10 June 2012

Alternative Investment Funds - a new regulatory environment for funds in India

SEBI has come out with a final set of regulations for alternative investment funds. These are completely different from the draft regulations SEBI had come out with last August. Based on public comments and feedback SEBI has in fact rationalised the regulations not just substantially but wholly. In fact, the departure from its draft form put out for public comment is a triumph of the open process of regulation making which SEBI subscribes to, where it listens to others for their views with an open mind rather than hosting draft regulations for the sake of mere formality. I can think of many regulators who put out exposure drafts for comments but still go ahead and do what they had in mind in the first place. I can’t think of too many regulators anywhere who would so freely and fairly take public comment and so dramatically improve the quality of their regulations.

So besides the process, why are these regulations important? Because they create a regulatory route for large investors to pool money and invest in companies. Because these pools of capital impact capital formation in young and seasoned companies alike and allow them to grow. Because this is some of the smartest money chasing the brightest ideas – it has to be good for the Indian economy. Any regulatory scheme which creates an enabling umbrella for this kind of an ecosystem must be good.

Before the regulations were notified in May this year, the regulatory regime for pooling of money was quite hazy and unclear. Some avenues were also open for pooling under a portfolio management scheme, however, that window is now shut to pooling of funds. SEBI’s informal view was that one could pool money for investment and registration with SEBI was really optional. Further, SEBI’s registration was only under venture capital regulations rather than all types of investment pools. In other words SEBI had till now only thought about regulating pools of capital (that too optionally) which invested in unlisted and often early stage companies rather than mature or listed companies. For those eligible, there were investment restriction and also some benefits from lock-in requirement, certain exemption under takeover law and tax pass through benefit. This created a regulatory environment where anyone wishing to invest mainly outside the venture companies would be forced to remain unregistered. And those eligible, deciding whether or not to register taking on both regulatory burden and benefits. This has now been done away with. A pool  can be created for any kind of investment,  whether venture capital, private equity, real estate only, or any other sectors or combinations possible.

Under the new regime, SEBI has created three types of  pools, divided as Category I, II or III. The first category is a pool which invests in socially beneficial companies like welfare companies, venture capital companies etc. These would then be given targeted benefits like tax exemptions. Category II are those funds which can invest anywhere in any combination but are prohibited from raising debt (except temporarily in limited quantity). The third category can invest anywhere it wants and also can raise debt. This category can be termed as domestic hedge funds. Since the third category can pose systemic risk, additional reporting and other regulatory burdens have been imposed on them.
Since the regulatory scheme has been drastically modified and given that people had invested money under the old regime which was mainly based on contract, there are provisions which permit the old funds to continue upto their contractual commitments with some limitations (the grandfathering regulations in legal jargon). Since the venture capital regulations stand repealed, there is a provision for transitioning from the old regime to the new one if two thirds of the investors by value vote in favour of a new regime registration. Else, they can continue till their contractual maturity date.

The new regulations do impose some restriction on pooling of money though. In line with the requirements of corporate law, there can be no public offer to invite investments. Offers must be made privately and the minimum contribution is Rs. 1 crore per person. This is intended to exclude un-sophisticated investors from investing in often risky ventures – of course the assumption is that very rich people are also very sophisticated. Then there is a requirement of Rs. 20 crore (in each scheme) for the fund to register. This requirement is presumably introduced to allow only credible people to manage the pool, as not everyone would be able to raise such a large amount from sophisticated investors.

Managers of the pool are also expected to shell out 2.5% of the size of the pool or Rs. 5 crores whichever is lower i.e. a minimum commitment of Rs. 50 lakh. While this is supposed to ensure that the managers also have skin in the game i.e. if they mis-manage the portfolio, they are also likely to lose money with the investors. However, though no one would protest as this is also market practice, the rule is likely to exclude very smart people from managing money who don’t have their own money to put as co-investor. A smart manager doesn’t necessarily need to have so much money to invest. The commitment amount is double in the case of Category III pools.

While previously governed by contract, now the regulations provide a level of disclosure, particularly of any conflict of interest that the fund manager may have towards the investors. There is a need to be transparent about the fund manager’s background and experience, the fees being charged by the manager, the tenure and strategy of the fund and conflict of interest situations. These are welcome additions to the cow-boy regulations previously in place. Since the marketing material is to be filed with SEBI, the chance of a fund manager taking liberties is substantially reduced.

The regulations permit the listing of most funds after they have raised money, but to protect unsophisticated investors, the minimum lot size of trading must be Rs. 1 crore. These kinds of markets are common in the west and are known as big-boy markets where only highly sophisticated people trade. Listing with such large lot sizes ensures both liquidity and protection of the small investor at the same time and this is a great compromise thought up by SEBI.

There are several other prudential investment restrictions like the maximum percentage of capital of one company a fund can hold and restrictions on related party transactions. There are provisions of investor protection like valuation on a periodic basis, addressing of investor complaints and record keeping which have been introduced.

On the whole, the regulations introduce the concept of a regulated pool of capital and with few silly rules, most people have welcomed the introduction. Most importantly, investors who previously found the unregistered trust structure somewhat dubious would now invest much more freely as they invest under the protective umbrella of SEBI to whom they can complain if there is any kind of mis-conduct by the fund manager. The regulations would indeed increase the costs of compliance for previously low cost investment pools governed by contract alone, but the benefits easily out-weigh the costs.

Unfortunately or fortunately these have come at a time when the India story is at one of the worst periods. Unfortunately, because despite the enabling environment, not many people can raise funds from investors to invest in the Indian economy, and that too investment in companies which would bear the brunt of any reduction in growth in the economy. Fortunately, because when everyone believes it is the end of the world is often a good time to buy shares, just as when your paanwala talks of stocks being a great investment, it is probably a great time to sell.

Sandeep Parekh is the founder of Finsec Law Advisors and former ED of SEBI

1 comment:

Anonymous said...

“Contrast the lack of compensation to Satyam investors in India, where nothing substantial has even been initiated, with the partial settlement in the US where Satyam securities holders (American depository receipt holders) have settled the case with several of the accused and received compensation.” This difference has nothing per se to do withthe availability or lack of consent mechanism to the regulator. US investors could settle the case directly with the defendants because the US Supreme Court at least since “J. I Case Co. v. Borak - 377 U.S. 426 (1964)” read into Section 27 of the Securities Exchange Act, 1934 a private right of action. On the other hand, Sections 15Y and 20A of the SEBI Act, as interpreted by the Mumbai HC in “Kesha Appliances v. Royal Holdings Services Ltd. 2006 65 SCL 293 (Bombay)” have been marshalled to argue that no such private right of action exists in India. In fact, you, along with Prof. Vikramaditya Khanna successfully convinced the federal district court for SDNY that this is the legal position and so the motion to dismiss for forum non conveniens is meritless! (Let me add that there are people who believe that the judgment in Kesha Appliances should be read restrictively as it involved a matter solely arising out of SEBI Act and Regulations whereas the Satyam case is distinguishable as in this case the common law tort of deceit remains available).

An afterthought : If SEBI enters a consent order, without the other party admitting or denying guilt, would it mean that SEBI declined to `determine’ (within the meaning of 15Y) the relevant matter? In that case, neither SEBI would determine that particular matter, nor any other forum would have the power to do so. Where does it leave the harmed investors?

-Mangesh Patwardhan