SEBI Eases Demat Rules for AIFs: Impact on Investors & Startups

In a significant regulatory shift, the Securities and Exchange Board of India (SEBI) has relaxed its mandates for Alternative Investment Funds (AIFs) concerning the dematerialisation of securities. This move comes amidst a broader push by the market watchdog to modernize investment practices, enhance transparency, and safeguard investor interests. But what does this really mean for the Indian investment landscape? And why is this change important now? Let's explore with TICE.

The Push for Digitalisation in Investments

In an era where digital transformation is redefining industries, SEBI has been gradually steering the Indian financial ecosystem towards complete digitisation. One such critical step has been the push for the dematerialisation (or "demat") of securities—a process that converts physical shares and investments into electronic form.

Dematerialisation is not just about going paperless; it enhances security, simplifies transactions, and reduces the risks associated with physical certificates, such as loss, forgery, or damage. For investors, this means greater ease of trading, faster transactions, and a streamlined regulatory framework.

AIFs, which serve as privately pooled investment vehicles collecting funds from institutional and high-net-worth individual investors, have now been given additional flexibility in holding their securities. While the original mandate required all AIF investments to be in demat form, SEBI has now provided conditional exemptions for investments made before July 1, 2025.

Breaking Down SEBI’s New Guidelines

Under the revised framework, any investment made by an AIF on or after July 1, 2025, must be held in dematerialised form—whether acquired directly from an investee company or through secondary transactions. However, investments made before this date will be exempt from this requirement, provided they do not fall under specific conditions.

What Are the Exemptions?

SEBI has carved out certain exceptions to this mandate, providing relief to AIFs under specific circumstances:

1. Investee Companies with a Legal Mandate for Dematerialisation

   • If an investee company is legally required to dematerialise its securities, then any AIF investment in that company must also be dematerialised—regardless of when the investment was made.

2. AIFs with Controlling Influence

   • If an AIF, either independently or in collaboration with other SEBI-registered entities, exercises control over the investee company, the dematerialisation mandate will still apply. In such cases, investments must be dematerialised by October 31, 2025.

3. Short-Term Schemes & Extended Tenures

   • Some AIF schemes are fully exempt from the dematerialisation requirement. This includes schemes that are set to end by October 31, 2025, or those that have already entered an extended tenure as of February 14, 2025.

These revised regulations, effective immediately, are expected to create a more balanced approach, allowing AIFs the flexibility to adjust while still aligning with SEBI’s larger vision of digitised financial markets.

AIFs and SEBI’s Larger Regulatory Overhaul

This latest update is part of SEBI’s ongoing efforts to refine the regulatory landscape for Alternative Investment Funds (AIFs) and Venture Capital Funds (VCFs). Over the past few years, SEBI has introduced a series of changes aimed at improving transparency, governance, and investor protection in the AIF sector.

Key SEBI Reforms for AIFs

1. June 2023: Mandatory Dematerialisation for Large AIFs

   • SEBI mandated that AIFs with a corpus of INR 500 crore and above must dematerialise their units by October 31, 2023.
   • Smaller AIFs (with less than INR 500 crore corpus) had until April 30, 2024, to complete the process.

2. September 2023: Revised Valuation Rules

   • SEBI introduced new valuation norms, aligning most securities held by AIFs with mutual fund regulations under the SEBI Mutual Funds Regulations, 1996.
   • The exception was made for unlisted, non-traded, or thinly traded securities, which continue to be valued differently.

3. August 2024: Borrowing Flexibility for AIFs

   • SEBI allowed Category-I and Category-II AIFs to borrow for up to 30 days to meet operational and temporary needs.
   • However, borrowing was capped at four times a year and limited to 10% of total investible funds.

These measures reflect SEBI’s commitment to fostering a more structured and regulated investment ecosystem, while also addressing the operational challenges faced by AIFs.

What This Means for the Indian Startup Ecosystem

The alternative investment space plays a crucial role in fueling India’s startup ecosystem. AIFs, particularly Category-I and II funds, are primary investors in venture capital, private equity, and infrastructure projects—sectors that drive innovation and economic growth.

By introducing greater transparency and reducing the risks associated with physical securities, SEBI’s regulatory changes could:

• Encourage more institutional participation in startup investments.
• Boost investor confidence, making it easier for startups to secure funding.
• Streamline exit mechanisms, enabling quicker liquidity events for investors.

However, the transition to a fully dematerialised system does come with operational hurdles. Many startups and smaller companies still rely on physical securities, and adapting to the new norms may require additional costs and compliance efforts.

Final Thoughts: A Step in the Right Direction?

While SEBI’s decision to relax dematerialisation mandates for AIFs offers short-term relief, it is clear that the broader vision remains focused on full digital adoption. By October 31, 2025, most investments will need to be in demat form, marking another milestone in India’s journey towards a fully digitised capital market.

For AIFs, this means a more structured investment environment, albeit with some growing pains along the way. For startups, this could mean greater access to regulated and transparent funding avenues—a win for both investors and entrepreneurs alike.

As the Indian startup ecosystem continues to evolve, the role of regulatory bodies like SEBI in shaping a fair, transparent, and efficient investment landscape will be more crucial than ever. The coming years will reveal how well these reforms align with the fast-moving world of alternative investments.

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