Tightening the screws on AIFs

I have a piece with Raghuvamsi Meka and Rashmi Birmole ‘Tightening the screws on AIFs’ in today’s Financial Express on SEBI moving away from leaving the funds market to the law of contract to a more intrusive set of regulations. The full piece is as below:

Recent years have seen the increasing relevance of alternative investment funds as a sought-after asset class in the Indian investment landscape. According to the data released by the SEBI, the AIF industry has grown by 42% from June 2021 alone, and an impressive 600% from June 2017 in terms of allocations received from investors. While the contributing factors supporting this growth warrant a separate discussion of their own, the momentum of AIFs can be primarily traced to its ability to offer bespoke diversified investment avenues to affluent and sophisticated investors. The growing base of potential acquirers has also reduced the liquidity risk in private markets and supplemented AIFs’ perception as popular and innovative instruments. 

Flexibility in investment strategies and structuring is a hallmark of the AIF Regulations, which regulate AIFs in India. The light-touch regulation of AIFs is based on the principle that given the high minimum ticket size, AIFs are bound to attract marquee sophisticated investors who understand the underlying risk associated with their investments, and do not require intense regulatory oversight. However, the transformative growth of the AIF industry has revealed existing practices and ambiguities in the AIF Regulations, which if left unchecked, may compromise the growth that the flexibility and light-touch regulation intend to facilitate. On November 17, 2022, SEBI issued guidelines to address two such specific practices in relation to the first close and tenure of close-ended schemes. 

As a pooled investment vehicle, the fundraising process is a critical stage in the lifecycle of an AIF. This process is generally divided into several phases to enable the AIF to raise funds from investors, termed ‘commitments’. The initial round of commitments is termed as ‘first close’ by the AIF depending on the achievement of certain milestones of the targeted corpus. On reaching the said milestone, AIFs typically start drawing down funds and investing monies in line with the investment objective of the scheme. SEBI has observed that certain AIFs are yet to raise commitments from investors and launch schemes despite the passage of several years post the filing of the private placement memorandums or PPMs. Since PPM forms the foundational document based on which commitments are sought from investors, this practice runs the risk of seeking commitments based on outdated information. This practice, coupled with the absence of a prescribed time period within which schemes may be launched by an AIF, underscores the need to prescribe timelines for the period within which AIFs would be permitted to launch schemes and raise funds post filing of the PPM with SEBI. 

Recognising this need, SEBI has now stated that the validity of the PPM shall be linked to the first close of the scheme which shall, in turn, be determined in accordance with minimum thresholds. The guidelines specify that firstly, AIFs shall be required to declare the first close of a scheme within 12 months from the date of filing the PPM with SEBI. Secondly, the first close declared by an AIF shall not be less than the minimum corpus prescribed under the AIF Regulations for the applicable category. This threshold has been specified in order to harmonise the determination of the first close milestone, post which AIFs typically start making investments. Thirdly, commitments made by the sponsor or manager of the AIF at the time of declaration of first close shall not be reduced or withdrawn post raising the initial round of funds. This restriction has been introduced to prevent sponsors or managers from making higher commitments with the sole intention of ensuring that the first close meets the threshold of the minimum corpus under the AIF Regulations. 

SEBI has also observed that various AIFs have extended the tenure of their schemes multiple times, which may leave investors in a lurch. With these guidelines, SEBI has also amended the method for calculation of tenure for close-ended funds. As the name suggests, a close-ended scheme is one that accepts commitments for a limited duration from the investors, and has a fixed tenure post which assets are liquidated and proceeds are distributed among the investors. Until now, the tenure of a close-ended scheme is required to be calculated from the date of final close, i.e., the last round of fundraising following which no new commitments shall be accepted from the investors. While the manner of calculation of tenure was specified, the reference point which forms the primary basis of this calculation, i.e., the date of final close, has been a subject of ambiguity. 

In the absence of any regulatory timelines governing the final close, the timeline for declaring the same can be found in the PPM of a scheme and is generally calculated from the date of the first close, often being subject to an extension based on the manager’s discretion. This gives rise to the possibility of an extension in the overall tenure of the close-ended scheme beyond the prescribed term and without the consent of the investors, under the name of an extension of the final close date by the manager. In addition to circumventing the requirements of the AIF Regulations, such extensions obscure the investor’s understanding of the timeframe for which their investment shall remain locked in a close-ended scheme. To tackle this issue, the guidelines issued by SEBI now attempt to crystallize the reference point from which the tenure of a close-ended scheme shall be calculated. The reference point of ‘final close’ has been replaced by ‘first close’ of the scheme in question. The idea is to put across a clear picture of the total timeframe for which an investor shall remain invested in the scheme to enable informed decision making. Mindful of the need to allow flexibility to AIFs, SEBI has permitted AIFs to modify the tenure of the scheme at any time before the declaration of the first close. At the same time, investors have been empowered to withdraw or reduce their commitment prior to such declaration, to accommodate their interest in the event the determination of tenure on the basis of the first close date does not suit their overall investment goals. While this change of tenure calculation might have brought certainty to a number of investors, this change is not applicable to schemes which have already declared their first close, and thus, there are numerous schemes where the term is still ambiguous. Taking this into account, a few days back, SEBI has asked all AIFs to state the reasons for not declaring final closure and define ‘end’ dates. We can expect SEBI to come up with another circular in this regard.

AIFs, as investment avenues, are fast transitioning from ‘alternate’ asset classes to mainstream investment vehicles in India. For this transition to be sustainable and to ensure investors are not short-changed, regulatory support is required which protects investor interest without repressing the flexibility which enables innovation in the AIF space. The changes recently introduced by SEBI demonstrates foresight on part of the regulator and can be viewed as a step in the direction of streamlining the processes adopted by AIFs to protect investor interest. However, care should be taken to not over-regulate this sector and jeopardise the key strength of the fund industry – flexibility and agility.