The proposed amendments to the SEBI (Alternative Investment Funds) Regulations, 2012, aim to clarify the regulatory framework for Alternative Investment Funds (AIFs) by ensuring fair treatment of investors through the maintenance of pro-rata and pari-passu rights. These rights ensure that each investor’s share of returns corresponds with their investment proportion. The amendment seeks to address past practices where some AIFs used a priority distribution model that undermined these principles, allowing certain classes of investors to receive higher returns or absorb more losses than their proportional share. This model has raised regulatory concerns, particularly regarding its potential for misuse and mis-selling, especially in light of past financial crises. The Working Group recommended that while the priority distribution model should not be entirely banned, it must come with checks to mitigate misuse, particularly when assets are acquired from unrelated parties. However, SEBI has maintained that without clear and reliable valuation methods for differing classes of AIF units, such a model poses structural vulnerabilities. Therefore, SEBI continues to emphasize the need for transparent valuation practices and a unified approach to investor rights to uphold investor protection and avoid regulatory arbitrage.
Securities and Exchange Board of India
Monday 30th September 2024– SEBI Board Meeting
1. Objective
With an objective to clarify the regulatory intent of Alternative Investment Fund (‘AIF’) being a pooled investment vehicle and to ensure fair and equal treatment of investors of an AIF, this Board Memorandum proposes to amend SEBI (Alternative Investment Funds) Regulations, 2012 (‘AIF Regulations’) to explicitly mandate maintaining pro-rata and pari-passu rights of investors of AIFs.
Further, in order to provide operational flexibility to AIFs and their managers, it is also proposed to provide certain relaxations from the aforesaid requirement, such as allowing government-owned entities and multilateral institutions, besides sponsors and managers, to subscribe to junior tranches in AIFs, and exempting Large Value Funds from ensuring pari-passu rights.
2. Pro-rata rights of investors of AIFs
2.1. As per AIF Regulations, AIF is a privately pooled investment vehicle that collects funds from investors for investment in accordance with a defined investment policy for the benefit of its investors. Since AIF is a pooled investment vehicle, the investors have rights in each investment of the AIF in the ratio of their contribution in the AIF, i.e., on a pro-rata basis.
2.2. To elaborate on the aforesaid principle, investors commit funds to the AIF which are pooled to form the corpus of scheme of the AIF. Upon identification of an investment opportunity, the AIF draws down capital from investors in the ratio of their commitment to the scheme of the AIF and makes investment. This results in pro-rata contribution/ rights of each contributing investor in each investment of the scheme, in the ratio of their commitment to the scheme.
2.3. While not explicitly stated in the AIF Regulations, maintaining pro-rata rights of investors in each investment of the scheme of the AIF is an essential characteristic of the AIF as a pooling vehicle. Consequently, distribution of investment proceeds should also be pro-rata to the rights of investors in each investment of the scheme, except in cases where it has been provided in the extant framework i.e. (i) where the investors do not participate in the investment due to excuse/exclusion from the investment, (ii) where the investors default in providing drawdown amount to AIF for making investment, and (iii) where the investors share profit with the manager of AIF as performance fee/carried interest.
2.4. In this context, AIF industry’s request for permitting co-investment for select investors through issuance of separate class of units was not acceded to, considering that the same was not in line with the aforesaid principle of pro-rata rights in each investment. Without compromising the aforesaid principle, to provide flexibility to investors of AIFs to make co-investment, an agenda to facilitate co-investment by investors of AIFs through portfolio management route, was approved by the Board in the meeting held on September 28, 2021 and corresponding amendments to AIF Regulations and SEBI (Portfolio Managers) Regulations, 2020 were notified.
2.5. As an exemption to the aforesaid principle, to provide flexibility to sponsor/ manager in their negotiation with investors for fund raising by committing to bear higher losses, vide SEBI circular no. CIR/IMD/DF/14/2014 dated June 19, 2014, the following was specified (Clause 11.1.1. of SEBI Master Circular for AIFs dated May 07, 2024):
‘With respect to investment by the sponsor/manager in the AIF, the sharing of loss by the sponsor/ manager shall not be less than pro-rata to their holding in the AIF vis-à-vis other unit holders’.
Thus, sponsor/manager of an AIF may share loss higher than their pro-rata holding vis-à-vis that of other investors, i.e., investors of the scheme may have priority in distribution or proceeds over sponsor/ manager of the AIF. It is important to note that the aforesaid provision does not specifically provide for investors sharing losses more than their pro-rata holding.
2.6. In this context, it was observed in the past few years that certain schemes of AIFs had adopted a distribution waterfall in such a manner that one class (‘Junior class/tranche’) of investors, other than sponsor/manager, shared loss more than pro-rata to their holding in the AIF vis-à-vis other classes (‘Senior class/ tranche’) of investors, since the latter had a priority in distribution of proceeds over the former (hereinafter referred to as ‘priority distribution model’). Thus, in case the scheme incurs a loss, the losses of Senior class investors are compensated out of the residual capital accruing to the Junior class investors. Similarly, in case of profit scenario, distribution is made first to Senior class investors till their agreed hurdle rate of return is met, and thereafter, the remaining proceeds, if any, are distributed to Junior class investors. In both the scenarios, the pro-rata distribution of proceeds among investors is not complied with.
2.7. It was also brought to SEBI’s attention that AIFs with priority distribution model may be structured by certain regulated lenders to facilitate possible ever-greening of their loans and take advantage of regulatory arbitrage to avoid compliance with regulatory requirements applicable to them, in the following manner:
2.7.1. The regulated lender identifies loans given to certain borrower companies, which are in financial stress and are expected to default in near future. Typically, the regulated lender would subscribe to Junior class of units of a scheme of an AIF set up for this purpose, and the AIF, in turn, would fund the lender’s stressed borrower by subscribing to debt securities issued by the borrower.
2.7.2. The AIF on-boards other investors who are willing to subscribe to Senior class of units, by offering protection on their investment, to the extent of securing priority of return over Junior class investors.
2.7.3. The expected loss on the loan portfolio at the time of structuring, i.e., the expected haircut, appears to be a factor in determining the amount to be invested by the regulated lender as a Junior class investor in the AIF. Accordingly, the Senior class investors invest to the extent of perceived fair market value of the loans that the regulated lender intends to clear off from its books.
2.7.4. With the aforesaid understanding between the regulated lender, Senior class investors and the borrower companies, the AIF invests in NCDs issued by the borrower companies so that amount invested by the AIF in the borrower companies is used to repay the loans extended to them by the regulated lender.
2.7.5. The stressed asset in the books of the regulated lender would in effect be replaced with the investment in the Junior class units of the AIF. This effective structuring allowed some regulated lenders to avoid classification, provisioning, disclosure and other applicable regulatory requirements under RBI Regulations with respect to these stressed assets. The recognition and disclosure of deteriorating creditworthiness of the borrower may have also been deferred.
2.7.6. Considering this, the aforesaid modus operandi and details of instances involved were brought to the attention of RBI. RBI acknowledged the regulatory concerns in this regard as corroborated by issues identified under their own supervision. Subsequently, RBI issued a notification dated December 19, 2023 on ‘Investments in Alternative Investment Funds (AIFs)’ to their regulated entities (viz., Banks, Non-Bank Financial Institutions, and other Financial Institutions), inter-alia, to address concerns relating to possible ever-greening through the AIF route.
2.8. Apart from the aforesaid circumvention, considering that AIFs/schemes with priority distribution model are intended to cater to different set of investors having different risk appetite, with the same pool of underlying investments, the aforesaid structure has a significant scope for conflict of interest and valuation related issues. Also, by having different classes with highly differential risk return profile, the structure is also prone to mis-selling.
2.9. In this context, it is pertinent to mention that, during the global financial crisis of 2008, the practice of tranching was a part of the creation and distribution of complex collateralized debt obligations (CDOs). The complexity of the CDOs with tranches and the lack of transparent pricing and valuations made it difficult for investors to accurately assess the risks involved in such instruments. Many such investors had invested large amounts in CDOs with tranches, without fully comprehending the potential risk/downside. Subsequently, when the crisis hit and value of CDOs plummeted, many investors alleged mis-selling with respect to CDOs with tranches, which led to investor grievances and various litigations.
2.10. Thus, tranching, amidst subjectivity in pricing and valuations, has in-built structural vulnerabilities and a high potential for mis-selling, especially with respect to returns accruing to junior tranches.
2.11. After consideration of the aforesaid issues, it was felt that the priority distribution model is not in line with the regulatory intent of AIF being a pooled investment vehicle and, therefore, there was a need to provide clarity to the industry regarding pro-rata rights of investors in investments and distribution of proceeds of the AIF, subject to specific provisions or exclusions.
Consultation with stakeholders:
2.12. Considering the above, an agenda was placed in meeting of Alternative Investment Policy Advisory Committee (‘AIPAC’) of SEBI held on November 22, 2022, to explicitly provide in AIF Regulations that pro-rata rights of investors shall be maintained in all investments, including distribution of the proceeds of the AIF. After deliberations, AIPAC recommended that a Working Group may be formed to address the regulatory concerns and suggest safeguards in the matter pertaining to priority distribution among investors. SEBI informed the Committee that a stand has been taken to not allow priority in distribution among investors, which may be reviewed upon receipt of recommendations from the aforesaid Working Group, if considered appropriate.
2.13. Accordingly, vide SEBI circular dated November 23, 2022, schemes of AIFs that adopted priority distribution model were directed to not accept any fresh commitment or make investment in a new investee company, till a view is taken by SEBI in this regard.
2.14. Subsequently, the Working Group constituted to provide its recommendations on allowing AIFs to adopt priority distribution model, along with measures and safeguards to prevent regulatory arbitrage/misuse, submitted its report in March 2023. The Working Group recommended that the priority distribution model should not be entirely prohibited and that instead, checks and balances should be evaluated to mitigate the risk of any misuse. The Working group suggested prohibition only in limited cases where such measures are found insufficient to prevent the misuse of the priority distribution model.
2.15. The Working Group further recommended that the priority distribution model may be permitted in cases where the AIF is acquiring or refinancing assets of an unrelated third party and none of the investors, directly or indirectly, are associates or group entities of the parties from whom assets are being acquired
or being refinanced. The Working Group also suggested an alternative that, if the contributor of the assets, directly or indirectly, holds more than 10% of the AIF units, then the contributor shall confirm that the valuation of the AIF units in its books would continue at the value after provisioning ‘as if’ the assets continued to be held directly by the contributor. A brief summary of the recommendations of the Working Group and SEBI’s views on the same are given at Annexure A.
2.16. The merits in permitting the priority distribution model were deliberated at length. However, it is evident that such a structure with a differential distribution mechanism has inherent conflict of interest issues and is prone to misuse, by benefitting from regulatory arbitrage. The issues being considered here are not just from the perspective of investor protection, but also about structural vulnerability that arises from regulated entities bypassing applicable regulatory requirements coupled with subjective valuation of assets that may mask true asset quality.
2.17. It may be noted that the Working Group had acknowledged the issue of valuation of the assets held by such AIFs and provided certain recommendations pertaining to appointment of independent valuer and transparency around valuation. However, such recommendations alone may not be sufficient to address concerns with respect to subjectivity in valuation of differential units issued under Senior/ Junior class and underlying assets, which remains the basis for not permitting priority distribution model. The Working Group acknowledged that the valuation methodology could create a window for potential arbitrage. This is especially a concern as there is ambiguity and lack of guidelines around how the junior class units of AIFs would be valued and recognised in the books of junior class investors.
2.18. Considering the above concerns, it was felt that it may not be prudent to permit AIFs to adopt priority distribution model. It was further felt that the cost of permitting priority distribution model outweighed benefits of the same, which can be achieved through other regulated structures. Even AIF Regulations provide flexibility to AIFs to launch multiple schemes under the same AIF registration with different strategies to attract investor groups of different risk appetite, while also investing in the same investment portfolio.
2.19. In meeting of AIPAC held on May 10, 2023, SEBI informed the Committee regarding the recommendations of the Working Group and that the same did not adequately address the primary concerns surrounding valuation of the assets of AIFs. Accordingly, the decision to not accede to the recommendations of the Working Group until the issue of valuation is resolved to satisfaction, was also apprised to AIPAC.
Public Consultation:
2.20. SEBI issued a consultation paper on May 23, 2023 (Annexure B), soliciting comments from public on the proposal to maintain rights of investors pro-rata to their commitment to the scheme, while making investment and distributing proceeds of the investment. A total of 7 responses to the consultation paper were received from the stakeholders such as AIFs, AIF industry associations, etc.
2.21. Commenters have predominantly suggested allowing priority distribution model, stating that prohibiting the same will restrict India from attracting investments, and fund managers from managing pools of capital through such products including providing potential cushion to other investors.
2.22. While commenters have provided examples of few funds in foreign jurisdictions that have adopted priority distribution model, especially in the context of blended finance, no specific reference to any regulatory framework from jurisdictions that regulates funds (as is the case in India) and not just fund managers, which allows such structuring in funds, has been provided.
2.23. Further, the comments received in support of priority distribution model mostly reiterate the recommendations provided by the Working Group as given at Annexure A. Certain safeguards have also been suggested for allowing priority distribution model such as permitting only institutional investors, accredited investors in Junior class, prohibiting regulated lenders from participating in such structures, transparency in valuation, prescribing maximum contribution of an investor in Junior class, etc.
2.24. As stated at para 2.16, 2.17 and 2.18 above, while such safeguards do not adequately address the issues pertaining to allowing priority distribution model in AIFs, it is seen that there may be a case for permitting priority distribution for AIFs only under a specific framework where the related concerns are minimal, as elaborated below. A brief summary of other public comments received and SEBI’s views on the same are given at Annexure C.
2.25. Accordingly, it is felt appropriate to clarify in the AIF Regulations regarding requirement of pro-rata rights of investors in a scheme of an AIF, with specific exemptions as discussed below.
Framework for AIFs to adopt priority distribution model:
2.26. While it is felt that maintaining pro-rata rights of investors in each investment of an AIF scheme is an essential feature of AIF being a pooled investment vehicle, various commenters have highlighted the need for permitting priority distribution model with adequate safeguards, in order to raise capital through AIFs for investment in emerging sectors and companies which are in need of capital infusion.
2.27. The need for such priority distribution model is even more pronounced in the context of Blended Finance structures which are intended to bring private capital to sectors/ domains in need, backed by public/ philanthropic investment. Commenters have referred to various global blended fund structures, which have adopted priority distribution model to raise private capital for investment in emerging areas such as renewable energy, green finance etc.
2.28. It may be noted that the World Economic Forum has been taking consistent efforts to promote blended finance structures globally. As per the World Economic Forum and OECD, Blended Finance is defined as the strategic use of development finance and philanthropic funds to mobilize private capital flows to emerging and frontier markets. It has highlighted that Blended Finance deliberately channels private investment to sectors of high-development impact while at the same time delivering risk-adjusted returns. It offers promising potential as an ecosystem solution to close the development funding gap, resulting in positive results for both investors and communities. Typically, Blended Finance structures employ some kind of risk protection measures for the private investors, including offering priority in distribution, to improve fund raising from private players.
2.29. In this context, it may be noted that, Government of India has also been utilising AIF route for infusing funds in capital deprived sectors. Some of the Government sponsored AIFs, which are set up for financing sectors in need are SWAMIH Investment Fund I, funds of NIIFL, NSIC Venture Capital Fund Limited etc. There have been instances where Government has used AIF route to channelize funds from Government or Government related investors from other jurisdictions and multilateral organisations by way of entering into various economic partnerships.
2.30. Considering that India is a developing country, with many sectors in dire need of capital, it is desirable to facilitate structures (similar to Blended Finance structures) that enable private capital investment in such sectors. The same is in line with the objective of the Government to enhance private investment in sectors in need and to facilitate public private partnerships.
2.31. Thus, it is felt that, the commenters’ suggestion to permit AIFs to adopt priority distribution while limiting entities that can subscribe to Junior class of units, warrants merit, in order to encourage structures adopting Blended Finance model. Since Government/ Government related investors typically invest in AIFs which, in turn, invest in sectors in need of capital for development or those which result in social/environmental impact, it is considered to allow Government/ Government related investors to subscribe to junior class of units of AIFs. In such cases the concerns of mis-selling and misuse of the priority distribution model would not arise.
2.32. Accordingly, the proposal to allow only the following entities to bear loss more than their pro-rata holding in the scheme, i.e., subscribe to junior class of units, was discussed in a meeting of AIPAC held on June 18, 2024 –
(i) Manager or sponsor of the AIF (presently allowed);
(ii) Multilateral or bilateral development financial institutions;
(iii) State industrial development corporations;
(iv) Entities established, owned or controlled by the Central Government or a State Government or the Government of a foreign country, including central banks and sovereign wealth funds. Considering that the proposal is intended to provide relaxation/flexibility to AIFs/managers, the Committee recommended the aforesaid proposal.
2.33. Additionally, the Committee also recommended that funds/ entities regulated by other financial sector regulators such as banks, pension funds and insurance companies may also be allowed to subscribe to junior class of units of AIFs. In this regard, it is noted that the identified circumvention for ever-greening of loans through AIFs involved entities regulated by other financial sector regulators.
2.34. In this context, it may also be noted that AIF Regulations have been amended and notified on April 25, 2024, to cast obligation on AIFs, managers and their Key Management Personnel (KMPs) to carry out specific due diligence of their investors and investments, so that AIFs do not facilitate circumvention of specified regulations administered by financial sector regulators. Under this obligation, the Standards Setting Forum for AIFs (‘SFA”) is formulating implementation standards to prevent facilitation of various circumventions through AIF route, including ever-greening of loans by regulated lenders through AIFs.
2.35. Accordingly, the suggestion of AIPAC to allow other regulated entities to subscribe junior class units of an AIF may be examined in due course after studying the effectiveness of the implementation standards formulated by SFA to address concerns relating to circumvention through AIFs.
2.36. To ensure that priority distribution model is not misused in case of schemes where manager or sponsor subscribe to junior class of units, the investment made by such scheme in its investee company shall not, directly or indirectly, impact any existing commercial relationship with manager or sponsor or their associates and, the amount invested by the AIF in the investee company shall not be utilized directly or indirectly to repay any obligations or liabilities to the manager or sponsor or their associates.
2.37. Further, it may be noted that, in case of Angel Funds registered under Category I VCFs, investments are made on deal-by-deal basis, i.e., manager is required to obtain consent of investor for their participation in each investment opportunity. Accordingly, it is viewed that the requirement to maintain pro-rata rights across investments of AIFs may not be applicable to Angel Funds at the fund level.
3. Pari-passu rights of investors of AIFs
3.1. While providing clarity regarding pro-rata rights of investors in investments of AIFs, ensuring equal treatment of investors in the AIF in various other aspects is also critical. In this regard, it has been observed from the examination of PPMs submitted by AIFs that the AIF industry issues various classes of units or enters into side letters with investors to provide differential benefits/ rights to certain investors over others. Few such terms on which differential rights are being provided by AIFs, generally through side letters, are drawdown timeline, hurdle rate of return/ performance linked fee, transfer of AIF units, access to information, representation on investment committee or other committees/ boards of the AIFs, co-investment etc. While these terms may be commercial or non-commercial in nature, differential rights on some of these terms may affect the rights of other investors.
3.2. AIF Regulations do not specifically provide a list of the terms on which the differential rights may be provided. However, in terms of template for PPM mandated for AIFs specified vide SEBI circular dated February 05, 2020, AIFs are required to clearly disclose:
3.2.1. the list of commercial and non-commercial terms on which differential rights may be offered to certain investors (through side letters or by way of issuance of separate classes of units)
3.2.2. the criteria for offering differential rights through side letters to any investors. Manager has full flexibility to determine the parameters (quantitative or qualitative) for qualifying an investor for entering into a side letter arrangement.
3.2.3. that the differential rights offered on various terms, do not have any adverse impact on the economic rights or any other rights of other investors.
3.2.4. that nothing under the side letters shall alter the rights of the other investors available to them under their respective contribution agreements.
3.3. Further, vide the aforesaid circular, differential rights shall not be offered on the following terms:
(i) Preferential exit from Fund/ Scheme
(ii) Contribution to Indemnification
(iii) Giveback
(iv) Drawdown (except as per the provision for ‘excuse and exclusion’)
It may be observed from the above mentioned list of terms that the same is intended to ensure that rights of other investors are not affected by issuance of side letters on different terms to select investors, i.e., all the investors in the scheme are treated pari-passu with respect to rights provided by the AIF to its investors. In legal parlance, the principle of ‘pari-passu’ means that investors are treated at par/ equally, without preference to any specific investor.
3.4. As may be seen, primarily disclosure norms have been specified with respect to offering of differential rights so that investors in AIFs are aware of the terms on which there may be a differential treatment to certain categories of investors in the fund and that their interests are not affected by such differential treatment. However, while processing applications for launch of schemes, it is seen from PPMs that AIFs propose to provide differential rights which results in impacting the interests of other investors such as w.r.t. in-specie distribution, excuse of investors etc.,. Thus, it suggests that there is lack of clarity in AIF industry on the differential rights that may affect the rights of other investors.
3.5. To assess the industry practice in this regard, the schemes which had issued units under multiple classes of units, linked to large number of ISINs in the depository system were examined. It is seen that, in many cases, different classes of units were issued to distinguish between different commercial terms to investors, especially management fee and hurdle rate of return.
3.6. On further analysing differential rights offered through side letters by a few schemes, it was seen that a select investor was given differential treatment to not pay equalization amounts/ equalization premium amount (i.e., have the ability to enter late into an investment at cost, without having to pay the current higher valuation), to not bear cost of warehousing investments, limiting the indemnity obligation for certain preferred investors, etc. These differential rights may result in other investors of the fund bearing liability/ cost accruing to that particular investor who has been provided the differential right through side letter.
3.7. While flexibility is provided to AIFs to have multiple classes of units or enter into side letters to provide differential rights to investors, it is also essential to ensure that all investors are treated pari-passu with respect to rights provided by the AIF to its investors, as long as the differential rights provided to a certain investor does not adversely impact the rights of other investors in the AIF.
3.8. It is pertinent to mention that the Report on ‘Elements of international regulatory standards on fees and expenses of investment funds’ published by the technical committee of the International Organization of Securities Commissions in November 2004, discusses the issue of fair treatment of investors in investment funds. The report, while analysing fee structure in funds having multiple class of units, has prescribed that the existence of different share classes should not result in a breach of equality of investors who invest or have invested in the same share class and that no advantage should be provided to a share class that would result in a prejudice to another share class or to the fund.
3.9. Further, reference is drawn to Alternative Investment Fund Managers Directive 2011 (2011/61/EU), legal act of the European Union on the financial regulation of hedge funds, private equity, real estate funds, and other “Alternative Investment Fund Managers” (AIFMs) in the European Union. Article 23 of Commission Delegated Regulation (EU) No 231/2013 of 19 December 2012, specifies the following with respect to fair treatment of investors in the AIF:
(i) The AIFM shall ensure that its decision-making procedures and its organisational structure, ensure fair treatment of investors.
(ii) Any preferential treatment accorded by an AIFM to one or more investors shall not result in an overall material disadvantage to other investors.
3.10. It is evident from the global references given above that equal and fair treatment of investors is a core and inherent principle for investment funds globally. Thus, it is essential to expressly provide that AIFs shall not provide any differential treatment to investors which affects rights of other investors. Thus, AIFs may be allowed to offer any differential rights to investors that do not affect the rights of other investors, such as differential management fees, hurdle rate of return, performance fees/ carried interest, co-investment facility etc. The same would provide comfort to investors of AIFs without taking away the flexibility of managers to issue certain differential rights to help negotiate and raise funds from investors.
Consultation with stakeholders:
3.11. SEBI issued a consultation paper on May 23, 2023 (Annexure B), soliciting comments from public on the proposal to maintain pari-passu rights of investors, i.e., investors of the AIF/scheme shall be treated equally with respect to economic rights of the investors. A total of 7 responses to the consultation paper were received from the stakeholders such as AIFs, AIF industry associations, etc.
3.12. Upon analysing the comments received, it is seen that there is ambiguity with respect to what constitutes economic rights and with respect to the terms on which differential rights may be issued, without affecting rights of other investors. A brief summary of other public comments received and SEBI’s views on the same are given at Annexure C.
3.13. Accordingly, while it may be clarified in the AIF Regulations that the rights of investors of an Alternative Investment Fund shall be pari-passu in all aspects, it may also be specified that AIFs may offer differential rights to select investors of a scheme, which do not affect the rights of other investors of the scheme.
3.14. Further, for consistency in industry practice with respect to such terms, the SFA may, in consultation with SEBI, formulate and specify the list of terms on which differential rights may be permitted to be provided to investors, based on the aforesaid principle to be included in AIF Regulations. Further, the criteria for offering differential rights on such terms to certain investors shall also be disclosed in the PPM of its scheme, as already required by SEBI.
3.15. An agenda on pari-passu rights of investors and specifying a list of terms on which differential rights may be provided by AIFs to certain investors, without affecting the rights of other investors in the AIF, was discussed in meeting of AIPAC. Upon deliberation, the AIPAC recommended the principle that differential rights offered by an AIF to select investors should not affect economic rights or other rights of other investors and suggested prescribing a negative list of terms on which differential rights shall not be offered by AIFs.
3.16. In this regard, as per the discussions, it was agreed that the industry association shall compile a negative list of terms on which differential rights shall not be offered by AIFs and submit the same to SEBI. The submissions of AIF industry for negative list has been examined and it is felt that the suggested terms are too broad and open to interpretation. Thus, such a negative list leaves scope for AIFs to offer differential rights on various terms which may affect other investors’ rights, which is fundamentally against the concept of pari-passu treatment of investors.
3.17. It may also be noted that the principle, by itself, or along with negative list of terms on which differential rights shall not be offered, would be open to interpretation by the AIF industry and hence, would pose challenges in implementation and monitoring compliance with the same over the period of time. On the other hand, a positive list of terms for offering differential rights would bring consistency and provide necessary clarity to AIF industry for ease of compliance, while also facilitating better enforceability by SEBI which would stand in court of law.
3.18. Further, the SFA would be formulating the positive list of terms on which differential rights may be offered and hence, the same may be reviewed and updated as and when required, in consultation with SEBI. Accordingly, it is felt that prescribing an exhaustive list of terms on which differential rights may be offered by AIFs, subject to need based review, is appropriate rather than providing a negative list of such terms. In this regard, a framework may be laid down by SEBI, by way of circular, for guidance to SFA in formulating the list of terms on which differential rights may be offered, in consultation with SEBI.
3.19. Further, the manner of dealing with differential rights already issued by AIFs, not falling within the positive list of terms, may also be specified by SEBI.
3.20. Also, as per the suggestions received from public and also recommended by AIPAC, Large Value Funds for Accredited Investors (LVFs) may be exempted from the requirement of maintaining pari-passu rights for its investors.
4. Proposals:
4.1. Taking into account SEBI’s discussions with AIPAC and the AIF industry, comments received from public and internal deliberations, it is proposed that AIF Regulations may be suitably amended to –
4.1.1. Specify that the investors of a scheme of an AIF shall have rights pro-rata to their commitment to the scheme, in each investment of the scheme and in distribution of proceeds of such investment, along with an enabling clause for specifying exemptions in certain cases;
4.1.2. Provide exemption to Angel Funds from aforesaid requirement at para 4.1.1 above;
4.1.3. Specify that the rights of investors of a scheme of an Alternative Investment Fund, other than that specified in para 4.1.1, shall be pari-passu in all aspects. Provided that, AIFs may offer differential rights to select investors of a scheme, in the manner as may be specified by SEBI, without affecting the rights of other investors of the scheme; and,
4.1.4. Provide exemption to LVFs from requirement of maintaining pari-passu rights among investors as given at para 4.1.3 above, subject to such conditions as may be specified by the Board.
4.2. The proposals as specified above, shall come into force from the date of notification of amendment in this regard.
4.3. It is proposed to specify the following by way of issuance of circular, to be effective from the date of the circular:
4.3.1. The requirement of maintaining pro-rata rights of investors in an investment of the scheme of the AIF and distribution of proceeds of the investment shall be exempted in the following cases:
4.3.1.1. The following entities may accept returns on their investment lesser than their pro-rata rights in the investments of the scheme, i.e., subscribe to junior/subordinate class(es) of units –
a. Manager or sponsor of the AIF;
b. Multilateral or bilateral development financial institutions;
c. State industrial development corporations;
d. Entities established, owned or controlled by the Central Government or a State Government or the Government of a foreign country, including central banks and sovereign wealth funds.
4.3.1.2. To the extent an investor has been excused or excluded from participating in the investment of the AIF,
4.3.1.3. To the extent an investor has defaulted on providing his/ her pro-rata contribution for the investment(s), and,
4.3.1.4. To the extent performance linked fee, if any, is charged by the manager, as per the terms of contribution agreement with each investor.
4.3.2. The manager/ sponsor may subscribe to junior / subordinate class(es) of a scheme of an AIF, provided that the amount invested by the AIF in the investee company shall not be utilized directly or indirectly to repay any obligations or liabilities of the investee company to the manager or sponsor or their associates.
4.3.3. Existing schemes of AIFs that have adopted priority distribution model, and not falling under the exemptions given above, may continue with the existing investments but shall not accept any fresh commitment or make investment in a new investee company, directly or indirectly. Consequent to the compliance with this directive, if such schemes are not able to comply with investment limits specified under AIF Regulations, such deviation shall not be considered as non-compliance.
4.3.4. The terms on which differential rights may be provided by AIFs to certain investors, without affecting the rights of other investors, shall be formulated by SFA, in consultation with SEBI. The SFA may be guided by the following framework while formulating the list of terms on which differential rights may be offered –
4.3.4.1. Any such rights shall not result in any investor bearing liability accrued or accruing to other investors of the fund;
4.3.4.2. Any such rights with respect to non-monetary/ non-commercial terms shall not provide control to an investor on the decision making of the fund, not including investors/their nominees being part of investment committee set up in terms of Regulation 20 of AIF Regulations; and,
4.3.4.3. Any such rights shall not alter the rights available to other investors under their respective agreements.
4.3.4.4. Any such rights and eligibility for the same shall be transparent.
4.3.5. The AIF shall disclose the criteria for offering differential rights to certain investors with respect to aforesaid terms and that any investor meeting the criteria shall be eligible for the same, in the PPM of its scheme.
4.3.6. As stated at para 3.2 above, in terms of standard template of PPMs prescribed by SEBI vide circular dated February 05, 2020, AIFs are required to disclose to investors in their PPM that they will not offer any differential right to an investor(s) that would adversely impact the rights of other investors. In this regard, AIFs who had issued such differential rights affecting others’ rights, post applicability of aforesaid circular, shall discontinue with such differential rights and appropriate action may be initiated by SEBI in such cases.
4.3.7. LVFs shall be exempted from the requirement of maintaining pari-passu rights among investors as given at para 4.1.3 above, subject to a waiver provided by each investor to this effect.
5. Proposal to the Board –
5.1. The Board may consider and approve the following proposals to amend the AIF Regulations, to:
5.1.1. Specify that the investors of a scheme of an AIF shall have rights pro-rata to their commitment to the scheme, in each investment of the scheme and in distribution of proceeds of such investment, along with an enabling clause for specifying exemptions in certain cases;
5.1.2. Specify that the rights of investors of a scheme of an Alternative Investment Fund, other than that specified in para 5.1.1, shall be pari- passu in all aspects. Provided that, AIFs may offer differential rights to select investors of a scheme, in the manner as may be specified by SEBI, without affecting the rights of other investors of the scheme; and,
5.1.3. Provide exemption to Angel Funds from requirement at para 5.1.1 above and exemption to LVFs from requirement at para 5.1.2 above, subject to such conditions as may be specified by the Board.
5.2. The draft amendment to AIF Regulations and the draft notification for the proposed amendment are placed at Annexure D and Annexure E respectively.
5.3. The Board is requested to consider and approve the proposals as in the Memorandum and authorize the Chairperson to make consequential and incidental changes and take necessary steps to give effect to the decisions of the Board.
Encls:
1. Annexure A (04 pages) – Brief summary of the recommendations of the Working Group and SEBI’s views on the same.
2. Annexure B (11 pages) – SEBI consultation paper on proposal with respect to pro-rata and pari-passu rights of investors of AIFs.
3. Annexure C (10 pages) – Brief summary of public comments received and SEBI’s views on the same.
4. Annexure D (02 pages) – Proposed draft amendment to SEBI (Alternative Investment Funds) Regulations, 2012.
5. Annexure E (04 pages) – The draft notification for the proposed amendment.
Annexure A
This has been excised for reasons of confidentiality.
Annexure B
The consultation paper is available at the following link:
Annexure C
This has been excised for reasons of confidentiality.
Annexure D
Amendment to SEBI (Alternative Investment Funds) Regulations, 2012, shall be notified after following the due process.
Annexure E
Amendment to SEBI (Alternative Investment Funds) Regulations, 2012, shall be notified after following the due process.
