The Legal Structure of Private Equity Funds

Introduction

Private equity (PE) funds play a pivotal role in fueling business growth, enabling corporate restructuring, and facilitating innovation. As an asset class, private equity has expanded rapidly in India, with both domestic and foreign investors seeking structured, legally compliant vehicles for investment. Understanding the legal structure of PE funds is essential for stakeholders—from fund managers to limited partners and regulators. This article outlines the key legal components, regulatory frameworks, and strategic considerations shaping private equity funds in India.

Background or Legal Framework

A private equity fund is a pooled investment vehicle typically organized as a trust, company, or limited partnership that invests in private companies or takes public companies private. In India, PE funds are primarily governed by the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 ("AIF Regulations").

The legal structure encompasses:

• Fund formation (entity selection)

• Investment vehicle structure (trust, LLP, or company)

• Management structure (General Partner vs. Limited Partner roles)

• Regulatory compliance and disclosures

  
  

Depending on the fund’s domicile, Indian PE funds may also be subject to:

• Foreign Exchange Management Act, 1999 (FEMA)

• Income Tax Act, 1961

• Companies Act, 2013, where applicable

  
  

1.     Fund Structure: Trust vs LLP vs Company

Most Indian private equity funds are structured as private trusts registered with SEBI as Category II AIFs. The trust structure offers tax pass-through status (i.e., income is taxed in the hands of investors, not the fund), making it more efficient.

Alternatively:

• LLPs are used in some domestic setups, especially for co-investment vehicles.

• Companies are rare, owing to higher compliance burdens and potential double taxation.

2.     General Partner – Limited Partner Model

Though India does not formally follow the GP-LP terminology (common in the U.S. and UK), functionally the structure mirrors this.

• Sponsor or Investment Manager acts like the General Partner (GP), managing investments, earning management fees, and sharing in profits through carried interest.

• Investors are the Limited Partners (LPs), contributing capital without management control but with defined rights via fund documents.

The Contribution Agreement, Private Placement Memorandum (PPM), and Fund Trust Deed govern the terms between the manager and investors.

3. SEBI’s AIF Classification

Under SEBI’s AIF Regulations:

• Category I AIFs: Invest in socially or economically desirable sectors (e.g., infrastructure, startups).

• Category II AIFs: The most common for PE—no leverage except for operational needs.

• Category III AIFs: Hedge-fund-like, engage in leverage and complex strategies.

Private equity funds fall under Category II, with restrictions on leverage, minimum ticket size (₹1 crore per investor), and transparency obligations.

4. Regulatory Compliance and Reporting

SEBI mandates:

• Quarterly reporting on fund performance and investments

• Minimum corpus of ₹20 crore

• Independent custodian (for funds > ₹500 crore)

• Annual valuation by a Category I merchant banker or auditor

PE funds with foreign investors must also comply with FEMA rules on capital account transactions, sectoral caps, and downstream investment conditions.

5. Taxation and Exit Strategy

• Trust-based funds enjoy pass-through taxation on most income streams.

• Capital gains depend on the nature and holding period of the investment.

• Carried interest received by managers is taxed as business income.

Exit options include:

• Strategic sale to another company

• IPO and market sale

• Secondary sale to another fund

• Buybacks or promoter purchases

Each exit route comes with regulatory and tax implications that must be factored into the fund's strategy.

Challenges or Gaps

1. Regulatory Complexity

   Compliance with overlapping regulations (SEBI, RBI, IT Act) creates friction, especially for foreign-sponsored funds.

   
   

2. Limited Domestic Capital

   Most Indian PE funds depend on foreign LPs due to a thin domestic investor base—particularly among institutional investors.

   
   

3. Tax Uncertainty

   Despite pass-through provisions, differing tax interpretations (especially around carried interest) pose risk to fund managers.

   
   

4. Long Gestation Periods

   PE investments often take 5–7 years to exit, requiring legal structures that are resilient to changes in law and economic conditions.

   
   

Suggestions or Way Forward

1. Consolidated Legal Framework

   India needs a unified investment code consolidating AIF, FEMA, and tax rules to reduce compliance burdens.

   
   

2. Encourage Domestic LP Participation

   Relaxing rules for domestic pension and insurance funds to invest in PE can build a strong local capital base.

   
   

3. Carried Interest Clarity

   Tax law should define carried interest clearly—preferably aligning with capital gains treatment to incentivize fund management.

   
   

4. Strengthen Fund Governance

   Mandate independent advisory boards and clear LP-GP dispute resolution mechanisms to protect investor interests.

   
   

Conclusion

Private equity funds have emerged as vital engines of capital formation in India, particularly in the startup and growth-stage sectors. However, their long-term effectiveness depends on a sound legal framework that balances flexibility with transparency. As regulatory complexity grows, India must simplify and modernize its legal approach to private equity—ensuring it remains globally competitive while protecting investor confidence.

References 

1. SEBI (Alternative Investment Funds) Regulations, 2012, Gazette of India, Notification No. LAD-NRO/GN/2012-13/04.

2. Foreign Exchange Management Act, No. 42 of 1999, India Code (1999).

3. Income Tax Act, No. 43 of 1961, India Code (1961).

4. Companies Act, No. 18 of 2013, India Code (2013).

5. SEBI, Handbook on Alternative Investment Funds (2022), https://www.sebi.gov.in.

6. RBI Master Directions – Foreign Investment in India (2022), https://www.rbi.org.in.

   
   
   
   

DISCLAIMER- This article has been submitted by Abhinash Mahapatra, a trainee under the LLL Legal Training Program. The views and opinions expressed in this piece are solely those of the author.