Introduction
As the Securities and Exchange Board of India (SEBI) seeks to implement its new Transparency Program for Alternative Investment Funds (AIFs), venture firms and PE Funds must rethink their entire structure and plan as set out in its recent consultation papers (Papers)[i] – the five papers institute methods to bring more fairness to investors. On a plain reading, most proposals empower investors by providing a magnifying glass to investors on the flow of their money and are well-intentioned.
However, it is important to recognize that not all proposals are created equal, and some may have unintended consequences that could harm investors. Additionally, even with the best intentions, regulatory frameworks can be circumvented by those seeking to exploit loopholes for personal gain. Therefore, while empowering investors through increased transparency is a positive step, it is equally important for regulators like SEBI to remain vigilant and continually monitor and update the system to stay ahead of those seeking to take advantage of it. However, this must be balanced with risks in the market, including volatility and Manager discretion, and therefore should not flood the chain with compliance checks to compromise on profits.
All these were proposed in October 2021 as well, but AIFs in the Covid era were not ready to accept them, and the same has been reiterated.
In this post, the key issues will be analyzed. This will be followed by the nature of changes brought by the older regime and how efficient it may be. The article shall end with comments and concerns about counter-productivity, as has been the case in many SEBI proposals.[ii]
Direct Plan and Trail Methods: Will it be as great as it has been for Mutual Funds?
Direct plans are currently available only for mutual funds, not AIFs. The introduction of direct plans for schemes of AIFs will allow investors to invest directly in AIFs without intermediaries. This move is aimed at providing investors with more choices and greater transparency. Direct plans will have lower expense ratios than regular plans, which typically include distribution expenses.
Moreover, direct plans will provide investors with a clear view of the actual costs involved in investing in AIFs and the performance of the underlying assets. The proposed changes will also allow fund managers to market their direct plans to investors, creating greater awareness of them. This will benefit investors, more specifically those who are looking to invest directly in AIFs, as they will have more options to choose from.
Overall, introducing direct plans for AIFs is a positive move that will benefit investors, fund managers, and the industry. It will provide greater transparency, lower costs, and more choices to investors while enabling fund managers to raise funds and pursue new investment opportunities.
Currently, AIFs pay upfront commissions to distributors for selling their products. This model incentivizes distributors to push AIFs to investors, regardless of the suitability of the investment for the investor. The SEBI consultation paper proposes adopting a trail model for distribution commission in AIFs, which will help align the distributor’s interests with those of the investor.
Under the trail model, distributors will receive a commission based on the investor’s Assets Under Management (“AUM”). This commission will be paid periodically, based on the AUM of the investor in the AIF. This model seeks to incentivize distributors to provide better service to investors, as they will receive ongoing payments only if the investor continues to invest in the AIF.
Furthermore, since distributors will receive ongoing payments based on the AUM of the investor, they will be incentivized to ensure that the investment is suitable for the investor and that the investor remains invested in the AIF over the long term. These proposed changes also help to reduce the mis-selling of AIFs.
Related Party Transactions
AIFs can buy and sell investments from/to their associates, subject to certain conditions. These conditions are designed to ensure that such transactions are conducted at arm’s length and do not harm the interests of investors. However, SEBI has proposed introducing a new requirement that mandates investor consent for such transactions. Under the proposed changes, AIFs must obtain investors’ consent before buying or selling investments from/to their associates.
This consent must be obtained through a 75% majority of investors, who will have to vote on the transaction. This move aims to ensure that such transactions are conducted transparently and fairly and that the interests of investors are protected. A 75% threshold aligns with the rigorous rules for the same in listed companies under Section 188 of the Companies Act 2013.
The proposed changes will have a significant impact on the AIF industry. It will ensure that investors have greater control over the buying and selling of investments from/to associates of AIFs. This will provide greater transparency and accountability to the industry and reduce the potential for conflicts of interest.
To place a compliance check similar to listed corporates is excessive, as AIFs merely pool investments, profit from wealthy stakeholders, and are not involved in corporate governance or business models. This is detrimental to the entire regime and will curb, if not ban, such transactions that are integral to the functioning of Funds.
The requirement for investor consent may also result in a delay in the completion of such transactions. The AIF must wait for investors’ approval before proceeding with the transaction. This may impact the timing of such transactions, which may be critical in certain situations. Moreover, the proposed changes may also result in increased compliance costs for AIFs. They must set up systems and processes to obtain investor consent for such transactions. This may result in increased administrative costs for AIFs, impacting their profitability.
Dematerialization – Liquidity and possible listing
Currently, AIF units are issued in both physical and dematerialized forms. However, SEBI has proposed to make the dematerialization of AIF units mandatory. This move aims to ensure greater transparency and accountability in the industry and provide a secure and efficient way for investors to hold and trade AIF units.
Under the proposed changes, AIFs must ensure that all units issued are dematerialized. This will be achieved by registering with a depository participant (DP) and issuing the units in dematerialized form. This will ensure that all transactions involving AIF units are recorded electronically and are transparent to investors. It will also ensure that the ownership of AIF units is easily transferable between investors.
The proposed changes will have a significant impact on the AIF industry. It will provide investors with a secure and efficient way to hold and trade AIF units. It will also ensure that all transactions involving AIF units are recorded electronically and are transparent to investors. This will reduce the potential for fraudulent activities and improve the overall integrity of the industry.
The requirement for dematerialization of AIF units may also result in increased compliance costs for AIFs. They will have to set up systems and processes to ensure that all units issued are dematerialized. This may result in increased administrative costs for AIFs, impacting their profitability. Moreover, the proposed changes may also delay the issuance of AIF units as AIFs must register with a depository participant and set up systems and processes to issue units in dematerialized form. This may impact the timing of such transactions, which may be critical in certain situations.
This is different from other securities as AIFs are not listed on stock exchanges, and therefore, have different regulatory requirements. Furthermore, AIFs are typically used for private investments, and the timing of transactions may be critical in certain situations. For example, in the case of private equity investments, delays in the issuance of AIF units may result in missed investment opportunities or may impact the ability of investors to meet their funding obligations. Therefore, any changes in the regulatory framework governing AIFs can have a significant impact on the functioning of these funds and the investors who use them.
Comments of the Author
The direct plan should be made simple and easy to understand for investors. This can be achieved by providing precise and concise information about the fund, including its investment objectives, risks, and fees.
SEBI should educate investors about the benefits of direct plans and the trail model for distribution commissions in AIFs. This can be achieved through various means, such as investor education programs, online resources, and media campaigns.
Regarding related party transfers, AIFs should provide clear and concise disclosure about the associate’s identity, the nature of the transaction, and the potential conflicts of interest. This will enable investors to make informed decisions about their investments from/to associates of AIFs
Regarding dematerialized units, the only path forward should be listing units on the stock exchange, as investors can easily view such units. SEBI must permit trade on the open market to ensure liquidity in the secondary market for AIF Units.
The dematerialization process should be made simple and easy to understand for investors. This can be achieved by providing precise and concise information about the process, including the requirements, fees, and timelines.
How the SEBI can emulate practices from abroad
Both the UK and the US have implemented robust regulations in this area, which have been largely successful in increasing transparency and accountability within the AIF sector.
In the UK, the Financial Conduct Authority (FCA) requires AIF managers to disclose detailed information about their funds to investors on a regular basis. This includes information on the fund’s performance, investment strategy, fees, and risks. The FCA also requires AIF managers to appoint an independent valuer to determine the value of assets held by the fund, and to provide regular reports to investors on the fund’s valuation.
Similarly, the US Securities and Exchange Commission (SEC) requires AIF managers to register with the Commission and provide detailed information about their funds to investors. This includes information on the fund’s investment strategy, risks, fees, and conflicts of interest. The SEC also requires AIF managers to file regular reports with the Commission, which are publicly available and provide investors with valuable information about the fund’s performance and holdings.
SEBI can learn from these examples by implementing similar transparency laws for AIFs in India. This would include requiring AIF managers to disclose detailed information about their funds to investors, as well as appointing independent valuers to determine the value of assets held by the fund. By implementing these measures, SEBI can help to increase transparency and accountability within the AIF sector, and protect investors from unscrupulous managers who seek to exploit loopholes for personal gain.
While investor protection is important, it is also important to ensure that the regulatory framework does not stifle innovation or impede the growth of the AIF industry. SEBI should strive to strike a balance between investor protection and industry growth.
(This article is authored by Mr. Aditya Rao, currently a IV semester B.A. LL.B. (Hons.) student at NALSAR University of Law. The author can be contacted at: adityarao@nalsar.ac.in)
[i] Consultation paper on Investor consent for buying/selling investments from/to associates of AIFs;
Consultation paper on review of eligibility criteria for the key investment team and prescribing qualification for compliance officer of Manager of an Alternative Investment Fund;
Consultation paper on dematerialisation of units of AIFs;
Consultation paper on direct plan for schemes of Alternative Investment Funds (AIFs) and trail model for distribution commission in AIFs;
Consultation Paper on providing option to Alternative Investment Funds and their investors to carry forward unliquidated investments of a scheme upon completion of its tenure.
[ii] SEBI’s Proposed Disclosure Regime: Impact on Public M&A and Directors’ Liabilities.
NUALS Restructuring and Insolvency Law Journal 