[Sagun Modi is a 4th Year B.A. LL.B. (Hons.) student at National Law University, Odisha]
Alternative investment funds (‘AIFs’) have emerged as vital investment vehicles in the global financial landscape. They provide investors with diversified investment opportunities beyond traditional asset classes. India witnessed a 30% increase in investment commitments into AIFs, from Rs. 6.41 trillion in the financial year 2021-22 to Rs. 8.33 trillion in the financial year 2022-23, up by Rs. 1.92 trillion. With the growth of the AIF industry, regulatory authorities have been diligently addressing concerns related to investor protection, transparency, and equitable treatment within these investment structures.
Against this backdrop, the Securities and Exchange Board of India (‘SEBI’) released a consultation paper dated 23 May 2023 to solicit public feedback on a proposal concerning the pari-passu and pro-rata rights of investors in AIFs. The issuance of this consultation paper was prompted by the AIF industry’s request for the introduction of a distinct class of units for co-investment alongside AIF investments. However, SEBI rejected this request while explaining that investors in an AIF possess rights in each AIF investment proportionate to their contribution in the AIF, commonly known as pro-rata rights. Also, SEBI underscored the significance of fair and equitable treatment by proposing that an AIF should treat its investors on a pari-passu basis, meaning they should be treated equally in terms of their economic rights.
In this post, I aim to provide an in-depth analysis of the consultation paper issued by SEBI and examine the proposal as well as the recommendations put forth by the working group, in relation to the pro-rata and pari-passu rights of investors of an AIF. Moreover, I will explore the potential impact of these proposals and recommendations on the pro-rata distribution rights of investors, within the framework of broader corporate governance principles.
The Regulatory Concerns and Proposed Changes
Presently, a prevailing practice observed within the realm of AIFs is the preservation of pro-rata rights among investors in each investment made within the AIF scheme, encompassing the distribution of investment proceeds. Furthermore, a SEBI circular dated 19 June 2014 specified the following: “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”. This indicates the regulatory intent to maintain the pro-rata rights of investors, including during the distribution of investment proceeds.
However, SEBI’s examination revealed that specific schemes of AIFs have implemented a distribution waterfall mechanism that segregates investors into distinct classes or tranches, leading to a differential allocation of investment proceeds concerning these investor classes. This differential treatment results in a situation where the junior class of investors bears losses disproportionately higher in relation to their holdings in the AIF compared to the senior class of investors. The reason behind this inequitable allocation stems from the senior class of investors enjoying priority in the distribution of proceeds over the junior class, giving rise to what is commonly referred to as a priority distribution model (‘PD Model’) among the investors.
As implemented by select AIFs, the PD model entails a specific compensation mechanism that operates in both losses and profits. In the event of a loss scenario, the PD model ensures that the senior class of investors are compensated for their losses from the residual capital of the junior class’ investors. Conversely, when a profit scenario arises, the distribution of profits follows a predefined order wherein the senior class of investors receives their share of profits until their hurdle rate is met. Subsequently, any surplus amount remaining after meeting the senior class’s hurdle rate is allocated to the junior class of investors.
It was brought to SEBI’s attention that AIFs adopting the PD model were structured to take advantage of the regulatory arbitrage with respect to compliance with other regulatory requirements. This arbitrage arose due to the lack of an express prohibition on the disproportionate sharing of losses among different classes of investors. It was observed that such structuring of AIFs had the potential to facilitate the ever-greening of loans extended by regulated lenders. By subscribing to the junior class of investors, these lenders could effectively incur a reduction in returns from the AIF. The application of the PD model raised concerns about the emergence of conflicts of interest among different classes of investors, as each class may possess varied risk appetites while investing in the same entity. As a consequence, there was a heightened risk of mis-selling, as investors found it challenging to accurately assess the potential risks associated with their investments.
With this backdrop in place, the Alternative Investment Policy Advisement Committee (‘AIPAC’) put forth a recommendation to establish a Working Group tasked with addressing regulatory concerns and proposing mechanisms to safeguard the priority distribution of proceeds amongst investors. In response to AIPAC’s recommendation, SEBI advocated the discontinuation of the PD Model and stressed the necessity of explicitly incorporating provisions in the AIF regulations that mandate the maintenance of pro-rata rights for investors in all AIF investments.
Recommendations of the Working Group
The Working Group recommended that the PD Model should not be totally outlawed, but rather checks and balances should be in place to mitigate the risks of any misuse. Also, the PD model should be disallowed only in select circumstances when such safeguards are considered insufficient to prevent the misuse. The recommendation entails permitting the PD model under specific circumstances, subject to the fulfilment of two essential conditions. Firstly, the AIF must be established through the acquisition or refinancing of assets belonging to an unrelated third party. Secondly, the limited partners should not have any affiliations with the entities from whom the assets are being acquired/refinance, either directly or indirectly. However, an exception is made, allowing the contributor of the assets to hold up to 10% of the AIF units.
SEBI, in its response to the recommendations, expressed its disapproval and instead advocated for a distinct approach regarding the rights of investors in AIFs. SEBI’s proposed framework entails two fundamental principles:
(a) The rights of each investor within the AIF scheme should be maintained in proportion to their respective commitments to the scheme during the investment phase, as well as during the distribution of proceeds from the investment. This is what is known commonly as the ‘pro-rata rights’ of investors, and;
(b) All investors participating in the AIF or its specific schemes should be treated equitably concerning their economic rights. However, it noted that this provision would not be applicable in cases where differential rights are granted based on terms related to the hurdle rate of return, performance-linked fee or additional return, and management fees.
SEBI’s proposed regulatory framework aims to reinforce transparency, integrity, and investor confidence within the AIF structures, in alignment with overarching principles of corporate governance. The proposal carries significant implications for the junior class of investors, as it seeks to address the issue of concentration of power that may arise in favour of the senior class of investors concerning the distribution of investment proceeds. By advocating the maintenance of pro-rata rights of investors in each investment of the scheme, the proposal serves as a pivotal mechanism to mitigate potential imbalances of power between different classes of investors.
Moreover, the proposal effectively curtails the predominant influence of the senior class of investors, thus promoting a level playing field among all investors within the AIF structure. The preservation of pro-rata rights emerges as a fundamental and distinctive characteristic of the proposal, aligning with the core objectives of the AIF framework. This measure is designed to foster equitable treatment and fair allocation of benefits, reinforcing the principles of corporate governance and bolstering investor trust in the AIF industry. By mitigating the possibility of undue concentration of power, SEBI’s proposal contributes to a more robust and investor-friendly AIF ecosystem, fostering greater confidence and participation among investors across all classes.
Striking the right balance between investor rights, managerial autonomy, and industry competitiveness will be crucial in ensuring the successful implementation of the proposed measures for the AIF framework. Given that India is slowly becoming a popular investment destination across the globe, regulatory concerns should not hinder such investments into the country. As proposed by SEBI, maintaining the pro-rata rights of investors within the AIF framework is also in line with global best practices. This would benefit the entire AIF industry as a whole.
– Sagun Modi