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Investor Rights in Alternative Investment Funds (AIFs) in India: What You
Parul Jain
Radhika Parikh
Ipsita Agarwalla
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The Alternative Investment Fund (AIF) industry has seen significant growth in India in recent years. In response, the Securities and Exchange Board of India (SEBI) has introduced key amendments aimed to ensure fairness and equal treatment for all investors. These changes emphasize that AIFs are blind pool investment vehicles and require that:
1. AIFs are blind pool investment vehicles and require that: Investors have rights to the underlying investments in proportion to their capital commitment ("Pro-Rata Rights")
2. All investor rights must rank equally("Pari-Passu Rights")
These amendments may prompt fund managers to re-evaluate their fund structures, documents, and the rights negotiated with investors. Below, we explore the implications of these changes from both the investor and manager perspectives.
Pro-Rata Rights: What Does It Mean for Investors?
Pro-Rata Rights are directly tied to the economic rights of Limited Partners (LPs) in the underlying investments and distributions from these investments. SEBI now mandates that these rights be maintained based on the inter-se ratio of capital commitments made by investors.
However, an investor’s capital commitment isn’t just used for making portfolio investments. It also covers management fees, operating expenses, and other fund liabilities. Investors typically negotiate different terms for fees or caps on expenses, meaning that one investor might end up using a larger portion of their capital commitment for fees and expenses compared to others. This can lead to uneven allocations across investors.
If Pro-Rata Rights are interpreted based solely on total capital commitments, this could create impractical situations. For example, an investor with a larger unfunded commitment might find themselves in a position where they cannot make further investments due to lower management fees. Conversely, an investor with a smaller unfunded commitment might struggle to meet drawdowns.
Therefore, SEBI’s mandate may need to be understood as requiring Pro-Rata Rights based on unfunded capital commitments.
As a result, fund structures may need to be reassessed to ensure that investors' economic rights are in line with Pro-Rata principles. Importantly, SEBI has not grandfathered existing arrangements. If an AIF does not provide Pro-Rata Rights, it will be prohibited from accepting fresh commitments or making new investments. This could reduce the fund's size and impact overall fund performance. Additionally, distributing carried interest in line with Pro-Rata principles may become more complex, particularly when sharing it with investors (other than the manager, sponsor, or their employees).
Pari-Passu Rights: Ensuring Equal Treatment
SEBI has also emphasized that all investors' rights should be pari-passu—equal in all respects. However, the regulator allows for differential rights, provided they don’t negatively impact the interests of other investors. AIFs raise funds from sophisticated investors, who often negotiate their rights upfront. A positive list of differential rights has been released by SEBI which inter-alia includes the following rights:
- Waiver of fund expenses for specific investors
- Differential management fees, carried interest, and hurdle rates
- Co-investment rights
- Accelerated reporting for select LPs
While these provisions might reflect typical investor requests, some might question whether such detailed regulation of AIFs was necessary in the first place.
Fund managers now have to necessarily disclose the eligibility criteria for availing differential rights in the placement memorandum. Fund managers have been provided one month’s time to disclose the differential rights to SEBI and terminate the rights which are not in conformity with the positive list. Terminating of a negotiated right will put managers in a difficult position with investors. Certain rights which are not included in the positive list currently includes transfer rights, the manner and form of distribution (e.g. cash-only distribution, no in-specie distribution), restrictions on reinvestments, exemption from equalization premiums and draw-stop rights to name a few. Conducting an investor-by-investor exercise to determine whether their rights are in conformity with SEBI’s mandate may be a daunting exercise. This may be even more challenging in cases where managers have launched multiple AIFs.
The Road Ahead
The regulatory landscape for AIFs in India is evolving quickly. Both fund managers and investors need to stay updated and prepare to adopt these changes. While the amendments aim to foster fairness and transparency, they may require significant adjustments to how funds are structured and how rights are allocated and offered to investors.
By understanding and adapting to these shifts, AIF managers and investors can better navigate the changing landscape and ensure that their interests remain protected.
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