AIF Registration

SEBI issued a Consultation Paper on Proposal with Respect to Pro-rata and Pari-passu Rights of Investors of AIFs

The Alternative Investment Funds (AIFs) Pro-rata and Pari-Passu Rights Proposal Consultation Paper has been published by the Securities and Exchange Board of India (SEBI) to solicit public comments. The goal is to clarify how these rights will be maintained in the SEBI (Alternative Investment Funds) Regulations^[1], 2012. The article tackles concerns regarding the priority distribution mechanism that some AIF schemes have adopted, which impacts the pro rata return of capital to all investors. SEBI hopes to minimise regulatory arbitrage and potential abuse of the priority distribution scheme by recommending protections to reduce risks. The consultation paper includes working group proposals and gives SEBI’s opinions on the subject.

Pro-rata

According to the pro rata definition, the Latin word implies “pro rata,” which means “proportionally” or “per the rate”. It is used when a certain sum proportionate to an investor’s involvement in a particular business needs to be reimbursed. Prorating is considered to be a prorated amount and a method for calculating pro rata.

Pari-passu

A financial word, “pari-passu,” denotes that all individuals to a contract or assets involved would be treated equally. Pari-passu, a Latin phrase that means “on equal footing,” is frequently used when an individual or company declares bankruptcy. The Latin phrase “pari-passu” (literally, “on equal footing”) denotes that all parties to a financial contract are of equal rank and are entitled to receive payment.

Objective

The main objective of this proposal is to gather feedback and suggestions from interested parties and the general public regarding the proposal to add clarification to the SEBI (Alternative Investment Funds) Regulations, 2012, regarding retaining pro-rata and pari-passu rights of AIF investors.

Background

• According to the SEBI (Alternative Investment Funds) Regulations, 2012 (the “AIF Regulations”), an alternative investment fund is a privately pooled investment vehicle that collects money from investors and uses it to make investments in accordance with a specified investment strategy for the benefit of those investors.
• Recently, the Alternative Investment Funds industry requested that a separate class of units be issued to allow for co-investment alongside AIF investments; however, this request was denied, and investors’ co-investment was made possible through portfolio management. 
• To expound on this, the AIF collects funds from investors (in the form of commitments) for the AIF’s corpus. After identifying a potential investment, it requests funds from investors in proportion to their commitment to the scheme or AIF. It makes investments, resulting in pro-rata contributions or rights (in proportion to their commitment to the scheme) of each contributing investor in each investment of the scheme.
• Maintaining pro-rata rights of investors in each investment of the scheme of the AIF, even when making the distribution of investment proceeds, is a crucial aspect of the AIF structure, even though the aforementioned principle is not expressly stated in AIF Regulations.

Identified Issues

• It was noted that some Alternative Investment Fund schemes had adopted a distribution waterfall in such a way that certain classes of investors (the “Junior class/tranche”), other than the sponsor/manager, share loss more than pro rata to their holding in the AIF compared to other classes of investors/unit holders (the “Senior class/tranche”) since the latter has priority in the distribution of proceeds over the former (the “priority distribution model,” also known as the “PD model”). 

• In the event of a loss, the remaining money of the Junior class investors may be used to make up the loss and pay the Senior class investors. Similarly, in a profit scenario, Senior class investors get distributions first until their hurdle rate is fulfilled, and any residual funds, if any, are then given to Junior class investors. The pro-rata return of money to all investors is impacted in both circumstances.

• AIFs with PD models may be set up to benefit from regulatory arbitrage in terms of adhering to other regulatory criteria. It was also brought to SEBI’s attention. To assist the likely ever-greening of loans made by some regulated lenders, it was given to understand that such structure may be constructed in the following ways:
  • The magnitude of the investment made by the regulated lender in the AIF, as a Junior class investor, is based on the estimated loss on the loan portfolio at the time of structuring (haircut). The Senior class investor(s) invest up to the perceived fair market value of AIF’s assets acquired from the regulated lender.
  • The Alternative Investment Fund purchases NCDs from the borrower companies with the understanding that the proceeds will be used to pay back any loans given to those companies by the regulated lender.
  • The amount repaid by the borrower investee company and an investment in junior class AIF units replace the loan portfolio in the records of the regulated lender.
  • It is important to highlight that the investment made by the regulated lender in AIF units, which appear to represent the haircut structured in the loan portfolio, may be recorded in its books of accounts at a value equal to that of Senior class units.
  • The regulated lender may be allowed to avoid the categorisation, provisioning, and other applicable compliance requirements regarding the loans that are defaulting or are anticipated to do so as a result. Additionally, any potential loss in loan repayment could result in a future investment loss in the AIF.

• Under this arrangement, it is possible to postpone acknowledging the investee company’s declining creditworthiness.
  • Additionally, given that Alternative Investment Funds/schemes with PD models are designed to serve various investor groups with various risk appetites using the same pool of underlying investments, the abovementioned structure offers a considerable opportunity for conflict of interest problems.
  • From this perspective, it is important to note that the practise of “tranching,” which was a component of the development and distribution of collateralised debt obligations (CDOs), was one of the primary reasons contributing to the global financial crisis of 2008. Within the CDOs, many tranches with varying degrees of risk and possible return were established. 

• After considering the aforementioned problems, it is concluded that the PD model violates the regulatory aim of an AIF being a pooled investment vehicle because it is structurally weak and prone to abuse.

Consultation with stakeholders

Given the foregoing, it was decided to include in the agenda of the Alternative Investment Policy Advisory Committee (‘AIPAC’) of the SEBI meeting held on November 22, 2022, that it should be explicitly stated in the AIF Regulations that investors’ pro-rata rights must be maintained in investments (including distributions) of the AIFs and that structures using the PD model are not permitted. 

After consideration, AIPAC suggested establishing a Working Group to examine regulatory issues and provide safety nets in the context of investor priority allocation. SEBI notified the committee that a position had been taken to forbid priority distribution or transacting among investors or unit holders. If the recommendations from the aforementioned working group were deemed appropriate, the position might be revised.

In light of this, schemes of alternative investment funds that have adopted the aforementioned priority distribution model were instructed by SEBI in a circular dated November 23, 2022, to refrain from accepting any new commitments or making investments in new investee companies until SEBI has decided in this matter.

The Working Group suggested that rather than altogether outlawing the PD model, checks and balances should be assessed to reduce the risk of any misuse, and the PD model should only be outlawed in the rare instances where such measures are found to be insufficient to prevent the misuse. It was suggested that the PD model be approved in cases where both of the following criteria are met:

In conclusion, the benefits of allowing the PD model have been carefully considered because it may accommodate investors with various risk tolerance levels inside the same scheme structure. Obviously, a structure with asymmetrical distribution has an inherent conflict of interest problems and is quite vulnerable to abuse by taking advantage of regulatory arbitrage. The working group’s proposed precautions do not solve the issues with the PD model.

SEBI’s View on Working Group Suggestions

• Before the AIPAC members’ meeting on May 10, 2023, the suggestions of the aforementioned Working Group on “Priority Distribution among Investors of AIFs” were distributed. In the aforementioned meeting, SEBI informed the committee that the Working Group’s recommendations did not sufficiently address the main issues relating to the valuation of the assets of AIFs. As a result, it was decided not to accept the Working Group’s recommendations.

• In light of the foregoing, it is required to expressly forbid AIFs from using differential distribution models and any other practice that gives investors different rights and impacts the investment vehicle’s necessity for pooling.  

• As a result, the AIF Regulations may clarify how to maintain investors’ pro-rata rights to investments (including distributions of AIF proceeds).

Pari-passu rights of investors of an AIF

The issue of economic parity between AIF investors is crucial, even though it is being considered to provide clarity on the pro-rata rights of investors in investments of AIFs. In this regard, it has been noted from the analysis of Private Placement Memoranda (‘PPMs’) given by AIFs that the sector employs various practices that grant differing privileges or rights to some investors over others. A few of the terms under which AIFs offer differentiated rights, typically through side letters, are as follows:

• The deadline for drawing down funds.
• The hurdle rate of return and performance-linked fee.
• The transfer rights and information rights of new investors.
• The compensatory contribution for investors was added at a later close (excluding the catch-up contribution for retaining investors’ pro-rata rights).
• Rights to co-investment, etc. Regardless of whether these phrases are commercial or non-commercial.

Some of these agreements offer varying rights, which may impact the financial rights of other investors.

Differential rights may be granted on a variety of conditions, none of which are specified in the AIF Regulations. Investors must instead be informed of the conditions under which differential rights may be granted. According to a SEBI circular dated February 5, 2020, AIFs must adopt a template for Private Placement Memoranda that stipulates a minimum level of information in a clear and comparable style.

Similarly, under the section “Side letters,” AIFs are required to provide a list of commercial terms and non-commercial terms on which differential rights may be offered to the extent the manager intends to offer favourable/preferential terms by entering into side letters with certain investors. Additionally, it is specified that discriminatory rights cannot be provided under the following conditions:

• Priority withdrawal from the Fund/Scheme 
• Contribution to Indemnification 
• Giveback 
• Drawdown (unless in accordance with the “excuse and exclusion” rule)

From the list of terms mentioned above, it can be seen that they are designed to ensure that other investors’ economic rights are not affected by the issuance of side letters on different terms to certain investors, i.e., that all investors’ rights in the scheme are equal in terms of economic terms.

New Proposal

It is suggested that investors have the following pro-rata rights:

• When making investments, each investor’s rights shall be maintained.
  • Pro-rata to their commitment to the scheme, in each investment of the scheme during investment; and
  • Pro-rata to the investment made in the investee company when sharing the investment’s proceeds. As long as the manager can charge in accordance with the conditions of the contribution agreement with each investment.

• While the manager/sponsor may continue to have differential distribution to bear loss more than their pro-rata holding, this is subject to the condition that the amount invested by AIFs in the investment company is subject to the stipulation that it will not be used directly or indirectly to pay off any outstanding debts owed to the manager/sponsor or their associates.

• Existing AIF schemes that have embraced the priority distribution model may keep making their current investments, but they are not permitted to take new commitments or make investments in additional investee companies.

The following is suggested with regard to the pari-passu rights of investors:

• All investors in the Alternative Investment Fund/scheme must be treated equally with regard to their economic rights; in other words, no investors in the AIF/scheme may be granted differential rights that would affect the economic rights of other investors.

• The aforementioned clause does not apply when differential rights are based on hurdle rates of return, performance-linked fees/additional returns, and management fees.

Conclusion

Comments are invited from the side of SEBI for the proposal. The comments and suggestions may be provided in an Excel file per the format of the consultation paper. Also, it is mentioned to put the subject as “comments on the consultation paper on the proposal with respect to pro-rata and pari-passu rights of Investors of AIFs”. Comments as per the format are invited till June 04, 2023. 

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