New Horizons for AIFs: SEBI’s Circular on Investor Rights and Flexibility

[Ujan Sarkar is a fourth-year law student at the National Law University Odisha.]

Introduction

In light of the evolving landscape of Alternative Investment Funds (AIFs),  Security Exchange Board of India (SEBI) has released the circular on Pari-Passu Rights and Pro-Rata Rights for AIF (Alternate Investment Funds) Investors on 13th December 2024 (Circular). This aims to supplement the circular released on 18th November 2024 on AIF Regulations (Fifth Amendment) (November Circular) and, ultimately, with SEBI’s Master Circular on Alternative Investment Funds (Master Circular) and the SEBI (AIF) Regulations, 2012 (Regulations), build the framework that regulates AIFs in India. 

This blog aims to critically analyse the changes brought forward by this circular and highlight its shortcomings and potential impacts. 

Understanding the AIF regime

AIFs are funds that have been established in India, which work as a private vehicle wherein qualified investors, both domestic and international, pool their funds to invest in them. The entire AIF is regulated primarily by its investment policy, laid out in AIF schemes. 

Regulation 20(21) holds that it is a norm for investors to have their rights to distributions of proceeds from the scheme, being pro-rata or proportionate to their commitment and investment in the scheme. This creates investor equity by ensuring that the monetary benefits of the investors are always directly related to the amount of investment in the fund. 

Regulation 20(22) provides that the other rights of the investors are supposed to be pari-passu in every respect, which means that the rights of investors of a specific class of the AIF are supposed to be equal. This brings in uniformity and equality among investors, especially with regard to decision making, and reduces preferential treatment of certain investors depending on the amount of their investments. 

Exceptions to Pro-Rata Rights

The Circular has provided exceptions to the norm regarding pro-rata distribution rights in three specific scenarios. 

First, investors who are excluded or excused from taking part in an investment are exempted from the rule regarding pro rata distributions. This can be due to legal, regulatory, or even contractual restraints, such as the rules of the AIF scheme. This would allow investors the freedom to excuse themselves from specific investments to maintain stronger ESG compliance.

Second, investors who default on providing their pro-rata contribution to the fund would be disenfranchised from the pro rata distribution of the proceeds of the said fund. This aims to increase accountability and incentivize investors to honour their capital commitments to the fund. This would also increase the amount of liquidity available to the fund and limit disruptions in its operations. 

Finally, the carried interest provided to the fund manager or sponsor of the AIF is also exempt from the pro-rata rule. Carried interest is a percentage of the profit generated by the fund, given to its manager/sponsor in the form of compensation. This works as an incentive for the managers to increase their involvement in the fund and look to increase its profits. 

Subordinate units

The Circular has conclusively validated the concept of subordinate units. These are classes of units that exist subordinate to a normal class in an AIF. It allows investors to accept lesser returns of profits or share losses more than their pro-rata rights. This would allow investors with varying risk appetites to be a part of the fund, as it would allow investors to face lesser risks if they are fine with lesser profits, and vice versa.  

The Circular has laid out 4 types of entities that can take the benefit of subordinate units: the investment manager/sponsor of the AIF, Multilateral or Bilateral Development Financial Institutions, State Industrial Development Corporations, and government-controlled entities. 

There is, however, a caveat, wherein if the manager subscribes to a subordinate class of a unit, then it must be ensured that the funds invested are not utilized to repay any personal obligation or liability of the manager. This safeguard is crucial to prevent fund mismanagement and conflict of interest, thereby increasing accountability and transparency. 

The Circular also restricts AIFs from making new investments or taking up new commitments if they have adopted priority distribution models outside the 4 entities specified in the circular. Priority distribution models are a distribution waterfall model inclusive of subordinate units, wherein 1 (junior) class of investors shares losses more than pro rata to their holding compared to other (senior) classes, thereby prioritizing one class over the other. This comes after the November Circular had set an injunction, prohibiting schemes of AIFs with priority models from accepting fresh commitments or making investments in a new company until SEBI took a final view on this regard. SEBI has ultimately granted this benefit of priority distribution models only to the specific entities allowed to create subordinate units in this Circular.

Grant of Differential Rights

Differential rights (DRs) allow AIFs to provide additional terms and privileges to specific investors without impacting the other investors in the same class. These include providing differential management fees, a hurdle rate of return, carried interest, and other beneficial rights to specific investors. 

The Circular has allowed AIFs to provide DRs and has accordingly laid out certain guiding principles. The investor receiving the DR, however, should not have to bear the liability of other investors. Further, DRs cannot grant undue voting influence or powers unless specifically defined by the investment committee of the fund. Finally, the eligibility criteria and terms of the DR must be explicitly mentioned in the private placement memorandum (PPM). Allowing funds to have DRs is crucial to attracting more diverse investments and allowing better negotiation of risk. 

Analysis and Limitations

While the circular primarily succeeds in making a more equitable and innovative framework, there are certain limitations in the circular that require clarification from SEBI.  The exemption from pro-rata rights in respect of carried interest is specified for the fund manager/sponsors. It follows that any investor other than the manager/sponsor cannot avail of this exception, including employees. This is not in consonance with existing regulations, as SEBI has in its Master Circular recognized that employees are entitled to carry distributions from AIFs.

The circular also misses out by not extending to Employee Welfare Trusts (EWT) directly. Private Equity and Venture Capital funds often issue carry units to EWTs whose beneficiaries are employees of the investment manager. This is a more tax-efficient way to transfer carry units as the taxation on them is deferred until it is sold, especially when compared with giving the carry units to the corporate investment manager. 

Moreover, when the manager/sponsor subscribes to a junior unit of an AIF, the money cannot be used to repay any personal liability of the manager/sponsor. It must be noted that there is no statutory ban on AIFs repaying back its debt to the manager/sponsor. Hence, an AIF will be able to bypass this circular if they are able to show that the money used to repay the debt is not the same as the money invested in the company by the AIF. 

It will be necessary to bring AIFs and their investors up to date with this circular for good governance and its impact on their returns. This circular primarily ensures that the rights and entitlements of investors remain proportionate to their commitments. Clear boundaries and transparency are followed in providing exceptions to this rule. This also allows investors to benefit from the differential rights framework by negotiating specific terms based on their risk-return expectations. The fund managers and sponsors also have increased flexibility in structuring their AIFs through subordinate units and DRs, which can ultimately help them attract more investors. 

However, the SEBI Standard Setting Forum for AIFs has formulated a positive list of DRs that can be offered. Having to restrict yourself to a positive list of DRs reduces the scope for innovation and flexibility, which is required in the dynamic fund market. The market for AIFs is primarily a private one, having major participation from high-net-worth individuals. An exhaustive set of DRs then infringes the scope of negotiation-based structuring in AIFs. While it is important to enforce certain principle-based rights, overregulation would reduce India’s attractiveness as a destination for fund investment.

Conclusion

Finding the right balance by allowing risk-taking in set guardrails is crucial to create a competitive fund ecosystem and elevate India’s standing as a destination for investment. The circular has taken the right step in reinforcing pari-passu rights and pro-rata rights, which look to enforce uniformity, equality, and transparency. This comes as a relief to investors as it would make capital distribution easier and reduce the scope of undisclosed preferential treatment.  While it is crucial for the AIF framework to emphasize transparency and disclosures, it becomes important to allow for freedom in terms of setting up structures based on investor confidence and their risk-taking appetite. Only then can India host diverse investors while increasing their quantity as well.  The circular then takes the right step in providing certain relaxations in this regard, in order to give AIFs the flexibility to make their scheme more attractive to investors and accommodate their diverse needs. With the necessary tweaks and clarifications, coupled with close supervision of its implementation, this set of changes could mark a watershed moment for the Indian AIF regime.