When fund managers think about an Alternative Investment Fund (AIF), most attention is understandably focused on fundraising, deployment of capital, portfolio management and exits.
Relatively little attention is paid to what happens at the very end of a fund’s life.
Ironically, that is often where some of the most complex operational and regulatory challenges arise.
A fund may have completed its tenure.
Portfolio investments may have been liquidated.
Investors may have received substantially all distributions.
Yet the fund may still find itself unable to complete the winding-up process.
Why?
Because winding up an AIF is not simply a matter of distributing money and closing bank accounts.
Pending tax proceedings, litigation, regulatory notices, investor claims and residual expenses often continue to exist long after the underlying investments have been exited.
Recognising these practical difficulties, SEBI recently introduced guidelines permitting retention of proceeds beyond the permissible fund life and introduced the concept of an “Inoperative Fund”. The circular provides long-awaited operational flexibility to funds approaching closure.
However, while the circular addresses an important industry concern, it also raises new practical questions for fund managers.
Before examining those questions, it is useful to revisit how the winding-up process works under the AIF framework.
Understanding the Winding-Up Process
The winding-up process generally involves the following stages:
Step 1: Expiry of Fund Tenure
The scheme reaches the end of its tenure, including any extensions permitted under the AIF Regulations and approved by investors.
At this stage, the manager is expected to have substantially realised the investments of the scheme.
Step 2: Liquidation of Remaining Assets
The fund proceeds to sell or otherwise liquidate remaining investments and realise proceeds.
The objective is to convert portfolio assets into distributable cash.
Step 3: Settlement of Liabilities
Before making final distributions, the fund must identify and settle outstanding liabilities including:
- Taxes
- Regulatory dues
- Vendor payments
- Audit and compliance expenses
- Litigation costs
- Other contractual obligations
Step 4: Distribution to Investors
Net proceeds are distributed to investors in accordance with the fund documents and applicable waterfall provisions.
Step 5: Closure and Surrender of Registration
Once all liabilities are settled and the fund has effectively ceased operations, the AIF may proceed with surrender of registration and final closure.
In theory, the process appears straightforward.
In practice, this is often where challenges begin.
The Problem That Many AIFs Faced
Historically, managers found themselves caught in an unusual position.
The investments had been liquidated.
Most investor money had been distributed.
No active fund management activity remained.
Yet the AIF could not be fully wound up because certain liabilities remained unresolved.
For example:
- A pending income-tax reassessment notice.
- An ongoing litigation involving a portfolio company.
- A regulatory inquiry.
- An indemnity claim from a counterparty.
- Residual operational expenses that may arise after closure.
As a result, managers were forced to keep the fund structure alive solely to deal with these unresolved matters.
This created a practical disconnect.
The fund was economically inactive but remained operationally and regulatorily active.
SEBI itself acknowledged this concern while considering the framework for facilitating the surrender of registration by such funds.
What Has SEBI Now Permitted?
Under the new framework, AIFs may retain proceeds beyond the permissible fund life under specified circumstances, including:
1. Existing Legal, Tax or Regulatory Proceedings
Where the fund has received a notice, show-cause notice, reassessment notice, summons, investigation communication or similar official correspondence indicating a potential liability.
2. Anticipated Liabilities
Where at least 75% of investors by value approve retention of funds to address anticipated litigation or tax liabilities.
3. Residual Operational Expenses
Where amounts are required to meet winding-up related expenses and can be appropriately substantiated.
SEBI has also introduced the concept of an “Inoperative Fund”, allowing such funds to remain in a dormant state while unresolved matters are being addressed. During this period, the fund cannot launch new schemes or undertake active fund management activities and is subject to a simplified compliance framework.
What Does This Mean for Fund Managers?
The immediate benefit is obvious.
Managers now have a clear regulatory pathway to deal with residual liabilities without artificially prolonging the life of the fund.
However, in our view, the more important takeaway is that winding up is no longer merely a legal formality at the end of a scheme’s life.
The quality of the winding-up process is determined by decisions made throughout the life cycle of the fund.
A manager who maintains robust records, documents investor communications, tracks contingent liabilities and proactively identifies potential disputes will find it significantly easier to justify retention of proceeds and navigate closure.
The Questions That Remain
While the framework is a welcome development, some practical questions are likely to emerge.
– How Much Retention Is Too Much?
The framework permits retention for anticipated liabilities with investor approval.
However, determining the appropriate quantum remains a matter of judgement.
Different managers may arrive at very different estimates for the same potential exposure.
– What Constitutes a Genuine Anticipated Liability?
The distinction between a reasonably anticipated liability and a remote possibility may not always be clear.
This could become an area of discussion between managers, investors and regulators.
– How Long Should Funds Remain Inoperative?
The framework provides flexibility, but prolonged inoperative status may raise questions around closure timelines and investor expectations.
– Will Investors Demand Greater Transparency?
Managers may increasingly need to explain:
- Why funds are being retained;
- How the retained amount was determined; and
- When investors can realistically expect final distribution.
Investor communication may become as important as regulatory compliance.
Conclusion
The new framework is a significant and practical reform for the AIF industry.
It recognises a reality that many fund managers have experienced for years: a fund may be commercially finished long before all liabilities are fully resolved.
By permitting retention of proceeds and introducing the concept of an Inoperative Fund, SEBI has created a more realistic pathway for fund closure.
At the same time, the circular serves as a reminder that winding up an AIF is not an event that begins at the end of the fund’s life.
Planning for an efficient exit begins much earlier, through robust documentation, governance and proactive management of potential liabilities.
The funds that will benefit most from this flexibility are likely to be those that have treated governance, documentation and compliance as ongoing responsibilities rather than activities reserved for the final year of the fund.