Private funds pool capital from investors of varying risk-reward profiles. In many foreign jurisdictions, including the UK, US, Japan and Germany, fund managers have the flexibility to set up and operate funds with different distribution models for different investors (i.e. where specific investors receive higher returns than other investors). may receive distributions from the Fund in priority (to a specified extent or degree), as long as appropriate risk disclosures have been made.
In India too, some private funds set up under the aegis of the Alternative Investment Fund (AIF) framework of the Securities and Exchange Board of India (SEBI) have explored this model in the past. However, in recent times, there has been a subtle regulatory shift on this issue. In a circular issued on November 23, 2022, the market regulator has temporarily prohibited AIFs with a priority distribution model from accepting fresh capital commitments or infusing capital into new portfolio entities.
SEBI’s apprehension was that disbursement of funds to one class of investors before another, if any, would harm others disproportionately. While such apprehensions are understandable, any order by SEBI in this matter is bound to have an impact on the market. Indeed, the circular has barred fund managers from structuring investment vehicles that are out of the ordinary, and investors are now wary of regulatory ambiguity around the priority distribution model.
One could argue that the use of a priority distribution model is imperative in AIFs for business reasons. For one, this model enables a large and flexible pool of capital to be assembled, creating bespoke, complex transaction structures to accommodate the needs of a diverse range of investors, each with a different risk appetite. Provides flexibility to investment managers A priority distribution waterfall is central to the distressed asset industry as it accommodates the diverse capacity of stakeholders to absorb risk. This philosophy is also reflected in the framework put in place by the central bank under its Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021, on acceptance of senior and junior tranches of pass-through certificates.
From an investor’s point of view, it is the sound logic of ‘higher risk, higher reward’ that underlies the priority distribution model – while subordinated investors risk bearing a higher proportion of loss than their priority category counterparts, They are also likely to get higher returns due to their continued investment in AIFs over the long term. Senior class investors can get some protection on their risk and return profile through the cushion provided by the subordinated tranche while continuing to infuse capital and invest in the desired asset class. The priority distribution model, therefore, accurately reflects market forces.
SEBI has repeatedly noted that AIFs are a high-risk asset class, where participation is restricted to sophisticated and well-informed investors. with minimum ticket size 1 crore, it is not intended to be an opportunity for retail investors. In fact, AIF investors shall be provided with full and complete disclosure of the distribution waterfall mechanism and all commercial terms through the private placement memorandum/offer documents of the AIF, which are mandatorily circulated to potential investors.
Fund managers are today demanding finalization of Sebi’s view on funds with differential return structure. The available regulatory commonality and commercial justification provide strong arguments to allow such funds and foster innovation in the Indian private fund industry. In order to address concerns regarding undue advantage of regulatory arbitrage by AIFs due to various norms, SEBI may prescribe mandatory disclosure of the end use of the fund’s commitments in its placement memorandum. Such reforms will improve transparency and facilitate innovative use of fund platforms for the benefit of all stakeholders, which may not be the case if funds with differential distribution models are purely net.
Vivek Sharma is the partner in Cyril Amarchand Mangaldas and Divya Laxman is the associate. A colleague Kartik Dheer also contributed to the article.
catch all business News, market news, today’s fresh news events and Breaking News Update on Live Mint. download mint news app To get daily market updates.