RBI and SEBI must reassess their overseas investment policy for AIFs

Should the Reserve Bank of India (RBI) increase the overseas investment cap of $1.5 billion for all alternative investment funds (AIFs) again? Since August 2023, applications from AIFs looking to invest in foreign companies, requiring SEBI’s approval, have been on hold as the $1.5 billion limit was quickly exhausted.

This backlog poses a significant issue, especially for angel funds aiming to invest in startups where quick action is crucial. The AIF industry has already requested an increase in this investment limit. Can SEBI explore alternative policies without needing RBI’s approval?

RBI sets the overall limit while SEBI approves applications after review. Once the limit is reached, further requests are halted until exits by an AIF free up funds. There is no data on the available pool, pending applications, or estimated approval times.

In May 2021, RBI doubled the overseas investment limit from $750 million due to growing interest in the Indo-US SaaS sector. With the Indian SaaS market projected to reach $50-70 billion by 2030 and the AI market expected to hit $200 billion by 2025, RBI and SEBI should enhance the current regulatory framework.

Policymakers could set different caps for different fund categories due to their varying risk appetites and deal sizes. The current $1.5 billion cap applies to all fund categories, disadvantaging angel funds. Category 3 funds typically don't use much of this amount. SEBI considered separate limits for each category but dismissed the idea due to insufficient data supporting a separate quota for angel funds.

SEBI worries that separate quotas for each AIF category might leave some limits unused, depriving others. If RBI is concerned about foreign exchange impacts from raising the cap, quotas within the overall limit could help manage forex outflows. SEBI could keep approving applications on a rolling basis. Differing limits based on ownership might also be explored, such as higher caps for Indian-owned funds. SEBI has the power to restructure quotas within the overall limit without RBI’s approval.

SEBI should also introduce a transparency ticker with data on applications and available limits to help AIFs plan investments. SEBI might need RBI’s support for deemed/post-facto approvals, ensuring smoother processes. Lack of clarity on approvals has led to innovative investment structures like call and put options.

Timeliness is crucial in investments. Often, by the time an application is approved, the target startup is seeking funds for a subsequent round at a higher valuation, leaving angel funds at a disadvantage without SEBI approval for the new round.

When an AIF cannot use its approved amount, it returns to the pool for the next application. The same fund cannot use it for other overseas investments. SEBI has clarified informally that an AIF may be exempt from the ₹25 lakh minimum investment requirement in certain cases. However, an AIF still needs to apply for clearance.

This informal guidance offers little relief to angel funds eyeing overseas investments, given the current application backlog. The concern is that uncertainty around AIF investments might deprive them of foreign investment opportunities. To expedite investments, funds prefer to be based abroad, and resident individuals favor foreign vehicles.

Indian regulators should revise investment policies to enable India-based funds to seize all available opportunities.

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