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Investment Funds: Monthly Digest
June 10, 20242024 AIF Mid-Year Report: SEBI’s focus on Clarity, Compliance, and Capability
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SEBI relaxes requirement for changes in terms of PPM to be intimated through Merchant Banker.
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New NISM Certification requirement for KIT members of AIFs.
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SEBI releases consultation paper on the framework for valuation of investment portfolio of AIFs.
INTRODUCTION
In the past year, the Securities and Exchange Board of India (“SEBI”) has been particularly proactive in updating and revising the regulatory framework governing Alternative Investment Funds (“AIFs”). SEBI’s momentum in introducing amendments to SEBI (AIFs) Regulations, 2012 (“AIF Regulations”) has continued this year, further demonstrating their commitment to evolving market needs. However, some stakeholders have expressed concerns about the pace and scope of these changes, arguing that they may increase compliance costs and operational challenges for fund managers. Balancing innovation with regulation remains a critical task for SEBI as it navigates the complexities of the AIF industry. This month’s digest explores the circulars and consultation papers released by SEBI in 2024 so far, highlighting their implications and the broader context of SEBI’s regulatory initiatives.
1. Foreign investment in Alternative Investment Funds (AIFs) (January 11, 2024) |
Summary |
Paragraph 4.1.2 of SEBI Master Circular No. SEBI/HO/AFD/PoD1/P/CIR/2023/130 dated July 31, 2023 (“Erstwhile Master Circular”) prescribes that an AIF shall, at the time of onboarding a foreign investor, ensure that such foreign investor or its underlying investors contributing 25% or more in the corpus of the investor or identified on the basis of control, is not a person(s) mentioned in the Sanctions List notified from time to time by the United Nations Security Council and is not a resident in the country identified in the public statement of Financial Action Task Force as–
SEBI on January 11, 2024 issued a circular revising the threshold from 25% ownership to beneficial owner as defined under sub-rule (3) of rule 9 of the Prevention of Money-laundering (Maintenance of Records) Rules, 2005 (“PML Rules”). In case an investor who does not meet the aforementioned requirements has already been onboarded, the fund manager is prohibited from drawing down further capital from such an investor until the investor is compliant. |
NDA Comments |
The Ministry of Finance in 2023 amended the PML Rules to lower the thresholds for determining beneficial ownership. As per the changes to Rule 9(3) therein, the threshold for determining beneficial owners of (i) companies has been decreased from 25% to 10% of the shares, capital, or profits; (ii) partnership firms has been reduced from 15% to 10% of the capital or profits.; and (iii) trusts has been reduced from 15% to 10% of the interest in the trust. Such amendments are not only aimed at ensuring consistency across different laws but also represent a coordinated effort to streamline processes, enhance compliance mechanisms, and promote transparency in AIF industry. |
2. Guidelines for AIFs with respect to holding their investments in dematerialised form and appointment of custodian (January 12, 2024) |
Summary |
SEBI issued a circular pursuant to the amendment of the AIF Regulations last year to prescribe guidelines for AIFs with respect to
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NDA Comments |
This strategic step, building upon the foundation laid by last year’s circular which focused on dematerializing units of AIFs, reflects SEBI’s ongoing efforts to enhance transparency and efficiency throughout the investment ecosystem. By mandating the dematerialization of AIF holdings, SEBI seeks to standardize and streamline the process of tracking ownership and transfers of these holdings, mitigating operational risks and improving regulatory oversight. SEBI’s requirement to appoint a custodian prior to the date of the first investment for any new scheme ensures that robust custodial oversight is in place from the inception of the scheme, potentially enhancing investor confidence by mitigating early-stage risks associated with investment deployment. Further, the requirement to appoint a custodian being applicable on all AIFs irrespective of size of corpus extends custodial oversight to a broader spectrum of AIFs, encompassing those with relatively smaller assets under management. Consequently, fund managers of these schemes may need to reassess their operational structures and budgetary considerations to accommodate the additional compliance requirements associated with custodial appointments. Furthermore, the stipulation regarding AIFs with custodians associated with the manager or sponsor underscores SEBI's commitment to addressing potential conflicts of interest within the AIF ecosystem. By mandating compliance with Regulation 20(11A) of the AIF Regulations, SEBI aims to strengthen governance practices and promote greater transparency in AIF operations. Fund managers will need to proactively review their custodial arrangements to ensure alignment with regulatory standards, potentially necessitating adjustments to existing custodial relationships or organizational structures. |
3. Circular on Standardization of the PPM Audit Report (April 18, 2024) |
Summary |
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NDA Comments |
By implementing a uniform reporting format and enabling online submissions, SEBI aims to streamline compliance processes and boost investor confidence. This initiative underscores the collaborative efforts between SEBI and industry stakeholders to advance and regulate the securities market in India. AIFs are required to follow the guidelines set forth in this circular, with the assistance of AIF associations, to ensure seamless adherence to regulatory standards. |
4. Flexibility to Alternative Investment Funds (AIFs) and their investors to deal with unliquidated investments of their schemes (April 26, 2024) |
Summary |
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NDA Comments |
Our views on the dissolution period framework may be accessed here. |
5. Framework for Category I and II Alternative Investment Funds (AIFs) to create encumbrance on their holding of equity of investee companies (April 26, 2024) |
Summary |
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NDA Comments |
Notably, such amendments come in the wake of the case concerning India Infrastructure Fund II, Global Infrastructure Partners India Private Limited, and IDBI Trusteeship Services Limited, where SEBI had held that Category I and II AIFs are not permitted to pledge the securities of portfolio companies to secure any loan availed of by such portfolio companies. Such practice was deemed to be akin to indirect borrowing by the AIFs. However, industry associations and certain funds submitted representations to SEBI to consider allowing pledging of equity investments by AIFs to secure borrowing by investee companies to protect/enhance the value of the AIFs’ investments. By allowing AIFs to invest in infrastructure projects without constraints, these amendments pave the way for increased private capital infusion into crucial infrastructure developments. This, in turn, is expected to catalyse infrastructure growth by fostering a more conducive environment for funding. Further, SEBI should have considered extending this provision to encompass investments beyond the infrastructure sector. Doing so may provide additional avenues for funding across various industries, thereby promoting greater liquidity and investment flexibility. Moreover, with appropriate safeguards and investor consent, such a move could have encouraged more robust participation from AIFs in supporting diverse sectors of the economy. Moreover, by disallowing guarantees and instead allowing pledging of securities, SEBI aims to strike a balance between facilitating access to financing for portfolio companies and safeguarding the interests of AIF investors. Pledging securities offers a more controlled approach to risk management, limiting the potential losses to the value of the pledged assets and ensuring that investors are not unduly exposed to the financial risks associated with guarantees. |
6. Relaxation in requirement of intimation of changes in the terms of the PPM of AIFs through Merchant Banker (April 29, 2024) |
Summary |
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NDA Comments |
This decision follows a thorough review prompted by feedback from market participants, indicating a strong commitment to improving the ease of doing business and reducing compliance costs for AIFs operating in India. SEBI’s decision to allow direct filing of changes in certain terms of the PPM reflects a proactive approach to regulatory reform, aiming to foster a more agile and efficient regulatory environment while safeguarding investor interests and promoting market development. The move is expected to benefit AIFs by reducing procedural complexities and facilitating smoother compliance processes. Further, the exemption for LVFs is consistent with the current framework, which does not require LVFs to submit their PPMs to SEBI via a merchant banker when launching a scheme. In any case, AIFs are required to ensure strict adherence to regulatory requirements and maintain transparency in their disclosures to uphold investor confidence and market integrity. |
7. Certification requirement for key investment team of manager of AIF (May 13, 2024) |
Summary |
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NDA Comments |
While this change was anticipated, given that it was pursuant to the second amendment to the AIF Regulations made back in 2023, it has nonetheless come as a double-edged sword for the funds industry at large. The removal of the experience qualification for key investment team members of the fund manager lowers the regulatory threshold for the entry of first-time fund managers and is a welcome change from this perspective. This adjustment opens doors for new talent and innovation in the industry, making it easier for fresh faces to establish themselves. This allows individuals with strong academic backgrounds, innovative ideas, or unique perspectives to enter the fund management industry without the previously required years of experience, thereby diversifying the pool of fund managers in the Indian AIF industry. However, the introduction of the NISM Certification requirement presents challenges, particularly for seasoned managers. Experienced fund managers now face difficulties in launching new funds or schemes within existing funds without either (i) seeking the certification for professionals with decades of fund management experience, or (ii) including younger professionals willing to obtain the NISM Certification into key investment teams. Fund managers are now required to allocate considerable effort towards ensuring their key professionals meet these new standards. This might involve arranging for study sessions, covering the costs of certification exams, and adjusting operational timelines to accommodate the certification process. Moreover, for experienced fund managers managing multiple funds or launching new schemes, the certification requirement could delay these processes. The need for certification might interrupt the flow of operations as key professionals prepare for and obtain their certifications, potentially leading to slower fund launches and possibly affecting market opportunities. |
8. Consultation Paper on review of certain aspects of the framework for valuation of investment portfolio of AIFs (May 23, 2024) |
Summary |
Based on industry feedback received on the existing valuation framework under the AIF Regulations and SEBI circular dated June 21, 2023, SEBI has proposed changes to the way AIFs value their portfolio investments. Summarily, the following proposals have been floated for public comments:
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NDA Comments |
By excluding unlisted securities held by AIFs from the purview of SEBI (Mutual Fund) Regulations, SEBI appears to acknowledge the distinct nature of AIFs compared to mutual funds. AIFs often invest in companies at various stages of development, including early-stage ventures and unconventional sectors, which may lack tangible assets or stable earnings. Therefore, methodologies like net worth or earnings per share, which are commonly used for mutual funds, may not be suitable for valuing these investments. The IPEV guidelines, on the other hand, offer a range of methodologies such as discounted cash flow (DCF) and internal rate of return (IRR), providing flexibility to adapt to the unique characteristics of AIF investments. SEBI’s proposal to not treating necessary adjustments in valuation methodologies as ‘material changes’, aims at reducing the operational and administrative burden on AIFs. It prevents a potential flurry of redemption requests that could arise from such regulatory alignment, allowing fund managers to focus on investment strategy rather than administrative compliance. Further, the establishment of clear eligibility criteria for independent valuers is intended to clear industry-wide ambiguities in relation to appointing independent valuers in the form of entities. Eliminating the requirement for every director, partner, or employee of the valuer entity to hold separate memberships in professional institutes provides flexibility in team composition. Valuer entities can now assemble teams based on expertise and experience, rather than solely on individual memberships. This flexibility enables valuer entities to optimize their resources and deliver tailored valuation solutions to AIFs. Additionally, extending the reporting deadline for AIFs to performance benchmarking agencies by an additional month addresses compliance challenges due to delays in obtaining audited data from investee companies, thereby improving the accuracy and reliability of the reported valuations. |
CONCLUSION
Notably, the amendments introduced and proposed in 2024 so far signify a dual emphasis on strengthening regulatory compliance and accommodating industry dynamics. Noteworthy measures include the streamlined reporting of annual changes in PPM through Merchant Bankers, a welcoming step towards reducing administrative burdens. Furthermore, by allowing for encumbrance on equity holdings for Category I and Category II AIFs SEBI seems to have recognised evolving market practices. Moreover, the standardization of AIF audit reports represents a step towards harmonizing reporting practices, thereby enhancing transparency and investor confidence. SEBI's introduction of NISM certification for key investment team members, while maintaining a balanced perspective, underscores its commitment to elevating professional standards within the industry. Looking ahead, the amendments to liquidation framework and proposed amendments to the valuation framework signify further evolution in regulatory clarity and operational efficiency.
While SEBI's proactive approach, coupled with its receptiveness to industry dynamics, infuses confidence in the trajectory of the AIF sector, it must also ensure that the interests of fund managers align with the broader goals of transparency, accountability, and investor confidence. This equilibrium between regulatory oversight and market flexibility is essential for the sustainable growth and integrity of the AIF sector. As stakeholders, we eagerly anticipate the forthcoming changes poised to shape the AIF landscape in the remainder of 2024 and beyond.
Authors
- Payal Saraogi and Dibya Behera
Funds Team
Nishith Desai, Global Strategy
Parul Jain, Fund Formation and International Tax
Radhika Parikh, Fund Formation and GIFT City
Prakhar Dua, Fund Formation and FSR
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1irrespective of whether investment is made directly in the investee company or is acquired from another entity.