19 August 2011

SEBI comes out with a proposed regulatory regime for AIF

I have a piece in the Economic Times yesterday on SEBI's proposed set of regulations on alternative investment funds. Here are excerpts:

Sebi recently came out with a proposed regulatory regime for alternative investment funds ( AIF). While the regulator has its heart in the right place, the proposals need to be thought through from the ground up.

What Sebi now seeks to do is create an umbrella regulatory regime for all funds. Sebi's stated objective is three-fold. First, create a regulatory framework which registers different types of funds based on investment objective like private equity, real estate, venture capital, debt, infrastructure, SME, social venture and strategy funds. This would enable targeted benefits for a particular sector. Second, to get a handle on systemic risk. As some overseas funds may be highly leveraged they may cause system-wide instability. Third, to improve disclosures, provide for conflict of interest and prohibit fraudulent acts. It is difficult to argue with these goals. Unfortunately, while talking about these, the paper ends up doing something quite different. It seeks to impose investment and other restrictions on these funds, which would hurt the industry without any regulatory benefit.

In Greek mythology, Procrustes, the son of a god, had an iron bed in which he invited every passerby to spend the night, and where he set to work on them with his smith's hammer, to stretch them to fit if they were too short and if the guest proved too tall, Procrustes would amputate the excess length; nobody ever fit the bed exactly because secretly, Procrustes had two beds. Sebi has many investment beds, and its proposals are no less dangerous.

The most damaging aspect of the proposal is that the paper seeks to create investment silos and imposes restrictions on where each type of fund may invest. This takes away the only free lunch available in the financial markets - of diversification in different types of companies. Thus, a fund which wants exposure in SMEs, early stage companies and listed companies would be prohibited from investing unless they create three different pools.

The proposal seeks to mandate the types of companies which are kosher for a particular fund, including whether investment should be in listed or unlisted debt securities. There is a provision for the fund size to be a minimum of Rs 20 crore, the minimum investment per investor to be 0.1% of the fund size.

Then there is a requirement that funds be close ended with a minimum tenure of five years. VC funds cannot hold more than Rs 250 crore in a single pool and cannot invest in companies promoted by the top 500 listed companies or their promoters. VC funds cannot invest in warrants or convertibles or even in listed debt securities (today a large number of VC funds are invested in convertibles). Private investments in public equity (PIPE) funds cannot invest in companies which are listed on exchanges that form part of any exchange index.

PE funds cannot invest in listed shares. Debt funds cannot invest in listed debt securities. Why a regulation should mandate investment in unregulated unlisted debt securities is unclear, when listed debt is a more regulated and secure asset.

None of this is useful and serves any regulatory benefit to investors or to the system. Besides the investment micro management, there are other issues too. The paper seeks to mandate minimum investment of 5% by the manager of the pool. This would make many smart managers to go out of business if they cannot shell out so much capital.

The philosophy behind managers investing in the funds that they manage is to create alignment of interest. This alignment has been elsewhere termed as 'conflict of interest' in the concept note. Thus the 5% minimum investment by the manager ends up mandating a minimum conflict of interest (as per its definition). If at the end of the tenure any investments are un-liquidated, they are required to be taken up by the manager/sponsor.

This is also dangerous, if there is a financial crisis and the securities cannot be sold at a reasonable price, both the manager and investor would be hit by a regulator mandated fire-sale and by a mandatory underwriting by the manger. There is, therefore, a premium on rich managers and a regulatory exclusion of smart managers - a regulatory self-goal. Sebi needs to seriously relook at its proposals rather than make Procrustes smile.

and here is a link to the full piece

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