[Dharmvir Brahmbhatt and Devarsh Shah are fifth year students at Gujarat National Law University]
Over the last three decades, private equity investments in India and overseas have witnessed phenomenal development. Institutional investors have been attracted to the asset class owing to its persistent outperformance of public market benchmarks. Historically, commingled funds or “blind pools” of money organised as limited partnerships have been the most prevalent means to engage in private investing. In India, blind pools are essentially “alternative investment funds” (“AIFs”) governed by the Securities and Exchange Board of India (Alternative Investment Fund) Regulations, 2012 in India (“AIF Regulations”). While the AIF remains the leading vehicle for accessing private equity markets, more fund managers are offering co-investment possibilities to their clients in recent years. Co-investing has aroused great interest due to the possibility for better profits and more direct participation; nevertheless, investors must also be aware of the associated hazards. The Securities and Exchange Board of India (“SEBI”) has recently introduced revisions to the AIF Regulations and the Securities and Exchange Board of India (Portfolio Managers) Regulations, 2020 (“PMS Regulations”) in response to emerging trends. The purpose of this post is to examine the recent amendments made by SEBI regarding co-investments funds and their impact on the Indian private equity market.
The What of Co-Investing
As the nomenclature indicates, co-investment means investing alongside the AIF. Co-investment is secondary to the “primary fund,” but it is becoming a regular element in the private equity industry, with its own emerging norms and procedures. Co-investment lets AIF investors invest in specific portfolio firms. Such investments are made parallel to the traditional fund structure and are under the common control alongside the main fund. Governing agreements of the main fund determine the co-investment vehicle’s investment operations and economic conditions. The co-investment vehicle may invest in the underlying portfolio investment on the same terms as the main fund at the level of the underlying target portfolio firm. The primary reason managers of AIFs have adopted the co-investment model is because it allows them to bridge the funding gap as well as minimize their risk while retaining complete control over the investment. Investors, on the other hand, do not have an incentive to invest in private equity when the management fees are too high. Co-investment solves this problem as they are typically offered with either reduced or waived management fees and, therefore, the co-investment model is adopted by the investors too. Due to the AIF Regulations’ diversification requirements, India never adopted the worldwide practice of distinct co-investment vehicles. Only direct co-investments were allowed in India before the latest modifications to co-investment laws in November 2021.
SEBI, on November 8, 2021, made significant amendments to AIF Regulations and the PMS Regulations. While the AIF Regulations did provide for some guidance in this direction, it was nowhere close to a comprehensive framework for regulating co-investments. The amendments seek to regulate co-investment opportunities provided by the fund managers to the investors. With this, SEBI became the first market regulator in all the major economies of the world to regulate private equity co-investments
Analysing SEBI’s Framework
First, the amendments have introduced a third category of portfolio managers known as the co-investment portfolio manager (“CIPM”). A CIPM is defined as follows: “Co- Investment Portfolio Manager means a Portfolio Manager who is a Manager of a Category I or II Alternative Investment Fund(s)”. The definition further stipulates that the CIPM can make investments only in unlisted securities of investee companies where such category I or II AIFs make investments. It is pertinent to note that only a manager of a category I or category II AIF can act as a CIPM.
The new co-investment framework allows CIPMs to offer services to investors in category I or II AIFs that have a common management and sponsor with the parent AIF. At the moment, it is not clear if this only means that a CIPM can offer co-investment opportunities for multiple funds with the same manager and sponsor, or if an investor in one AIF can also take part in a co-investment opportunity for another AIF where it is not an investor. Generally, sponsors also want to bring in a third party for strategic reasons, such as to make them the lead investor in a future fundraising. However, after the latest amendment, bringing on a third-party investor does not seem a possibility.
Second, while category I and II AIFs may invest in a large array of instruments, the co-investment framework authorises CIPMs to engage only in “unlisted securities”. It is not entirely obvious why SEBI would differentiate between listed and unlisted stocks. This might prove to be a major limitation from a business perspective, since it prohibits the use of co-investments in listed debt, a common investment structure for private funds. This bar imposed by the SEBI will restrain managers from utilizing the funds collected from co-investors for “take private” transactions. Whether such a bar will have an adverse effect on the returns of the co-investors is something only time will tell.
Third, under the new framework, the managers have been compelled to comply with a whole new set of regulations in order to enable them to offer co-investment opportunities to their investors. While certain exemptions have been granted under the PMS Regulations to the CIPM, one cannot deny the fact that compliance burden has significantly increased. Some of these compliance requirements are not just onerous but also redundant because the same are covered under the AIF Regulations such as the disclosure document which already has to be filed under AIF regulations. While it is clear that some major changes have been made to the co-investment framework, the question arises as to how these changes compare to the regulatory regimes around the world.
Global Regulatory Perspective
All the major jurisdictions of the globe follow a ‘disclosure’ based approach when it comes to governing co-investments by private equity funds. In the United States (“US”), unlike SEBI’s new approach, offering co-investment opportunities to investors does not necessitate getting a separate licence. The market regulator of the SEC, i.e., Securities and Exchange Commission (“SEC”), has offered minimum guidance in this respect. The SEC nonetheless demands that fund managers that provide co-investment opportunities publish additional disclosures. These disclosures should contain the division of expenditures, fees, and how returns from the portfolio firms are to be divided between the co-investors and the main funds. In addition, co-investment vehicles must have their financial accounts examined by an expert fiduciary. But, in no circumstance can these directives be considered to create a burden on the fund managers equivalent to complying with a complete new set of rules which SEBI has undertaken. Similarly, the European Securities and Markets Authority (“ESMA”) and the Financial Conduct Authority (“FCA”), the European Union (“EU”) and United Kingdom (“UK”) market regulators respectively, do not regulate or offer guidelines on co-investments directly. Fund managers have complete discretion over the degree and scope of co-investment options available to fund participants. They are, however, subject to Article 14 of Chapter III of the ESMA’s AIF Managers Directive, which states that the manager of an AIF must take all reasonable efforts to detect and disclose any conflicts of interest that occur while managing AIFs. What is obvious from the foregoing is that just the EU and the UK, use a disclosure-based strategy to oversee co-investments, similar to the US.
The revisions to the AIF and PMS Regulations represent a transition from a disclosure-based approach to a compliance-based approach. How the framework develops in the near future will determine the future of co-investments and their position in the private funds industry in general. The new co-investment framework opens the door to further capital investment in India. A structured framework might even encourage sponsors and investors to consistently co-invest. However, as previously noted, it has a few inherent limitations, including a restriction on the selection of co-investors, limits on the kind of securities co-investors may purchase, and increased regulatory burden for fund managers. The preceding debate raises the obvious question of whether improved disclosures would have been a better way to regulate co-investments in India. However, it is too early to remark on the new framework’s success and influence. The industry of private equity is very dynamic. Several modifications may become necessary as time passes. A great deal would depend upon the industry’s reception of the new structure. However, early impressions are a cause for caution.
– Dharmvir Brahmbhatt & Devarsh Shah