By Sandeep Parekh
A “sponsor” is the nucleus of a mutual fund (MF) precisely because it is responsible for promoting, bringing in capital, and setting up an MF. It is important to mention that the concept of a sponsor is a departure from the usual rule of a company being a separate legal entity. Third parties are never liable or responsible for either the financial or non-financials of a legal entity once incorporated. The reason for the departure from the stated policy is to introduce a promoting entity being responsible for the fund at a time the fund is somewhat new, and systems are still not fully in place for accountability. Owing to this central role of sponsors in retail-oriented funds, the bar set up by the Securities and Exchange Board of India (Sebi) for an entity to qualify as the sponsor of an MF is quite high. However, despite the sponsors’ important position, the market trend suggests that once an MF crosses a certain mark for assets under management (AUM), they earn a reputation and become established—and consequently, the role of a sponsor in such an MF begins to diminish and indeed should be eliminated.
According to the Association of Mutual Funds in India, the country’s MF industry has witnessed a two-fold growth in the past five years in terms of AUM. This growth, when quantified, amounts to around Rs 39.89 trillion as of December 31, 2022, from Rs 21.27 trillion as of December 31, 2017. This demonstrates that the MF industry has the potential for a lot more growth, for which new players may act as catalysts. Considering this, in April 2022, Sebi set up a Working Group to review the role and eligibility of a sponsor of an MF. In a recently-released Sebi consultation paper, the Working Group has proposed alternative eligibility criteria for Private Equity players (PEs) to enable them to act as sponsors of MFs while also viewing the viability of having self-sponsored Asset Management Companies (AMCs).
Over the past few years, PEs have been allowed to act as sponsors of real estate investment trusts, asset reconstruction companies, and entities in the insurance industry. In this light, it was observed that PEs have significant capital which can be invested to drive innovation and growth, consequently leading to constructive competition in the MF industry. Aiming to enable the entry of PEs into the MF industry, Sebi has proposed an alternative eligibility criterion wherein a sponsor would have to capitalise the AMC in such a manner that the positive liquid net worth of the AMC is not less than Rs 150 crore. In addition to this, the minimum positive liquid net worth would have to be Rs 100 crore, and the AMC would have to maintain such net worth till it has profits for five consecutive years. Further, the minimum capital contributed and minimum sponsor stake of 40% would have to be locked in for a period of five years.
While, on the one hand, Sebi’s proposal to make the MF industry more inclusive is laudable, on the other, the net-worth-based eligibility criterion defeats this purpose by erecting high entry barriers for interested players. As reiterated in this column many times, adding a net worth criterion for smart businesses ensures rich people rather than smart and ethical people enter. In any case, PE players usually come with scale, and thus net worth may not by itself be a entry barrier. Further, a PE will more likely enter as the financial sponsor of a running AMC rather than a greenfield venture. The core strength of PEs is bringing large amounts of capital and the ability to scale the business rapidly. Thus, once allowed, there will be mix-and-match between PE players and fund managers, bringing in capital from the former and expertise with the latter, in a jugalbandi.
Sebi has further observed that as MFs mature, AMCs acquire self-sufficiency and maturity in operations in the interest of the unitholders, thereby gradually reducing the sponsors’ obligations to insignificant activities. The Working Group has proposed a reduction of ownership of the sponsor in the AMC over time from the current requirement of 40% and has floated the idea of a self-sponsored AMC without any sponsor. The consultation paper highlights that a reduction of the sponsor’s stake in the AMC will pave the way for other significant shareholders, bringing in strategic guidance, inclusivity, and talent to fuel growth and innovation in the MF industry. Moreover, with the presence of other investors in the AMC, MFs will work in the interest of investors by engaging in fewer related party transactions and minimising investment in instruments connected to the sponsor, its associates, or group companies. This would counter-intuitively bring greater accountability for the MF and its manager rather than relying on some third party who knows little of what is going on.
The consultation paper recommends that such reduction may be achieved either voluntarily, where the AMC or the sponsor will have the liberty to apply for disassociation; or mandatorily, where the reduction in stake will be a regulatory requirement. In either case, the primary principle for permitting disassociation of existing sponsors will be that the AMC itself is able to meet the qualifying conditions for a self-sponsored AMC as prescribed by the regulator. It is possible that the disassociation of existing sponsors, as envisaged by Sebi, will result in some MFs continuing to have sponsors even as some operate without any sponsors, hence inviting two sets of compliance requirements catering to the specifications of each structure. A key distinction will be that, in the case of a self-sponsored AMC, all obligations of a sponsor, such as compensating for inappropriate valuation, maintenance of minimum liquid net worth of AMC on a continuous basis, etc, will be performed by the AMC itself. The disassociated sponsor will be considered a “financial investor’, and no obligation of a sponsor will apply to it.
Sebi is proposing to put in place ownership norms akin to those stipulated by RBI for banks, which require promoters to mandatorily dilute their shareholding in banks within a specified period as per the prescribed guidelines. Given that the underlying intention is to usher in a new era of self-sufficient AMCs, it is suggested that a mandatory reduction in the stake of sponsors is the way to achieve this. At the same time, it is important to gauge if a model mandating disassociation of sponsors will be practically feasible for the AMCs presently operating in the Indian markets, who would then be required to adopt these norms retrospectively. A more practical and consistent model would be to allow sponsors to disassociate themselves voluntarily after a period of maturity of the MF/AMC, without mandating a divestment. The assumption that fragmented shareholding by itself is a good thing is questionable, as we have seen in many banks. The regulator should let a thousand flowers bloom from a control perspective so long as it is without diluting accountability standards.
Overall, Sebi’s proposals will help achieve fresh capital injection, foster competition and innovation, enable new players to enter the MF space and provide an exit option to sponsors of AMCs. That said, Sebi must put in place more balanced provisions to ensure that PEs can enter and sponsors can exit the MF industry comfortably while also protecting unitholders’ interests against any market imbalances and disruptions that may be caused due to such actions. As the Indian MF industry continues to evolve, it will be interesting to see how these proposals pan out in terms of implementation in a market that might be set in its ways of operation.
(The writer is Managing partner, Finsec Law Advisors. Co-authored with Lipika Vinjamuri and Navneeta Shankar, associates, Finsec Law Advisors)
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