Promising poetry, offering prose

With global market uncertainties, India is poised to become the natural choice for global funds to deploy capital. This can be achieved by offering a principle-based regulatory regime that addresses emerging concerns

Promising poetry, offering prose
Recent developments, though well-meaning, have gradually widened the gap between the industry's expectation of having the flexibility to manage private pools of capital as per global practices and Sebi leaning towards regulating AIFs on a par with other types of intermediaries in the asset management business.

By Shikhar Kacker & Nikhat Hetavkar

As the Alternative Investment Funds (AIFs) industry sees a sharp rise in commitment size from a meagre `3,595 million in 2012 to a sizeable Rs 6.94 trillion now, Sebi has stepped up its vigil through inspections and a slew of regulatory changes aimed at strengthening their regulatory and compliance framework. Recent developments, though well-meaning, have gradually widened the gap between the industry’s expectation of having the flexibility to manage private pools of capital as per global practices and Sebi leaning towards regulating AIFs on a par with other types of intermediaries in the asset management business.

The AIF regulations, introduced in 2012, were welcomed by the private equity industry, as it then merely laid down the broad governance framework for each AIF category to minimise the systemic risks posed by them without regulating business risks. The beginning of 2020, however, marked a shift in Sebi’s approach when it introduced the standardised placement memorandum (PPM) template and annual audit requirements for AIFs. Principal terms offered by AIFs now were to be aligned with the standard template unless each investor was offered a minimum investment ticket size of `700 million. Sebi also introduced a prescriptive criterion for ‘professional qualifications’ of the key management team, similar to those prescribed for portfolio managers, but out of sync with global practices, which focused on good repute and experience. The amendment also brought investment committee (Committee) members, often external, within Sebi’s ambit by making them responsible for the AIF’s investment decisions alongside the investment manager (Manager). Subsequent restructuring of the Committee also required super majority consent of investors, inconveniencing Managers in seeking expertise to meet evolving needs of the AIF.

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Aditional regulatory layers came in 2021, holding Committee members responsible for ensuring that decisions of the Committee follow AIF Regulations. Sebi thereafter mandated AIFs to file their PPM only through merchant bankers, further increasing cost of compliance and setting up AIFs. In another significant change last year, it restricted Managers from offering co-investment opportunities to its investors, unless offered under the client-portfolio manager relationship by the Manager, requiring them to register themselves as a co-investment portfolio manager under Sebi’s portfolio manager regulations. Globally, large investors often negotiate a seat on the Committee with protective rights and seek preferred co-investment rights. The amendment burdened them with fiduciary responsibilities and restricted their flexibility to make opportunistic investments, compelling them to consider investing through offshore structures over AIFs.

This year, Sebi increased scrutiny on AIFs’ reporting obligations. Recently, the regulator imposed an `10-lakh fine on a category III AIF for breaching its 10% investable fund limit per investee company as it adopted a flexible methodology of calculating investable funds linked to returns accruing from temporary investments instead of a fixed expenditure calculation. The order, seeming reasonable at first, throws unanswered questions for AIFs regarding treatment of income generated from investments, what is available for reinvestments, and long stop date for calculating investment limits viz. through the life of the fund versus the date of final closing.

In a recent circular, Sebi directed all AIFs to create a permanent position of ‘Compliance Officer’, distinct from the CEO. The Circular also provides guidelines for the Large Value Fund for Accredited Investors (LVF) relating to filing of scheme documents with Sebi and conditions for the extension of their tenure. The guidelines dampen contractual flexibility and may prove to be counterintuitive to creation of this sub-category of AIFs.

Rising compliance needs don’t only increase the initial setting up and ongoing operating costs but also take away the promised flexibility to AIFs for managing non-retail pools of capital, distinct from other categories of asset managers, which cater to a wider investor base and pursue public market strategies.

Increasing their regulation is also viewed in a negative light by highly sophisticated investors that prefer the flexibility that comes with a light touch regulation over the regulatory protection in its current form, which does not distinguish between smaller AIFs and large AIFs having sophisticated investors with higher risk appetite and knowledge. Even the introduction of the concept of ‘accredited investors’ for AIFs has failed to counterbalance the cumbersome regulations, as despite nearly a year since their enactment, only a few accreditation agencies have been approved by Sebi.

With global market uncertainties, India is poised to become the natural choice for global funds to deploy capital, provided our investment management regime is aligned with the global best practices. This can be achieved by offering a principle-based regime that addresses concerns rather than imposes restrictive conditions, carving exceptions on the basis of the investment strategy of the AIF, its investor base, and systemic risk posed by it. We hope Sebi finds the right balance between poetry and prose, providing regulatory protection while ensuring exemptions for sophisticated investors who choose AIFs for their minimal regulation and higher flexibility.

The author is Lawyers, Khaitan & Co Views are personal 

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