at the IFSC for 10 consecutive years within a 15-year window
• Section 10(4E): Exemption on income from transfer of non-deliverable forward contracts
• Section 80LA: 100% deduction on profits of FMEs for the first 10 years (subject to conditions)
• GST exemption: Financial services provided within the IFSC are exempt from GST
• Withholding tax: Reduced or nil withholding tax on distributions to non-resident investors in many scenarios
• Stamp duty: Concessional stamp duty on fund documents

Contributed by – Sindhuja Kashyap