A new rule puts foreign money in funds on edge

Mumbai: The release of draft Foreign Exchange Management Act (FEMA) rules for 2026 has sent ripples of uncertainty through the alternative investment fund (AIF) industry. AIFs, which have been a popular choice for wealthy investors to invest in unlisted stocks and startups, have long benefited from a unique regulation allowing foreign-owned AIFs to be treated as domestic if they are managed and sponsored by Indian entities.

However, the draft rules suggest a shift in this interpretation, potentially treating AIFs as foreign-controlled entities (FCE) if a majority of their investors are foreign, even if the sponsor and asset manager are Indian-owned.

According to legal experts, this change could have far-reaching implications, particularly for AIFs that have raised significant capital from foreign investors. If the draft rules are implemented, it could trigger indirect foreign investment rules for these AIFs, affecting sectors such as real estate, financial services, defense, telecom, and retail, where FDI is either prohibited or subject to caps or performance conditions.

Moreover, pricing and reporting norms that typically apply to foreign investments may come into play, adding another layer of complexity for AIFs operating in these sectors.

Parul Jain, who leads international tax and funds formation practice at Nishith Desai Associates, expressed concern over the potential impact on existing AIFs that have raised money from foreign sources but are Indian-owned and controlled. She noted that the draft rules may put a question mark on the status of these AIFs, especially in the absence of specific grandfathering rules.

The draft rules have yet to be finalized, but their potential impact on the AIF landscape cannot be ignored. As SEBI works towards a final decision, the uncertainty surrounding the status of existing AIFs and the treatment of foreign-owned AIFs could create challenges for investors, sponsors, and managers alike. It remains to be seen how the final draft will shape the future of AIFs and the regulatory environment in which they operate.