Demystifying SEBI’s Rules For Co-Investment Vehicles: Will It Impact Startup Funding?

The Securities and Exchange Board of India (SEBI) released a consultation paper last month that could streamline co-investment strategies within the country’s private equity and venture capital (PE/VC) sector, unlocking new avenues for investment and advisory services. Made public on May 9, the paper has proposed two critical reforms.

First, it aims to replace the current co-investment framework, which is routed through PMS (portfolio management services) entities, requiring a separate licence and leading to numerous operational and compliance complexities. Instead, co-investments will be made via Co-Investment Vehicles (CIVs) within the framework of Alternative Investment Funds (specifically, categories I and II PE/VC funds).

Second, SEBI suggests removing the restriction that prevents AIF managers from offering advisory services in listed securities. If it goes through, these managers can offer guidance on public stocks, provided they comply with the rules. Both initiatives signal a transformative shift in India’s investment regulatory system.

The proposed CIV model will be structured as an independent scheme under the AIF, providing a formal and regulated framework for co-investments. In fact, a new CIV scheme must be created for every co-investment deal in an unlisted or private company under the main fund. Only investors already in the AIF space and acknowledged by SEBI as ‘accredited’ will be allowed to participate.

The core concept is all about better operations and greater efficiency. The proposed structure allows investors to contribute additional capital alongside the primary fund when supporting a particular startup. And CIVs will act as separate mini-funds under the main fund, dedicated to co-investments.

Moreover, instead of putting all co-investments into a single vehicle, AIFs can create a bespoke scheme for each co-investment, thereby aligning more closely with an individual investor’s expectations. This added flexibility can enhance deal structuring and help manage the unique risks inherent in private companies and projects.

The capital market regulator’s reinforced focus on PE/VC funding is not surprising. After two years of contraction due to geopolitical conflicts and global headwinds, PE/VC investments in India rose 9% YoY to reach $43 Bn in 2024, according to a Bain & Company-IVCA report. The recovery was driven primarily by venture capital and growth funding, while private equity dealmaking remained steady throughout the period.

Most stakeholders have lauded SEBI’s latest initiative, as this will reduce compliance overheads, increase operational flexibility for fund managers and enhance transparency for investors.

Nonetheless, the proposal has also sparked a debate across the industry, with people questioning its long-term impact on market dynamics and regulatory balance.

Concerns surrounding the proposed CIV framework are many, including restrictions on co-investors, tax issues and exit timelines for CIVs. According to some fund managers, CIV exits can lead to potential conflicts of interest if co-investors prefer a shorter or prolonged holding period to match their investment goals. As of now, CIV exits must align with those of the original AIFs. Moreover, the strict eligibility criteria outlined by SEBI will likely prevent a new class of investors from participating.

Many believe there could be a risk of double taxation if AIF-CIV investments lose their usual pass-through tax benefits, which allow income to be taxed only at the investor level. AIFs and CIVs are typically structured so that the income they generate is passed directly to investors, who then pay tax on it, thereby avoiding any tax at the fund level. To prevent tax conflicts, fund managers and co-investors must ensure that fund structures are clearly defined and compliant with current tax regulations (more on CIV red flags later).

“Despite its theoretical promise, the suggested CIV framework poses real-world challenges for venture capitalists. Co-investors’ usual desire for flexibility is undermined when exits are restricted to fit the AIF’s timeline, which could result in misaligned return expectations,” said Pearl Agarwal, founder and managing partner, Eximius Ventures, a pre-seed venture capital firm that invests in startups at the idea stage.

Agarwal further added that there is also a genuine threat of double taxation if pass-through status is jeopardised. Investor returns may weaken, and participation will be discouraged. Startups’ access to capital may also be restricted by SEBI’s stringent eligibility requirements, which may inadvertently exclude new investors.

According to Deepak Padaki, president of Catamaran Ventures, a private investment firm managing more than $1 Bn across strategic joint ventures, private and public equity, and growth-stage venture capital, the CIV model will not impact its investment strategy as the firm prefers to make larger investments directly into high-growth companies.

“Besides, the CIV model may not be able to include some limited partners (LPs), as only accredited investors can co-invest. It may restrict engagement from larger LPs who can bring in critical growth capital. Going by the proposal, a CIV will be coterminous with the original AIF. Therefore, it cannot resolve a key concern — the flexibility to extend holding periods for specific investments,” he added.

As SEBI seeks public feedback on its consultation paper, the full scope of the CIV model remains in flux. This explainer, part of our ongoing Moneyball series, aims to demystify the proposed framework, outline its differences from the existing system, and examine its implications for fund managers and investors while shedding light on the critical issues raised by industry stakeholders.

Why SEBI Rejected AIFs’ Push for In-Fund Co-Investments?

For a long time, the AIF industry has sought amendments to co-investment guidelines, aiming for easier investments and hassle-free fund flows, a win-win for both investors and investee companies.

In FY21, it advocated the introduction of co-investments within the AIF structure itself with the issuance of a separate class of units. Had SEBI approved it, investors could have co-invested in individual deals within a fund without having to create a separate fund vehicle.

Category I and II AIFs, which primarily invested in unlisted securities, faced significant challenges at the time regarding co-investments outside the fund framework. Constrained by regulatory restrictions, early exit risks and misaligned interests, fund managers requested that the regulator create a formal structure to address the following hurdles.

The current CIV model is based on that earlier proposal, offering a streamlined, compliant and aligned mechanism for co-investing within the AIF structure itself. However, SEBI rejected the earlier request for a couple of reasons.

To begin with, an alternative investment fund typically operates through a pooled structure, which means the capital from all investors is pooled together, and profits are shared proportionately. However, this fair and transparent structure might have been compromised if co-investments were made through a separate class of units.

It could have introduced the risk of unequal treatment among investors, thereby compromising the fundamental nature of the AIF as a truly pooled vehicle. Such a deviation might have diluted the integrity and cohesion that define the AIF model, potentially affecting investor trust and a fund’s long-term stability and structure.

As SEBI decided not to overhaul the core AIF structure, it allowed co-investments outside the AIF via the PMS route. This led to amendments in AIF and PMS regulations in December 2021, enabling co-investments under specific conditions that remain in effect today.

Why The Demand For CIVs Is On The Rise, Again?

Despite SEBI’s decision to give within-the-AIF co-investments a wide berth, its Ease of Doing Business Working Group (EoDB WG) identified several limitations within the current co-investment framework under the AIF regulations. Here is a quick look at what is not working well.

In its findings, the working group recommended replacing the PMS-based structure with a new CIV model within the AIF regulations to address these challenges. In alignment with the work group’s suggestions and SEBI’s internal deliberations, the new model proposes that AIF managers should offer co-investment opportunities to eligible investors under the following conditions.

Eight CIV Red Flags For Venture Capital Players

The VC landscape is expected to evolve with the introduction of CIVs under the revised AIF regulatory framework. Although the potential for co-investments offers numerous advantages, VCs must navigate tough conditions to make these vehicles effective.

Spanning across legal, operational and strategic fields, these eight challenges make it crucial for VC firms to approach CIVs with careful planning and expertise.

Complex fund structure: The CIV model requires one scheme per deal, each with its bank account, demat account and PAN, thereby increasing the administrative burden on VC players. Managing multiple CIV schemes alongside the main AIF can create a fund architecture that is hard to co-ordinate and monitor.

Delay in deal execution: Another operational hurdle involves aligning with each co-investor’s compliance framework and approval timelines, which can delay deal closures or result in losing competitive bids. Despite the shelf PPM, each new CIV scheme will typically require fresh deal-level legal documentation and diligence, as co-investors often mandate this even when investing in well-known companies.

Compliance and regulatory risks: VCs must make accurate, upfront disclosures about co-investment principles in shelf PPMs or risk falling short of SEBI’s transparency norms. Additionally, they have to adhere to quarterly reporting requirements and ensure compliance with SEBI’s implementation standards. All these add extra layers of responsibility, especially when one is managing multiple CIVs.

Managing investor expectations: CIVs provide attractive opportunities for accredited investors but may potentially alienate many LPs who are not eligible to co-invest. In such cases, maintaining clear and candid communications with these investors will be critical for venture capitalists whose fundraising largely depends on LPs. Moreover, co-investors may seek independent exit timelines, which can conflict with the overall strategy of the main AIF or disrupt the dynamics within portfolio companies.

Governance and conflict management: Determining how to allocate co-investment rights, whether by commitment size or by another metric, may lead to disputes. Additionally, when investment managers advise both the main AIF and its co-investors, conflicts of interest can arise regarding pricing, allocation, and access to deals. Effective governance frameworks will be essential in mitigating such conflicts.

Taxation and legal clarity: As a separate PAN is required for each CIV scheme, multiple tax returns will have to be filed for multiple co-investments. This may lead to greater scrutiny by tax authorities or even additional tax burdens such as a double taxation risk. With the regulatory framework for CIVs still evolving, interpretation gaps are likely to arise, resulting in conservative approaches. The lack of precedents may also delay regulatory adoption while investment firms continue to seek legal clarity.

Operational overheads: The setup and management of multiple CIVs may stretch VC firms’ resources, especially when they handle smaller co-investments. The administrative cost of running multiple vehicles, including investor communication, reporting and compliance, can easily outweigh the benefits. Massive overheads make CIVs less cost-effective for smaller VCs and may soon limit their appeal to larger firms with the infrastructure and deep pockets to support complex operations.

Strategy flip-flop: Portfolio companies may perceive CIV involvement as ‘side capital,’ which can affect negotiation dynamics. Despite their intended flexibility, CIVs are still subject to certain restrictions, as co-investments are limited to accredited investors and private companies. This may curb their broader strategic usage.

Will The SEBI Initiative Fulfil AIFs’ Co-Investment Needs?

SEBI’s proposed CIV within the AIF framework marks a well-considered move towards improved funding flow, structured co-investments and greater transparency. The only glitch: For VC players, the feasibility of adopting CIVs at scale hinges on resolving key regulatory and operational hurdles.

A critical issue that is now hotly debated is the stipulation that co-investors must exit with the AIFs. The idea is to prevent co-investors from negotiating preferential terms, such as early or staggered exits, that may disadvantage other investors. While the coterminous exit is intended to maintain alignment across stakeholders, it also introduces rigidity that may not be suitable for every deal.

In the past, the AIF industry called for greater flexibility in structuring co-investor exits. One such proposal advocated issuing separate unit classes within the same fund rather than setting up a separate CIV scheme for every co-investment. SEBI is currently evaluating all CIV terms and conditions and has requested stakeholders’ comments on whether exits should be coterminous for co-investors.

“More importantly, co-investors, especially corporate houses, often bring patient capital, strategic value and long-term alignment that can be instrumental in scaling startups,” highlighted Agarwal.

“For CIVs to succeed, its framework must accommodate such investors by offering greater flexibility in exit structures, clarity on investor rights and a consistent, investor-friendly tax treatment that preserves pass-through benefits. This will help unlock broader participation and foster deeper trust across the ecosystem,” she added.

The capital market regulator has undoubtedly taken a step in the right direction by engaging with the industry to steer the co-investment ecosystem towards stronger governance. It will be a win-win for all — funds, LPs and portfolio companies — if all essential measures are consolidated within a uniform structure that is free from biases.

The road ahead will require a careful balancing between investor protection, operational ease and regulatory clarity. For CIVs to gain meaningful traction, the model must embed flexibility without sacrificing governance, a delicate equilibrium that SEBI now appears to be intent on achieving.

[Edited by Sanghamitra Mandal]