AIF exits are hindered by winter funding, illiquid startups, and the regulations imposed by Sebi 

Introduction
The Alternative Investment Fund (AIF) industry in India, encompassing Venture Capital (VC) and Private Equity (PE) funds, is facing a brewing crisis. A significant number of AIFs, valued at ₹17,500 crore, are nearing expiration within the next 16 months, but winding down is proving challenging. The lack of liquidity and legal constraints resulting from a funding winter are major factors contributing to the dilemma. Moreover, the exit options available to AIFs are further complicated by regulatory requirements imposed by the Securities and Exchange Board of India (SEBI).

Exit Options and Challenges:
When an AIF’s term comes to an end, it has two options for closure: a liquidation scheme or an in-specie distribution. However, SEBI’s new provisions add complexities to both approaches. For a liquidation scheme or in-specie distribution to proceed, the fund manager must secure bids for 25% of the portfolio. This requirement may lead to delays, as finding suitable buyers for only a portion of the assets can be challenging.

Furthermore, SEBI mandates that the fund manager must obtain approval from 75% of investors by value. This creates a contradiction as SEBI typically prohibits preferential treatment, yet the rules prioritize certain investors in specific scenarios. Investors may also change their exit preferences after bids are arranged, further complicating the exit process and potentially leading to disputes.

Tax Liabilities and Liquidity Issues:
Swapping units from the original VC fund to the liquidation scheme can trigger significant tax liabilities for investors, resulting in liquidity challenges and tax payment issues. Tax Deducted at Source (TDS) and Long-Term Capital Gains (LTCG) tax payments can strain investor cash flows and create further hurdles during the exit process.

In-specie Distribution and Compliance Concerns:
Transferring shares to investors through in-specie distribution may face restrictions imposed by the startup’s Articles of Association (AOA). Additionally, investors may encounter conflicts due to limitations of the liberalized remittance scheme (LRS) and regulatory approvals for foreign investments. Compliance with Foreign Exchange Management Act (FEMA) guidelines on calculating fair market value can also pose problems, potentially violating Fema regulations.

Risks for AIF Investors:
Investing in startups through AIFs might be alluring, but failure to exit investments within the fund’s tenure can expose investors to a complex maze of liquidation rules. Without amendments to the current regulations, investors must exercise caution while pursuing the startup dream through AIFs.

Conclusion:
The AIF industry in India faces critical challenges in winding down funds, particularly for illiquid startups. SEBI’s regulatory constraints and liquidity issues exacerbate the situation, leading to uncertainties for investors. As the AIF ecosystem evolves, careful evaluation of exit strategies and compliance considerations becomes essential for safeguarding investor interests in this high-profile and glamorous startup investment landscape.