On August 1,2011, the Securities and Exchange Board of India (“SEBI”) has released draft guidelines to regulate alternative investment funds. The guidelines are currently available for public comment. SEBI has made a rational attempt to separate venture capital funds (VCFs), which are designed to invest in startup companies from Private Equity, real estate and PIPE Funds (Private Investment in Public Equity), all of which had assumed the vehicle of VCFs in India for regulatory purposes.
This post analyzes the impact of the draft guidelines for alternative investment funds on funding options available to startups. If the Alternative Investment Funds Guidelines are passed, will it help startups in any way? Will VCs find it easier to invest? Will VCs retain complete autonomy over their investment strategy?
SEBI’s effort to regulate investment structures in a catch-all manner may spell trouble for many so-called VC and angel funds in India. It may prevent seed funds and smaller precision venture capitalists from pooling capital, if the proposals in the discussion paper go through in the current form. In regulating alternative investment structures, SEBI may have gone beyond its original mandate to protect ‘investor interest’. Its draft guidelines may be retrogressive, as compared to the recent US legislation (passed on November 3) that permits crowd-funding of startup companies.
Some of the key issues that arise from SEBI’s move:
1. It has been understood that SEBI’s power to regulate is limited to listed companies (or companies which intend to list in the near future) only. However, lately, SEBI seems to have extended its powers over a wider turf, including companies which are not listed as well. In fact, SEBI’s proposal on alternative investment funds seems to be another instance of the exercise of power over vehicles that invest in unlisted companies.
This assertion of jurisdiction over matters that are not limited to public companies, is currently being challenged before its superior body, the Securities Appellate Tribunal (“SAT”) in a matter relating to the Sahara Group. SEBI’s attempt to govern all forms of investment structures, if the regulations are finalised, may also be subject to a similar challenge.
2. SEBI has imposed high registration fees of Rs. 6 lakhs on all alternate investment funds. Investing in startups is amongst the riskiest forms of investment, with no predictable indicator to anticipate success. Investors do elaborate planning and adopt strategies that minimize the impact of government charges and taxation. Some of it may be necessary to render investment in sunrise sectors and startup industries economically viable. SEBI’s exorbitant registration fees will add to the costs these funds face, and may come in the way of setting up smaller seed-funds.
3. SEBI has sought to comprehensively restrict the ‘business model’ of the funds, which can prevent fund infusion into high-risk industries and micro and small enterprises and startups.This has been done through the following measures:
a) Imposition of minimum and maximum limits on fund size
SEBI has imposed a maximum fund size of 250 crores for venture capital funds. This makes it more difficult for VC funds to invest in new and risky technologies, which have no ‘predictable’ or ‘charted’ path to success. These technologies can often lead to groundbreaking innovations, and these are the technologies which need VC investment most.
This can be understood better in light of the business model of VC funds. Statistically, a majority of VC investments fail, but the amount of returns on the investments that succeed far outweigh the amount lost out of failed investments, which enables VC funds to make significant profits. In order to make profits by investing in riskier and technology intensive developments, VC funds shall:
i. Need to invest more funds per venture;
ii. Require a huge capital base to ‘pool’ their funds over more ventures, so that success in some ‘risky’ ventures can outweigh the failure in others.
The cap of 250 crores might prevent funds from investing in some potentially useful technologies. It does not provide them the vast capital base that they need to pool their investments in the riskier ventures.
Note that the issue is not whether the cap should have been higher, but that determination of a cap is a subjective issue, and that the cap should be determined on the basis of the business model and the investment strategy of the fund. Can we imagine a limit being imposed on the maximum capital of a company? Isn’t the optimum amount of capital determined by economic indicators and the business model? SEBI’s limit on the maximum size of alternative investment funds is very similar to this.
In addition, SEBI has introduced a minimum size of any alternate investment fund to be Rs. 20 cr. Hence, smaller players cannot source money from high networth individuals or financial institutions. If we apply SEBI’s rationale of containing systemic risk and fraud to the minimum limits it has imposed, we see peculiar results – why would the small size of a financial entity add to the element of risk it poses to a financial system?
b) Requirement of high minimum contribution by fund sponsors
SEBI has required fund managers to themselves invest 5% of the total fund amount. For large funds, this can be a significant amount. For example, a fund with a size of Rs. 200 crore will require the sponsor to put in at least Rs. 10 crores of his own money! It seems that SEBI has given preference to richer managers, and not to the brightest or smartest managers.
This may be justified by SEBI on two grounds:
i. When people invest their own money into a venture, they are likely to be more careful with it, and it can avoid reckless and excessively risky decision making.
ii. The tendency to make short term gains with disregard to long-term gains is lower, when the fund manager’s own money is involved. This is supported by historical experience in the West – in the events that led to the financial crisis, fund managers in US and Europe have taken risky decisions and exploited loopholes in the system for high short term returns. As their own money was not involved, they could successfully walk out with huge bonuses, at the expense of the investors who contributed to the fund.
Recommendation: The West is trying to deal with this problem in a different way – through ‘claw-backs’ in the remuneration packages of fund managers, which allow the fund to take back fund manager’s compensation, if within a few years any reckless or fraudulent behaviour is discovered.This method could be considered by SEBI, as it enables the most competent managers to be appointed to manage the fund. Investors who contribute their own money may not always understand the relevant industry the best, or make the best investment decisions.
c) SMEs and Micro-Enterprises may be excluded from funding – SEBI has imposed a minimum investment limit of Rs. 1 crore, or 0.1% of the fund size, whichever is higher. Thus, a fund with a size of Rs. 2000 crore needs to have a minimum investment of Rs. 2 crore. This may prevent seed funding, and funding of micro and small entreprises in their initial phases. This will also completely block startups from accessing some of the most reputed and larger funds.
The reason that SEBI has sought to regulate various kinds of investment vehicles now is because if they are unregulated, they may pose risk to the financial system of the country in general, that is, the risk out of failure of the institution can affect other parties in the financial system. In that regard, some guidance should be taken on how the Reserve Bank of India has regulated important financial sector entities. RBI uses minimum net-worth requirements to determine whether a large entity in the financial sector, or a large holding company must be regulated.
Recommendation: SEBI could have used net-worth requirements as a criterion to impose more regulation on larger funds, instead of imposing limits on investment and fund-size. SEBI has clarified that its goal behind the guidelines has been to prevent fraud and unfair trade practices. Therefore, it could have specified a net owned fund requirement for alternative funds, instead of specifying a minimum and maximum size, and the minimum amount of investment, it could have added additional disclosure requirements if the size of the fund was more than a particular threshold, or if the investment in a company exceeded a certain percentage. That would enable funds to retain autonomy, while simultaneously guarding against fraud.
4. SEBI has the power to pass regulations to protect investor’s interest. On that basis, SEBI’s regulation of investors in VC funds may be justifiable. However, seed stage and angel investors stand on a different footing from other funds. They may operate with a smaller pool of capital as compared to a traditional VC fund, but they are very sophisticated, and invest in industries that the investors themselves closely follow and understand, as opposed to investors in VC and PE funds, who may rely completely on the expertise and judgment of the fund managers for investing their funds. While regulation of VC and PE Funds to protect investor interest may be justified, regulation of seed stage and angel investors for the same reason is not needed. It is simply a restriction on their scope of operation and limits their freedom to do business, with no purported benefit to any party.
5. SEBI attempts to regulate investments made by financial institutions and high net-worth individuals in order to curb fraud, conflict of interest, unfair trade practices, and to minimise systemic risk. However, it has not commented on the applicability of Know Your Customer (KYC) and Anti-Money Laundering guidelines, a key component.