[Kritika Jain and Niharika Singh are 4th Year B.B.A. LL.B. (Hons.) and B.A. LL.B. (Hons.) students, respectively, at Gujarat National Law University, Gandhinagar]
On November 7, 2025, the Securities and Exchange Board of India (‘SEBI’) released a draft circular (the ‘Draft Circular’) seeking public comments on operational clarifications to pro-rata and pari-passu investor rights for Alternative Investment Funds (‘AIFs’). Through this, the SEBI aims to provide fund managers with methodologies for calculating investor pro-rata rights to ensure that all investors participate proportionately and are treated equally in private capital markets. It represents SEBI’s commitment to implement investor equality principles across India’s AIF ecosystem, where it is not just a principle, but a day-to-day standard.
This post discusses SEBI’s evolving approach to investor equality in AIFs, analyses the practical impact of the Draft Circular, and identifies the gaps that remain unaddressed. For over a decade, AIFs in India relied on structuring tools that, while common across the industry, gradually created unequal outcomes for investors. Funds frequently used priority distribution structures, which allowed certain investors to get their returns first; special or differential investor rights, where some investors negotiated protections or enhanced terms unavailable to others; and subordinated unit classes, where smaller investors were placed in tranches that absorbed losses before senior tranches did. Fund managers justified these arrangements as necessary to accommodate diverse capital sources and incentivise managers. However, beneath this reasoning, junior investors bore disproportionate losses while senior investors consistently captured preferential returns. As a result, the connection between an investor’s commitment and their returns became increasingly negotiable, driven more by individual bargaining power than by mandatory principles.
However, with the developments of November 2024, the regulatory landscape entered a new phase. Through the Fifth Amendment to the Alternative Investment Funds Regulations, 2012 (the ‘AIF Regulations’), SEBI fundamentally altered the default framework governing investor treatment by introducing pro-rata and pari-passu rights under Regulations 20(21) and 20(22), respectively. The amendment introduced pro-rata participation, where each investor contributes to every investment strictly in proportion to their committed capital, and pari-passu distribution, where all investors receive returns on the same terms, mandatory across all AIFs. Hence, pro-rata and pari-passu treatment, which had earlier been permissible exceptions subject to the manager’s discretion, became mandatory legal obligations.
Regulatory Transformation: SEBI’s Operational Circulars
Two significant SEBI circulars have since given practical effect to this transformation. The first circular, published on December 13, 2024 (the ‘December 2024 Circular’) by SEBI, established the foundational framework, which enumerated permissible exemptions and prescribed guiding principles for differential investor rights. Subsequently, the Draft Circular released on November 7, 2025 provides operational guidance that the December 2024 circular left unclear. It seeks to clarify key implementation questions: whether pro-rata rights should be calculated based on total investor commitment or undrawn commitment, how existing schemes should transition to compliant methodologies, and how carried interest distributions should be treated. Together, these circulars give AIFs a clearer roadmap for applying SEBI’s equality mandate across different fund structures
Operationalizing Pro-Rata Rights through the Draft Circular’s Framework
To move these principles from theory into practice, the Draft Circular introduces a set of practical proposals. The most significant among them is the drawdown methodology, which provides fund managers with two clear ways to calculate each investor’s pro-rata share: they may calculate pro-rata obligations based on an investor’s total commitment or only on their undrawn commitment, i.e., the portion of capital that remains uncalled. This distinction matters because different AIF strategies deploy capital in distinct ways. For instance, growth funds typically call capital gradually, while buyout funds may draw larger tranches at specific stages. However, the Draft Circular clarifies that whatever model a fund adopts must be clearly disclosed in its Private Placement Memorandum (‘PPM’) at the outset and cannot be changed midway through the fund’s life, ensuring predictability and transparency for all investors.
It also incorporates important safeguards to ensure that the pro-rata framework is not misused. If an investor is excluded from participating in a specific investment, their unutilized commitment cannot be reallocated to other investments, thereby preventing strategic manipulation. Further, an investor’s stake in any single portfolio company cannot exceed regulatory concentration limits, typically 10-25% depending on fund category, ensuring that pro-rata rights do not create outsized exposures or allow preferential investors to secure disproportionate positions in a company.
For legacy schemes operating under non-compliant methodologies, the Draft Circular mandates alignment with one of the two prescribed approaches in future drawdown notices. SEBI classifies this shift as a non-material change, which means it does not require investor consent, but it still gives investors the right to opt out of any investments made after the transition. The Draft Circular also clarifies that all investor commitments must be recorded in INR for uniformity in pro-rata calculations, and it formally extends carried interest exemptions to include employee and director participation in fund returns. For Category III open-ended AIFs, SEBI has provided specific relief by permitting Net Asset Value (‘NAV’) based pro-rata distributions for schemes investing in listed securities, while requiring commitment-based pro-rata drawdowns only when the scheme invests primarily in unlisted securities.
Implications of the Framework for Fund Managers and Investors
These proposals in the Draft Circular reshape how fund managers structure investor participation and manage capital deployment. For fund managers, while the new framework ensures a more level playing field among investors, it still gives managers the flexibility to decide their drawdown approach and in structuring co-investments by the sponsors, or development finance institutions (‘DFIs’) through subordinate unit classes. The trade-off is a heavier one as more detailed documentation is required. PPMs must now clearly explain their chosen drawdown methods with illustrations, outline safeguards against investor breaching concentration limits, and specify provisions for the treatment of non-fungible units, i.e., unit classes that carry different economic rights and cannot be treated interchangeably with standard units. For previously non-compliant schemes, the impact is severe as they can neither raise nor deploy new capital until they restructure, effectively putting them on hold until they convert or wind up.
For investors, the framework delivers long-sought transparency and parity. Smaller institutional investors and Limited Partners (‘LPs’) gain guaranteed participation proportional to their commitment, eliminating the reliance on side-letter negotiations that favoured large anchored investors. Moreover, investors can now evaluate differential rights upfront through SEBI’s positive list framework rather than discovering preferential treatment after committing capital.
Critical Gaps Requiring Further SEBI Clarification
Despite setting out pro-rata principles, the Draft Circular leaves key implementation mechanisms unclear. First, the Draft Circular remains entirely silent on how pro-rata rights should be treated when an existing investor transfers fund units to another investor; a scenario increasingly common in AIFs’ secondary markets. It is unclear whether transferees should inherit all accumulated pro-rata rights from the fund’s inception or whether these rights reset from the transfer date. This confusion creates fairness concerns. If rights carry forward, accounting becomes complex. On the other hand, if rights reset, transferees entering at higher valuations receive unequal treatment compared to original investors, directly contradicting pari-passu principles. International fund governance standards, such as the ILPA Principles 3.0 in the United States, which set expectations on LP treatment, further involvement and disclosure in General Partner (‘GP’) led secondary transactions, and the FCA’s guidance in the United Kingdom on financial soundness, show how well-drafted rules can reduce distortions in secondary transfers. SEBI will similarly need to spell out successor rights in Limited Partnership Agreements to prevent parity issues.
Second, the Draft Circular introduces time-weighted pro-rata distribution, i.e., allocating returns based on how long each investor’s capital remains deployed, but provides no calculation methodology, leaving ambiguity about whether weighting should be based on holding periods or NAV fluctuations. Different AIFs could adopt varying formulas, creating inconsistency and exposing managers to trustee liability. In contrast, global PE/VC practice, such as the International Private Equity and Venture Capital Valuation (‘IPEV’) Guidelines, prescribe time-weighted allocation models that link investor entitlements directly to drawdown dates, reducing discretion and conflict.
Third, the Draft Circular prohibits reallocating unutilized commitments from investors who are excused from certain deals. However, it does not clarify whether these investors must continue to pay management fees or keep their carried interest rights for such excluded investments. This gap could create an incentive for managers to deliberately exclude investors with lower participation or influence from high-value opportunities; an outcome the new equality framework seeks to prevent.
Fourth, the Draft Circular places significant reliance on the Standard Setting Forum for AIFs (‘SFA’), an industry-led body that develops governance and operational practice standards for AIFs, to publish a positive list of permissible differential rights, which will serve as the industry’s compliance reference. However, the SFA has only released a preliminary outline rather than a detailed list. As a result, managers still cannot independently determine whether specific rights, such as liquidity preferences or step-up returns, are permitted. The dependence on an incomplete list leaves room for conflicting interpretations across funds.
SEBI should address these gaps through explicit calculation methodologies. Until these clarifications materialize, the regulatory framework, though well-intentioned, risks creating operational friction that could delay new capital deployment and invite interpretational disputes across the AIFs ecosystem.
Way Forward and Conclusion
SEBI’s Fifth Amendment to the AIF Regulations marks a turning point in how AIFs are structured. By mandating pro-rata and pari-passu treatment, SEBI shifts the balance toward investor protection over negotiation strength. This suggests that regulatory safeguards, rather than bargaining power, should shape investor outcomes in private markets. The Draft Circular continues this approach, aiming to embed these principles into everyday practice. Nevertheless, the operationalization of the framework remains incomplete.
Fund managers need clarity to deploy capital confidently, and investors need certainty to value their positions. The private capital ecosystem is at a critical juncture and cannot remain in limbo. Clear regulatory guidance will set a lasting precedent for improved AIF governance and affirm SEBI’s balanced commitment to investor protection.
– Kritika Jain & Niharika Singh
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