Tuesday, August 2, 2011

SEBI’s Concept Paper on Alternative Investment Funds

Currently, private pools of capital are not subject to detailed regulation. No mandatory registration of such investment vehicles is necessary. Registration of such vehicles as venture capital funds (VCFs) is more in the nature of a facility available to take advantage of various benefits available through such registration under SEBI VCF Regulations. While several private pools indeed register themselves as VCF to avail of such benefits, others prefer to stay below the radar screen.
In order to create a more protective regime for investors investing in such private pools of capital, SEBI has issued a concept paper that seeks to make it mandatory for them to register with SEBI before raising monies from investors. The concept paper is accompanied by the draft SEBI (Alternative Investment Funds) Regulations, 2011, and comments are due by August 30, 2011.
The following types of private pools of capital will be brought within SEBI’s mandatory registration regime:
- Venture Capital Funds

- PIPE Funds

- Private Equity Funds

- Debt Funds

- Infrastructure Equity Funds

- Real Estate Funds

- SME Funds

- Social Venture Funds

- Strategy Funds

- Residual category (including hedge funds).
SEBI’s move is consistent with regulatory changes in other markets around the world, including in the US and Europe where registration requirements for private pools such as hedge funds are being expanded in view of the financial crisis. SEBI has quite elaborately set out its regulatory philosophy:
(i) SEBI proposes to create a structure where regulatory framework is available for all shades of private pool of capital or investment vehicles so that such funds are channelized in the desired space in a regulated manner without posing systemic risk. At one end of the spectrum, there will be Mutual Funds or CIS which are for retail investors with prudential regulation seeking to regulate all kinds of risks. On the other end there are private pools of capital of institutions or sophisticated investors who entrust pooled funds to a manager who himself needs to have own funds forming part of the corpus. Such pools of capital could also potentially employ leverage. At this end, regulation does not try to regulate the business risks but would like to provide some minimum ground rules for disclosures, and governance practices to minimize conflict. In between there would be various specialized funds where risks are graded and investment portfolios designed to suit specific regulatory/other incentives.

(iii) The proposal intends to regulate private pools of capital where institutions or High Networth Investors (HNIs) invest as Alternative Investment Funds. While institutions and HNIs are expected to be savvy investors and need not be protected from market and credit risk, there is need for a framework to deter from fraud, unfair trade practices and minimize conflicts of interest. Mitigation of potential conflict and deterrence to fraud etc., will be addressed through disclosure, incentive structures, reporting requirement and legal agreements.

(iv) The alternate investment vehicle such as PE fund is raised privately rather than through public funding. The funds are for long term, draw down of funds from investors is staggered, based on illiquid structure and exit is permitted on expiration of fund term. The duties owed by a fund manager to the fund investors will be largely shaped by fund documents that are subject of negotiation between the fund and its investor. Dispute if any, would preferably be settled through mediation, conciliation or arbitration etc.
The principal outcome of the concept paper is to shift SEBI’s regulatory strategy from the existing facilitative regime to a mandatory regime. Under the draft Regulations, no AIF can raise money from investors without registering itself with SEBI. Hence, private pools will be left with no option but to register with SEBI, and comply with various operative requirements under the proposed Regulations, including minimum fund size, minimum investment amount, and the like.
The concept paper seems to regulate the raising of funds by AIFs, thereby directly covering AIFs established in India and raising investments locally. Foreign pools of capital such as foreign venture capital funds are expected to continue to be governed by SEBI Foreign Venture Capital (FVCI) Regulations, where the facilitative (or options) registration requirements will continue. Therefore, foreign private equity firms or hedge funds raising capital overseas, but investing in India, would continue to operate under the present dispensation without mandatory registration. The flipside is that they would be governed by the general requirements for foreign direct investment and securities regulation, and may not be entitled to some of the benefits that registered entities such as FVCIs have (in terms of benefits on entry and exit pricing norms, exemptions from lock-in during IPO of an investee company, etc.).

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