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Creating a Hedge Fund in India: The Structure

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How can you create a hedge fund in India? The name has no formal meaning in India, so we look at the various ways you can create a vehicle for someone to collect money from investors and invest it in markets. This essay takes you through different investment fund structures.

Contents

Thanks to Kaushik Gala and @Prashanth_Krish for inputs.

The Concept of a Hedge Fund

Create an investment vehicle that will:

  • Collect money from investors.
  • Invest that money into anything – money markets, bonds, stocks, commodities, real estate whatever makes sense.
  • Use derivatives to hedge or make outsized bets or what have you, which means you can leverage your capital.
  • Have limited liability for the members restricted to their investment capital. (i.e. overleverage cannot hurt the investors)
  • Allow for partial or full exits, additions of new investors and addition of extra capital at any time.
  • Compensate the fund managers in a transparent and simple manner. Typically there is an annual management fee, and a profit sharing fee, with a hurdle rate and a high watermark.
  • Could potentially use leverage or go short (benefit from market falls)
  • Be compliant with regulation.

This is the typical structure of a hedge fund or venture fund. Once you have such a structure, you can then create the investment plan and approach investors for capital.

This applies if you want to create a fund to invest in startups as well, a PE or VC fund.

Let’s say I figured that certain stocks are cheap today, and banks expensive. In the next two years, bonds will peak. We will also see real estate prices bottoming out after that, and in the meantime, there will be long and short opportunities in all sorts of markets. Can I create a fund that allows a few friends to put in their money behind my assertions?

Notes and Points to Consider

Taxation: Some investors might prefer an independently taxed entity (like a company). It saves them the hassles of putting the gains into their annual accounts, and then having to file returns for business income. Foreign investors, on the other hand, prefer pass-through mechanisms, where the capital gains occurs in their hands, since Mauritius/Singapore based FIIs pay no cap-gains taxes, even if such mechanisms have been partially taxed now. Other VHNIs may want to offset other losses with your investment gains, and prefer pass-through.

For the tax department, there is capital gains for most investments. Income from derivatives is business income, unless you are an FII, in which it is capital gains. Income from intraday trading is “speculative income”.

Pooling: It is useful to collect the capital in one entity or account and invest, compared to having to manage separate individual investor accounts. For example, if I need to buy 10 lots of Reliance Industries, and I have six equal investors, what do I do if they all have separate accounts? If it were pooled I could buy the 10 lots out of the single account, and eventually distribute the profits. Unfortunately some of the structures don’t allow pooling.

Regulators: Remember that if you put this out there for *anyone* to invest, SEBI will get ticked off; this investment vehicle must be restricted only to people you know. (Unless you choose the SEBI registered options) Other regulatory issues are about if you need a minimum capital to apply, what are the reporting and disclosure requirements etc.

Foreign investors: Three different categories exist – institutions (FIIs), foreign individuals and Non Resident Indians (NRIs or PIOs). Some can buy in India, some can’t. FIIs can’t buy into certain sectors. NRIs can’t buy Indian company debt. Such ring fencing impacts the structure you create. Foreign individuals can’t invest in most structures, so let’s consider FIIs or NRIs in this discussion.
To understand, let’s see what kind of structures exist.

Related Links:

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A Partnership

My friends and I could enter into a partnership, but this does not let me do limited liability. Meaning that if for instance we write a call option and lose a lot more money than we have put in (due to leverage), then each of us is separately required to make up the amount. The liability passes on to us individually. This route is closed before further discussion.

An Advisory

I create a company called Shenoy Advisors, in which I am the primary investor. I get a SEBI registration as a Registered Investment Adviser. (RIA)

I then ask my investors to create accounts with a brokerage, a bond dealer, a mutual fund, and so on. When I finalize an investment or a change, I talk to each investor and tell him to do this transaction. At the end of each quarter, I give them an account of the profits and ask them to pay me. SEBI now has a “Registered Investment Adviser” category which is allowed to charge a fee either as a % of AUM or a fixed fee.

Taxation: Pass through.
Pooling: Not allowed.
Foreign Investors: Yes. Account creation hassles, for each investor.
Capital requirement: None. A SEBI registered RIA needs about Rs. 1 lakh in net worth, though.
Leverage: May be suggested with appropriate disclosures.
Can go short? Is purely and advisory, so can advise short or hedge positions.

Upsides

Clean and doable by anyone. Requires RIA registration by SEBI, which can take about six months, but gives you a certificate to do so.

Downsides

  • No pooling. There is the fragmentation issue noted above.
  • Contract of hope: You may not be able to enforce payment. But this is not a big deal, usually.
  • Investment pain: My friends don’t want me to pain them every time there’s a trade – it’s too much of a pain for them to execute. If I executed the trade on their behalf, there cannot be separate execution services involved.
  • Multiple Account Maintenance: Lastly I need to keep each of their data updated at all the investment avenues separately, and if the customers choose to execute on their own, I need to track what they’ve done separately.
  • Can’t do a large number of retail investors. You will lose your sanity.

The PMS

A Portfolio Management Service is something that you get registered through SEBI, and allows you to manage client portfolios.
This allows you to solicit clients publicly, and to manage them. Technically you must not pool these accounts, but there is a regulatory mechanism that allows pooled execution (buy/sell) but the stocks must reside in individual and separate demat accounts. Derivatives can be pooled.

Update: PMS rules have been changed. They can take Rs. 50 lakh rupees, no less.

The restrictions:

  • Investors must put in Rs. 5 lakh 50 lakh each, at least. This may seem like a big deal when you’re starting out, but note that most people who only have one lakh to give, will also give you a lot of grief because it usually is money they can’t afford to lose. When you are doing aggressive trading, NEVER take money people can’t afford to lose. (Even if it’s 50 lakhs)
  • Only equities, commodities and derivatives. (No non-India-listed stocks, no currency, no crypto)
  • No leverage in derivatives. For instance, a bull call spread (buying a call, selling another of a higher strike) has zero risk beyond the net premium paid, but a PMS will be required to show it as two separate call exposures, which dramatically reduces potential returns.
  • A registration cost of Rs. 11 lakhs and then Rs. 5 lakhs every three years. You also need a net worth of 5 cr. That’s quite some money just to start operations.
  • Reporting to SEBI on a monthly and quarterly basis, on a client-wise and overall basis.

Taxation: Pass through.
Pooling: No, but we have seen some PMS providers do so with derivative trades.
Foreign Investors: Yes, but only NRIs. PMS can only advise FII clients.
Capital: 5 cr. net worth, 11 lakhs starting fee. (See FAQ)
Leverage: No.
Can go short? Yes, but only to the extent of capital provided.

Check out: Capitalmind Wealth, our PMS offering at Capitalmind.

Upsides

The PMS is a clean structure, and can be transparent, if you design it right. Reporting is not very difficult, though SEBI can be inquisitive and audit you.

You may be able to piggyback on someone’s PMS license if you have the right connections. Fee structures will be contractual.

Downsides

  • Regulatory approvals are tough, and costs are high. The 11 lakh is a bummer – you have to spend that much just to begin.
  • Non-pooling is a requisite on stocks.
  • Instrument restrictions: can’t do Non-India stocks, real estate or currency/crypto or such.
  • No leverage.

Read: How taxation in India works for PMS and AIF investors

The Alternative Investment Fund (AIF)

AIFs are new SEBI registered vehicles that allow pooling and leverage. You have to register as a Category III fund for the leverage. Category I and II are for Venture capital (unlisted mostly) and debt oriented structures and don’t allow leverage. Cat I also has a sub-category for angel funds. We’ll not discuss those as the idea here is to invest in listed entities.

The concept is that you build a trust or company or LLP that will be registered with SEBI. You need to put in, as a manager, Rs. 1 cr. at least, as your part of the capital. Every other investor needs to put in at least Rs. 1 cr. The total fund size needs to be at least 20 cr. just to start. Then you can trade stocks and derivatives.

Company or LLP route doesn’t allow easy entry or exit (for new entries or exits, you need permission of all the other people). Taxation

You can have leverage on your trades. The assumption is 2x leverage, so effectively for Rs. 100,000 managed, you can take positions with a gross exposure of 200,000 maximum.

Taxation: The trust or company of AIF is charged the tax, but exits are taxed based on the type of entity. LLP and Trusts have no tax on investor on exits. If a company (private limited) then there could be dividend tax on the investor if the exit is a dividend paid out, or if there’s a buyback, then the company pays 20% further tax.
Pooling: Yes.
Foreign Investors: Yes, we think, if it’s an AIF structure that allows it.
Capital: 10 cr. net worth, SEBI registration fees etc.
Leverage: Upto 200% is allowed.
Can go short? Yes, with a max 200% gross exposure

Upsides

The AIF is a clean structure, and while it requires high capital, you can use it to do leveraged trades and pool in capital.
It allows complicated option trades, shorting through leverage, increased diversification etc.

Downsides

  • Regulatory approvals are tough, and costs are high.
  • Per-customer restrictions of minimum 1 cr. reduces your customer market size.
  • Instrument restrictions: can’t do crypto or real estate or such.
  • SEBI might frown on more than 2x/3x leverage.
  • Taxation is a pain – as a trust, taxes are now 42.74% of income on derivatives, which can suck out all the returns you might make. (Read more)

Related Links:

How Alternative Investment Funds Raised Record Amounts in 2014 – A Premium Offering

How taxation in India works for PMS and AIF investors

A Private Limited Company

You could create a limited company, where you issue your investors shares, and they put in the money proportionately. You put in some money as well, and you then outsource the main activity (the fund management) to your advisory service or entity – this could be you as an individual, or an advisory entity you create.

You can calculate the per-share value of the company every day by valuing the pool, and here pooled investment is possible.

Note: you may not even be able to take this approach, because of a rule that says: If a company makes more than 75% of its income through investments, then that company needs to be an NBFC registered by the RBI. More on that later, but NBFCs require RBI approval and Rs. 2 cr. as capital, so if you’re smaller, you might as well forget about it.

Note: Reader Krishnaraj points out that RBI has new draft rules out about investing companies, but these seem to apply only to holding companies and not to companies that trade.

Taxation: No pass-through, the company is taxed. 25% taxes, with investment as the objective, could be classified as business income, not capital gains.
Pooling: Yes. All investments are from a common pool.
Foreign Investors: Yes. For more than 50% of equity, or large sums may need FDI approval. They may not be able to invest in an NBFC.
Capital: Starting a company is as cheap is Rs. 100,000. But if you need to be an NBFC, the minimum networth is Rs. 2 cr. and the costs are heavy.
Leverage: Can be taken, limited by how much a broker will provide.
Can go short? Yes.

Upsides

A company can invest in anything, even go abroad. You can even borrow money to trade. Pooled account is possible. Separately taxed.
Having a company also effectively hides the end-investor’s name. Good, for instance, to cross-invest in competitors.

Downsides

More than 200 investors can’t get in. That makes it a public limited company, which has more stringent regulation. Of course you could always build another company.
Exiting is tough. Investors own shares. They have to sell those shares to someone else – that is, someone needs to be buying shares as they leave. In India, it is not easy to sell shares back to the company itself – there are buyback rules that require you to offer the same price to all investors, and then you can only do one buyback every year. Buybacks also have 20% tax paid by the company. Partial exits are seriously difficult, and dividends are taxed in the hands of the investor.
Entry is also tough: A new entrant will probably need some level of handshaking with everyone else before he can get in, because their approval might be required (if they own more than 10% stake in the entity)
Distribution of profits is costly. Even the post tax profits that are in the company, if they must be distributed will be charged. Dividends are now taxed in the hands of the investor, so for a really high income investor, the tax will be 43%. This is beyond the 25% tax paid by the company (dividends can only be given from post-tax earnings).
Companies are painful to set up and maintain – you need at least two directors, the process takes many days, and because you will issue shares at par, you need a very high paid up capital (which costs higher in terms of registration fees). And then, you need all regulatory disclosures and so on.
Winding up in case you need to shut down the fund (say all investors want to leave) is a big problem in that you simply can’t do it in any time-bound manner. But India has the great jugaad, as in, there’s always someone waiting to buy a company from you, to save setup costs.

A Limited Liability Partnership (LLP)

The LLP is almost like a private limited in that investors have limited liability. Setup time is around the same, but regulatory disclosures and restrictions are lesser.

Each investor becomes a limited liability partner, and you become the managing partner.

Exiting is much easier, as is distribution of profits.

Taxation: No pass-through, the LLP is taxed. 30% taxes, with investment as the objective, could be classified as business income, not capital gains. Note however – as Reader Krishnaraj points out – the MAT of 20% means that even if the income is classified as capital gains, you will pay 20% tax on the gains.
Pooling: Yes.
Foreign Investors: Partially. Only in sectors where 100% FDI is allowed, but with govt. approval. FIIs and VC Funds are not allowed. While foreign investors are allowed, further downstream investments from a foreign funded LLP are not allowed. (HT @dearvishy)
Capital: Cheap: Rs. 10,000. Cannot run as an NBFC unless you get RBI approval.
Leverage: Yes, to the extent a broker will provide it.
Can go short? Yes.

Upsides

Can invest in pretty much anything, but as a new type of entity, certain sectors may not have application formalities set up. Taxable entity.
Profit sharing is easier – post tax, profits can be shared without any distribution taxes.
Exits are easy: each partner can take his/her (post-tax) share whenever they like.
Entry of a new investor involves getting a signoff from existing investors, and entry price can be the NAV of the pool plus an entry load.

Downsides

Getting RBI approval to act as an NBFC (see the section in the “Private Limited Company” section) is painful.
Conversion to a company later can be cumbersome, involving stamp duty and capital gains.
Winding up may not be quite simple, but it’s simpler than a company.

Related Links:

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A Mutual Fund

Creating a mutual fund allows pooling and allows you to get a large number of investors.

It’s cumbersome to set this up, though. You must get SEBI approval. First you need to have a sponsor company that has some kind of track record. Then you need to appoint trustees that will honour investor interests. Finally, you need the actual fund which will receive the money. Each scheme you create must be approved by SEBI and an offer document and “Key Information Memorandum” created.

Any public advertisement needs to have specific wording included. You need to submit information monthly and quarterly to SEBI.

You can only charge a management fee, limited to 2.5% per year. No profit sharing. You must use a registrar and transfer agent (RTA) like CAMS or Karvy to service investors.

Taxation: The mutual fund is not taxed on dividend or other income that it receives, not even capital gains. Specifically lower tax rates apply to equity funds (more than 65% equity) for investors when they exit (they pay lower capital gains taxes).
Pooling: Yes.
Foreign Investors: Partially. Allowed in Equity, not in debt. Now foreign individuals can also invest, but it’s complicated.
Capital: Expensive: Needs a 50-100 cr. networth and established presence.
Leverage: No.
Can go short? Can hedge positions, but cannot be net short.

Upsides

Entry and exit is remarkably easy – just calculate the NAV on any given day and offer that to investors. Dividends for equity funds don’t get taxed. In fact even capital gains from transactions (buy low, sell high) in equity funds don’t get taxed under current laws, even if you distribute the to investors. This is a remarkably tax efficient structure.
You can create Exchange Traded Funds (ETFs) to offer stock investors entry into your investing strategies.

Downsides

No profit sharing and very tough regulation. Very difficult to enter unless you’re an established player. Can take inordinate amounts of time to set up.
Investment restrictions: Can’t invest well in derivatives (no short options for instance) or in most commodities. Can’t do real estate and that kind of stuff.

Related Links:

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A Mauritius Based Company

If your investors are abroad, and you get a lot of money, you can register a company in Mauritius, set it up as an FII sub-account, and use that to invest. The sub-account needs to be registered by SEBI. Then you get a broker to do your trading or give you a terminal, and you run the money from here.
This is cumbersome and costly. It could take time to setup, and I have heard of costs going to more than a few lakhs.
What you then do is to charge this company your management and profit-sharing fees.
Taxation: Mauritius based companies don’t get capital gains tax in India currently.  Mauritius based companies now do get charged taxes on gains generated in India.  Mauritius has no capital gains taxes by itself, though.
Pooling: Yes.
Foreign Investors: Only foreign investors. You can’t take Indian money.
Capital: Expensive: You better be getting serious money (>$10m)
Leverage: Yes.
Can go short? Yes.

Upsides

A mauritius based fund can be structured such that entry and exit are easy. There is low capital gains tax.
You can invest outside India very easily (even if that is not the point).

Downsides

FII based investments are monitored by SEBI daily, so regulatory reporting increases. The cost of setting up is very high.
You can’t take investment from Indian investors. Which increases fund-raising costs.
Investment restrictions: You can’t invest in many products, like commodities or currencies inside India. Even within stocks, investment is restricted in certain sectors like Banks or power.

An AIF Trust as a VC Fund

You can create a trust, with a set of trustees. You then apply to SEBI to register the trust as an AIF VC Fund, where you will collect money from investors and invest in companies. See SEBI’s How to get registered as a VC Fund and the SEBI VC Regulations.
Also, see my Budget 2012 post on How you can create a Venture Fund.
(HT: Hardik, who has commented below)
SEBI needs the backgrounds of the investment manager (you) and the trustee company. You also need to provide the investment strategy for the fund, with target fund size and investor profiles, along with letters of commitment from investors. (At least Rs. 5 crores committed)
The SEBI Fees are Rs. 5 lakhs, plus 1 lakh for the application. If you get the registration, a placement memorandum must be created with full details such as promoter history, tax implications, investment strategy, profit distribution, etc.
According to the earlier links:

  • Minimum Capital is 5 cr.
  • Minimum per investor: Rs. 5 lakhs (employees of the fund can invest lesser)
  • At least 2/3rd of the funds should be in unlisted equity shares (Not suitable for a PE or hedge fund)
  • No buying into an NBFC, Gold Financing and other such activities, and even publicly listed stocks may be restricted.
  • Constant reporting is necessary.

Taxation: Majumdar and Co. say passthrough only works if you invest in unlisted firms.
Pooling: Yes.
Foreign Investors: Depends on whether you are a foreign VC fund or otherwise. Very tricky this bit.
Capital: Expensive: You better be getting serious money (>$10m)
Leverage: No.
Can go short? No.

Upsides

Simple structure, but so expensive! But it is useful for a potential pass-through structure if you get into unlisted equities.

Downsides

High regulatory and entry costs. And you can’t invest in much other than equity. So it’s a non-starter for a hedge fund, but could be useful as a VC Fund.

Conclusion

If you’re looking at a small fund of less than 10 crores, you can’t do any of the above other than the advisory.
At 10 crores, a PMS looks attractive.
At 20 crores, an AIF may also work if each customer is very high net worth.
At 50-100 crores, you may be able to get some level of interesting in starting (or buying) an NBFC. NBFC rules might change and prevent you from investing in certain sectors, or abroad, or in other such areas. If the profit sharing piece isn’t required, you could consider creating a mutual fund too.
This is a live article and will be updated. Please post in with your views!


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