SEBI Demat Compliance for AIFs: What the Regulations Actually Require

When AIF fund managers tell portfolio companies that demat is mandatory, some founders push back. They want to see the actual regulation. They want to know exactly what SEBI says, what the obligation is, what the consequences of non-compliance are, and whether there is any flexibility in the requirement. These are reasonable questions and answering them clearly removes the ambiguity that allows compliance to be deprioritised.

This guide covers the specific SEBI regulations governing demat for Alternative Investment Funds, what each regulation requires of fund managers and portfolio companies, the compliance cycle AIFs operate under, the consequences of holding physical shares in a portfolio, and what 'compliant' looks like in practical terms for both fund managers and the startups they invest in. This is a reference document cite it, share it, use it to ground your demat conversations in the actual regulatory text rather than a paraphrase of it.

KEY TAKEAWAYS

• SEBI's AIF Regulations 2012 and subsequent circulars require AIFs to hold portfolio securities in dematerialised form the obligation is on the fund, not directly on the portfolio company.
• The fund's obligation to hold demat securities creates a commercial and regulatory cascade that makes portfolio company demat effectively mandatory from the company's perspective.
• AIFs must submit quarterly and annual reports to SEBI that include portfolio holding details physical share holdings create disclosure exceptions that attract scrutiny.
• SEBI's inspection process for AIFs specifically reviews portfolio compliance, including the form in which securities are held.
• Non-compliant AIFs face registration consequences including cancellation or suspension of registration making demat compliance existential for the fund manager, not just operational.

The Regulatory Foundation: What SEBI Actually Requires

SEBI (Alternative Investment Funds) Regulations, 2012 The Primary Regulation

The SEBI (Alternative Investment Funds) Regulations, 2012 often referred to as the AIF Regulations govern the registration, operation, and compliance obligations of all three categories of AIFs in India. Regulation 20 of the AIF Regulations, which deals with general obligations of investment managers, requires that AIFs comply with all applicable securities laws and SEBI circulars in the conduct of their operations.

SEBI has issued multiple circulars under these regulations that specifically address the form in which AIFs must hold portfolio securities. The most directly relevant is SEBI Circular CIR/IMD/DF/10/2013 and its subsequent amendments, which require that securities held by AIFs be maintained in dematerialised form to the extent possible and SEBI's position through subsequent circulars and inspection guidelines has evolved this to a practical requirement rather than a best-efforts standard.

SEBI Circular on Portfolio Disclosure and Holding

SEBI has progressively tightened disclosure requirements for AIFs through a series of circulars. The requirement to hold securities in demat form is linked directly to the portfolio disclosure obligation: AIFs must report portfolio holdings in a standardised electronic format for SEBI's regulatory data systems. Holdings in physical form cannot be electronically reconciled with these systems in the same way that demat holdings can, creating reporting gaps that SEBI flags as compliance exceptions.

The MCA Mandate as a Compounding Obligation

For portfolio companies that have crossed Rs 4 crore in paid-up share capital, the MCA's September 2024 notification creates an independent obligation to dematerialise separate from and in addition to the AIF's SEBI obligation. This means that for most venture-backed Indian startups, demat is required by two independent regulatory frameworks simultaneously: the AIF's SEBI obligation (which requires the fund to hold demat securities) and the portfolio company's MCA obligation (which requires the company to have dematerialised its shares). The two obligations reinforce each other and leave no regulatory gap for physical share holdings to occupy.

Also Read: Why AIFs Are Mandating Demat Across Their Portfolio incentiv.finance/blog/aifs-mandating-demat-portfolio

Eligibility: Which AIFs Are Subject to the Demat Requirement

The requirement applies uniformly across all AIF categories. There is no category-specific exemption. There is also no size-based exemption a small Category I angel fund with Rs 50 crore in AUM faces the same demat holding requirement as a large Category II fund with Rs 5,000 crore.

Step-by-Step: The AIF Compliance Cycle and Where Demat Fits

Step 1: Registration and Scheme Document Compliance

When an AIF registers with SEBI, it submits a placement memorandum and scheme documents that describe the fund's investment strategy, risk management framework, and operational procedures. SEBI reviews these for compliance with the AIF Regulations. The scheme documents should explicitly state that the fund will hold portfolio securities in dematerialised form this is a best practice that makes the fund's demat position a stated obligation rather than an implicit one.

What can go wrong: Older funds that registered before demat requirements were emphasised may have scheme documents that are silent on the form of securities holding. These funds should update their scheme documents to explicitly address demat requirements when they next file updates with SEBI. A scheme document that does not address the form of holding creates ambiguity that makes the compliance conversation with portfolio companies harder.

Step 2: Investment Execution Pre-Closing Demat Verification

At the investment stage, the fund's legal and compliance team should verify demat status as a standard pre-closing condition. The verification checklist should confirm: the portfolio company has obtained ISIN(s) for all classes of securities, a DP has been appointed and a tripartite agreement executed, all existing shareholders' holdings are reflected in the depository system, and the proposed new allotment to the fund can be issued electronically to the fund's demat account.

Common gap: Funds that use generic due diligence checklists inherited from earlier deal cycles may not have demat as a named pre-closing condition. When this checklist is used for new deals, demat is either forgotten or treated as post-closing which creates the retroactive compliance problem the fund is then managing for years. Update the standard due diligence checklist to include demat as a mandatory pre-closing section.

Step 3: Post-Investment Corporate Action Reporting

After the initial investment, the fund must ensure that any corporate action affecting its holding is correctly reflected in its demat account. If the portfolio company issues new shares in a follow-on round, through ESOP exercises, or as bonus shares the fund's fully diluted ownership may change. The fund's demat account should reflect these changes through the depository's corporate action reporting mechanism. If the portfolio company fails to report corporate actions to its DP, the fund's demat account will show an outdated holding that does not reflect the correct post-action position.

What to do: Build corporate action notification into shareholder agreements. Require the portfolio company to notify the fund's operations team within five business days of any new allotment, conversion, or share-affecting corporate action. The fund can then verify that its demat account has been updated correctly.

Step 4: Quarterly Reporting to SEBI

SEBI requires AIFs to submit quarterly reports containing portfolio information including the names of investee companies, the nature of the investment (equity, preference, debt), the value of the holding, and other prescribed details. These reports are submitted through SEBI's regulatory portal in a standardised format. Holdings in physical form cannot be reconciled electronically with the same precision as demat holdings, and funds with physical share holdings must either manually input the details or flag the holding as non-electronic both of which attract compliance team attention.

What AIF Quarterly Reports to SEBI Must Include

• Name and details of each investee company
• Nature and type of investment (equity shares, CCPS, debentures, etc.)
• Number of securities held
• Cost of acquisition and current fair value
• Form of holding demat or physical (physical holdings must be explicitly identified)
• Any material changes in the investment during the quarter
• Status of any regulatory conditions attached to the investment

A fund with physical share holdings in a portfolio company must either: (a) flag the holding as non-demat and explain why, or (b) misrepresent the form of holding which is a more serious compliance violation. Both options create regulatory exposure. The clean resolution is demat completion.

Step 5: Annual Report and Audit

AIFs must prepare annual reports and financial statements that are audited by a SEBI-registered auditor. The audit includes a review of whether the fund's operations comply with the AIF Regulations, including the form in which portfolio securities are held. An auditor who identifies physical share holdings in a portfolio where demat is required will flag this as a compliance exception in the audit report which is then submitted to SEBI and shared with LPs.

An audit exception on demat compliance creates a paper trail that is visible to SEBI, LPs, and any co-investors who receive the audit report. This is a more formal and more consequential record than an internal compliance note. Funds with repeated demat exceptions in their annual audit reports face increased SEBI scrutiny in subsequent inspections.

Step 6: SEBI Inspection

SEBI conducts periodic inspections of registered AIFs. The frequency and scope depend on the fund's registration category, AUM, and prior compliance record. During an inspection, SEBI reviews the fund's operational compliance against the AIF Regulations and applicable circulars. Portfolio holding compliance including the form of securities holding is a standard inspection item. Inspectors will cross-reference the fund's quarterly reports with the actual demat holding statements and flag discrepancies.

Funds that receive an inspection finding on demat non-compliance are required to submit an action plan and remediation timeline. Repeated or unresolved inspection findings can escalate to formal enforcement action, which may include adjudication proceedings and, in serious cases, registration consequences.

Deadlines: Key Compliance Milestones for AIFs

The AIF compliance calendar has fixed deadlines that create predictable pressure points where demat non-compliance becomes most visible. Fund managers and portfolio companies should plan around these.

• Quarterly report deadline: Within 30 days of the end of each quarter (July 31, October 31, January 31, April 30). Portfolio holding details submitted here must reflect the current form of securities.
• Annual audit submission: Within 180 days of the financial year end (September 30 for March 31 year-end funds). Auditor review of holding compliance creates the annual audit finding risk.
• SEBI inspection: No fixed schedule typically annual or biennial for active funds. Inspections do not give advance notice of the specific items to be reviewed.
• New investment closing: No fixed deadline but demat must be complete before any new investment closes. This creates a deal-by-deal urgency for portfolio company demat.
• MCA demat mandate (for portfolio companies): September 30, 2024 for companies above Rs 4 crore paid-up capital this deadline has already passed. Companies above this threshold are already in non-compliance with the MCA mandate if demat is not complete.

Common Compliance Gaps And How to Close Them

Gap 1: Fund Has Invested But Portfolio Company Has Not Dematerialised

This is the most common gap for funds that invested before the demat requirement was strictly enforced. The fund holds the investment as a physical holding in its portfolio records, but its demat account shows no securities from this company. The fund's quarterly SEBI report either flags this as a physical holding or understates the position.

Resolution: Initiate the retroactive demat programme for the portfolio company immediately. Set a specific deadline tied to the next quarterly report submission. The fund should communicate that the holding will be disclosed as non-demat in the next quarterly report unless completion is confirmed before the submission deadline this creates concrete urgency for the portfolio company.

Gap 2: Corporate Actions Not Reported, Demat Account Not Updated

The fund invested, received demat shares at closing, but the portfolio company subsequently issued new shares in a follow-on round without notifying the fund's DP. The fund's demat account shows its original holding but not the diluted post-round position. The fund's quarterly report reflects the wrong ownership percentage.

Resolution: Require the portfolio company to report the corporate action to its DP immediately. The DP will then update the depository records to reflect the post-action fully diluted position. The fund should verify its demat account balance after every new allotment in any portfolio company, regardless of whether the company has proactively notified them.

Gap 3: Conversion of CCPS to Equity Not Reflected in Demat

When a portfolio company's CCPS converts to equity typically at the next funding round the fund's CCPS holding should be cancelled from the CCPS ISIN and replaced with equity shares under the equity ISIN. If this conversion corporate action is not reported to the depository, the fund's demat account still shows CCPS when it should show equity shares. This creates a securities type mismatch that affects the fund's compliance representation.

Resolution: Include CCPS conversion triggers and notification requirements explicitly in shareholder agreements. When conversion occurs, the fund should request written confirmation from the portfolio company that the conversion corporate action has been reported to the depository and that the fund's demat account has been updated.

Gap 4: Fund Holds Convertible Note or SAFE No Demat Required Yet

Some early investments are structured as convertible notes or SAFEs rather than direct equity or CCPS. These instruments are not securities in the regulatory sense and therefore do not require demat while they remain as unconverted debt. However, at conversion when the note or SAFE converts into equity or preference shares the resulting securities must be issued in demat form. The fund should track all outstanding convertible instruments and ensure that conversion is processed through the depository system.

What 'Compliant' Looks Like: The Demat Compliance Checklist for AIFs

A SEBI-compliant AIF demat position has the following elements confirmed and documented:

• Fund's own demat account: The fund has a demat account (typically held through a custodian) in which all portfolio company securities are credited
• ISIN for each investment: Every portfolio company in which the fund holds securities has an active ISIN for each class of securities the fund holds
• Fund holding in depository: The fund's demat account reflects the exact holding as reported in the fund's register of investments no discrepancies
• Quarterly reconciliation: The fund reconciles its demat account statements against its internal portfolio records quarterly, before each SEBI report submission
• Corporate action tracking: The fund has a process for verifying that its demat account is updated after every portfolio company corporate action
• Pre-closing demat condition: All new investments since the demat requirement was enforced have included demat as a pre-closing condition in the term sheet
• Retroactive demat programme: All portfolio companies that invested before the demat condition was standard have a documented demat completion timeline
• Annual holding statement collection: The fund requests updated holding statements from each portfolio company's DP annually for SEBI filing purposes

The Bottom Line

The SEBI demat requirement for AIFs is not ambiguous. The AIF Regulations and associated circulars require that portfolio securities be held in dematerialised form. The quarterly and annual reporting cycle makes non-compliance visible to SEBI, LPs, and auditors. The inspection process creates a mechanism for SEBI to identify and escalate non-compliance. And the consequences for fund managers from audit exceptions to inspection findings to registration risk are material enough to make demat compliance an existential priority for fund management teams, not just an operational preference.

For portfolio company founders, the implication is equally clear: a SEBI-registered AIF investor cannot hold your shares in physical form without putting its own regulatory standing at risk. When an AIF fund manager asks you to dematerialise, they are not being difficult. They are managing a compliance obligation that has real consequences for their registration. The appropriate founder response is to treat it with the same urgency the fund manager does.

Also Read: How AIFs Can Standardise Demat Compliance Across Their Portfolio

Also Read: Share Dematerialisation for Indian Startups: The Complete Guide

Frequently Asked Questions

Is there a specific SEBI circular that founders can reference when an investor asks for demat?

Yes. The foundational documents are the SEBI (Alternative Investment Funds) Regulations, 2012, and SEBI Circular CIR/IMD/DF/10/2013 on portfolio disclosures. Subsequent circulars on AIF reporting and valuation have reinforced the electronic holding requirement. The MCA Notification dated September 27, 2023 (effective September 30, 2024) establishes the independent obligation on private companies. A company secretary or legal advisor can locate the exact circular text through SEBI's official website. The combined reading of these documents makes the demat requirement unambiguous.

Can an AIF invest through a special purpose vehicle (SPV) to avoid the demat requirement?

No. If the AIF invests through an SPV, the SPV holds the portfolio company shares. The SPV itself is a company, and if it holds shares in a portfolio company that is subject to the MCA demat mandate, the SPV's holdings must be in demat form. Additionally, SEBI looks through SPV structures for the purposes of portfolio reporting the fund cannot avoid demat compliance by interposing an SPV between itself and the portfolio company.

What should an AIF do if a portfolio company refuses to dematerialise?

If the portfolio company is above the Rs 4 crore paid-up capital threshold, it is independently required to dematerialise under the MCA mandate refusal is regulatory non-compliance by the company, not just a commercial disagreement. The fund should formally document its request in writing, invoke any cooperation clauses in the shareholder agreement, and escalate through board representation if available. In extreme cases, the fund's legal team can advise on whether the failure to comply constitutes a breach of the shareholder agreement that triggers a remedy.

Does the demat requirement apply to debt investments by Category II AIFs?

Yes. Category II AIFs often invest in non-convertible debentures, compulsorily convertible debentures, or other debt instruments in addition to equity. These instruments are securities and are subject to the same demat holding requirement as equity investments. The portfolio company must have an ISIN for the specific debt instrument the fund holds, and the fund's holding must be credited to its demat account under that ISIN.

What is the fund's obligation if a portfolio company completes demat but then issues new physical shares in a subsequent round?

Issuing physical shares after demat is established and after the company is subject to the MCA mandate is a non-compliant act by the portfolio company. The fund should flag this immediately through the DP and require the company to correct the allotment to demat form. If the company issued physical shares to a new investor who is not an AIF, that new investor's holding remains an anomaly in an otherwise demat cap table that will surface in future due diligence. The fund has no independent obligation for the new investor's non-demat holding, but it does have an obligation to ensure its own holding remains in demat form.