This article has been written by Vignesh A L  pursuing a Diploma in Corporate Law & Practice: Transactions, Governance and Disputes course from LawSikho.

This article has been edited and published by Shashwat Kaushik.

Introduction

A mutual fund operates by pooling capital from investors to acquire a collection of securities, such as stocks and bonds, which are managed by a professional fund manager. The structure of the mutual fund is three-tiered, beginning with the establishment of a trust, which includes sponsors, trustees and asset management companies. At the heart of the mutual fund is the “sponsor”, who is responsible for promoting the fund, attracting investment and setting up its structure. Once a mutual fund is established, the external parties are relieved of any financial or non-financial obligations. In the initial stages, the promoting entity retains responsibility before any robust accountability systems are in place. Given the crucial role of sponsors in mutual funds, the Securities and Exchange Board of India (SEBI) imposes strict criteria for qualifying as a mutual fund sponsor. The market trends indicate that despite their significant role, once a mutual fund achieves a certain level of assets under management, it becomes well-established and gains credibility, reducing the sponsor’s importance, which arguably could be phased out. Recent statistics show that the Indian domestic mutual fund industry has doubled its assets under management over the past five years, highlighting a significant growth potential and opportunity for new entrants to play a significant role in this expansion. 

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In April 2022, a working group was formed to assess the role and qualifications of the mutual fund sponsors. This group proposed alternative eligibility criteria for private equity players and potential mutual fund sponsors and explored the feasibility of self-sponsored asset management companies as a part of their study.

Mutual fund

Mutual funds are investment vehicles that offer a convenient and accessible way for investors to pool their capital and gain exposure to a diversified portfolio of securities. By investing in a mutual fund, individuals can benefit from the expertise of professional fund managers who conduct thorough research and analysis to make investment decisions.

The process of mutual fund formation involves the collection of capital from numerous investors, which is then invested in a portfolio of various securities, including stocks, bonds, and other financial instruments. This diversification aims to mitigate risk by spreading investments across different asset classes and industries, reducing the impact of any single security’s performance on the overall portfolio. The selection of specific securities is guided by the fund’s investment objectives, which are outlined in its prospectus.

The prospectus serves as a vital document that provides investors with essential information about the fund, including its investment strategy, risk profile, and fees. Each fund typically has a specific investment mandate that outlines the types of securities it can invest in and the geographical regions or sectors it focuses on. Some funds may prioritize income generation through dividend-paying stocks or bonds, while others may aim for capital appreciation by investing in growth stocks.

The management of mutual funds is entrusted to professional fund managers who possess in-depth knowledge of the financial markets and a proven track record of successful investing. These fund managers are responsible for making investment decisions, buying and selling securities, and managing the portfolio’s overall risk exposure. Their expertise and experience enable them to navigate market fluctuations and identify investment opportunities that align with the fund’s objectives.

Mutual funds offer several advantages to investors. They provide an easy and convenient way to invest in a diversified portfolio without the need for extensive research or individual security selection. Moreover, mutual funds typically have lower investment minimums compared to directly purchasing individual securities, making them accessible to investors with varying capital levels.

However, it’s important to note that mutual funds are subject to market risks, and their performance can fluctuate based on economic conditions, interest rates, and geopolitical events. Investors should carefully consider their risk tolerance, investment goals, and time horizon before selecting a mutual fund. Additionally, fund expenses, such as management fees and operating costs, can impact the overall returns. Through these pooled resources, investors earn returns over time based on the capital they have invested. The fund manager, who is an investment professional, oversees the allocation of these funds into various securities, including stocks, bonds, gold and other assets, aiming to generate potential returns. Investors share in the gains or losses of the investment in proportion to their contribution to the fund.

Who is a sponsor

Under Regulation 2(x) of the Mutual Funds Regulations, a “sponsor” refers to an individual or a legal entity that plays a crucial role in establishing a mutual fund. The sponsor acts individually or in collaboration with another corporate body to initiate the process of setting up the fund.

The sponsor assumes significant responsibilities in the formation and operation of the mutual fund. These responsibilities include:

  1. Compliance with regulatory requirements: The sponsor must ensure that all necessary regulatory approvals and licences are obtained before the mutual fund can commence operations. This involves liaising with relevant regulatory bodies, such as the Securities and Exchange Board of India (SEBI), to obtain the requisite approvals.
  2. Establishment of asset management company: The sponsor is responsible for setting up an asset management company (AMC) to manage the investment portfolio of the mutual fund. The AMC is a separate legal entity that is responsible for making investment decisions, managing the fund’s assets, and providing investment advisory services to unitholders.
  3. Creation of mutual fund trust: The sponsor must establish a mutual fund trust. This trust serves as the legal structure that holds the assets of the mutual fund and acts as a custodian of unitholders’ investments. The trust is managed by a board of trustees who are responsible for overseeing the fund’s operations and ensuring that it complies with all applicable regulations.
  4. Fund raising: The sponsor plays a crucial role in raising funds for the mutual fund. This involves marketing the fund to potential investors, such as individuals, institutions, and corporate entities. The sponsor must ensure that all funds raised are invested in accordance with the fund’s investment objectives and risk profile.
  5. Compliance with reporting and disclosure requirements: The sponsor is responsible for ensuring that the mutual fund complies with all reporting and disclosure requirements prescribed by regulatory authorities. This includes providing regular updates to unitholders on the fund’s performance, investment strategy, and any material developments affecting the fund.

The sponsor’s role is vital to the successful operation and management of a mutual fund. The sponsor’s expertise, financial resources, and commitment to regulatory compliance contribute significantly to the protection of unitholders’ interests and the overall integrity of the mutual fund industry.

Ownership structure of MF

The ownership structure of mutual funds in India is a three-tier structure comprised of sponsors, trustees and asset management companies, respectively. The mutual funds are created by the sponsors and they work similarly to those of a promoter of a company. The funds are overseen by the trustees and asset management companies.

The trustees, with the approval of SEBI, holds the property of the mutual fund for the unit holders. A mutual fund is created by collecting money from investors, pooling the same and subsequently investing it in diversified securities based on pre specified objectives. The asset management companies deduct the expenses and then distribute the profits earned from the investment to each investor.

The issue and need pertaining to including PE as sponsors

SEBI has proposed an alternative eligibility criterion to facilitate the entry of private equities in the mutual funds sector. According to this proposal, the sponsors should put in capital into asset management companies to ensure a liquid net worth of not less than Rs. 150 crore, and the asset management companies must maintain a liquid net worth of Rs. 100 crore until they record profit for 5 consecutive years, along with a 40% sponsor stake and a minimum capital contribution that has to be locked in for 5 years.

Even though the initiative taken by SEBI is highly advantageous and would introduce positive changes in the market, it also carries a potential threat as it could create barriers to entry because it relies on net worth-based eligibility criteria, which would favour wealthy individuals over those with innovative ideas and ethical business practices but lack the wealth. 

Private equities often prefer investing in existing asset management companies, in contrast to starting a new venture from scratch. They operate on a large scale and the net worth eligibility criteria do not pose a prohibitive barrier to them as they have a high capacity to put substantial capital into ventures.

Considering these factors, they have a high ability to mobilise capital efficiently and scale a business rapidly, which would be a good reason to permit PE involvement in mutual funds, which could lead to a symbiotic relationship between fund managers and private equity players, where the managers could provide the expertise and PE players could provide the capital, which will create a collaborative and growth environment of industry and market knowledge, expertise and financial resources.

The working paper proposed a reduction in the ownership stake of sponsors in asset management companies from 40%, which is the current percentage of stake for improving inclusivity and opening avenues for other shareholders, which could foster strategic guidance and attract top talent, which could act as a driving force of growth and innovation in the industry.

Eligibility criteria for sponsor

Regulation 7 of the MF Regulations provides the eligibility criteria for the sponsors of a mutual fund, which emphasises a sound track record, a general reputation of fairness and integrity in all business transactions, putting in place the necessary resources for the setting up of a mutual fund, fit and proper requirements, etc., as mentioned above. The Working Group, after a detailed study of various requirements and global best practices, recommended a two-pronged approach. It has been recommended that while the existing eligibility requirements be further strengthened to ensure that only high-quality entities qualify, an alternative set of eligibility requirements may also be introduced to enable the qualification of entities, including private equity funds, who do not qualify based on the main eligibility criteria to be considered sponsors. However, the alternative set of eligibility requirements should be such that there is no regulatory arbitrage.

The main eligibility criteria proposed are:

  1. Sound track record

The current criteria for operating in the financial services sector include conducting business for a minimum of five years, maintaining a positive net worth throughout this period and having a sponsor whose net worth exceeds the proposed capital contribution to the asset management company in the form of a positive liquid net worth. 

In situations where there is a shift in control of an existing Asset Management Company (AMC) due to the acquisition of shares, the sponsor is required to demonstrate a solid commitment to preserving the financial stability of the AMC. To achieve this, the sponsor must maintain a positive liquid net worth or secure external funds that are equivalent to the aggregate par value or market value of the shares being acquired.

This requirement is imposed to ensure that the AMC has sufficient financial resources to meet its obligations and to protect the interests of investors. By maintaining a positive liquid net worth, the sponsor demonstrates that it has the financial capacity to support the AMC’s operations and to absorb any unexpected losses. Alternatively, by securing external funds, the sponsor provides a cushion of financial support that can be tapped into if needed.

The amount of funds required to be maintained or secured is determined by the aggregate par value or market value of the shares being acquired. This ensures that the AMC has sufficient resources to cover the potential liabilities associated with the acquired shares and to maintain compliance with regulatory requirements.

The sponsor’s commitment to maintaining positive liquid net worth or securing external funds is a key factor in obtaining regulatory approval for the change in control of the AMC. It demonstrates that the sponsor has the financial strength and resources to ensure the ongoing viability and stability of the AMC. Additionally, the sponsor must have recorded profits after accounting for depreciation, taxes, and interest in at least three or five years immediately preceding the most recent year.

These requirements are reviewed as follows:

  • Net profits must be recorded in each of the immediately preceding five years after accounting for depreciation, tax and interest.
  • The average net annual profit over the preceding five years, after accounting for depreciation, interest & tax, should be at least INR 10 crore.

These requirements will remain in place.

  • SEBI has stated that the existing “fit and proper” requirements are adequate and do not need further review as they were recently evaluated.
  • The AMC is required to maintain positive liquid net worth of INR 50 crore on a continuous basis. The sponsor is responsible for ensuring that the AMC complies with this requirement of maintaining the minimum positive liquid net worth.

The SEBI Consultation Paper has proposed an alternative set of eligibility requirements to enable entities, including PE Funds, who do not qualify based on the existing eligibility criteria, to be considered as sponsors of mutual funds. The following are proposed as alternate eligibility criteria for sponsors of mutual funds:

  • The proposed sponsor must sufficiently capitalise the asset management company with a minimum contribution of at least INR 150 crore.
  • The AMC must maintain a positive liquid net worth of at least INR 100 crore continuously until it has achieved five consecutive years of profitability
  • The sponsor is responsible for ensuring the AMC consistently meets the minimum positive liquid net worth requirement.
  • The capital that contributes to AMC, up to the required minimum of INR 150 crore, will be locked in for 5 years. Additionally, the sponsor’s minimum 40% stake in the AMC will also be locked in for 5 years.
  • The sponsor must appoint personnel with sufficient experience so that the combined experience of the CEO (chief executive officer), COO (chief operating officer), CRO (chief regulatory officer), CCO (chief compliance officer), and CIO (chief investment officer) totals at least 30 years.
  • The proposed sponsor must meet the adequate capitalization requirements and maintain a positive liquid net worth equal to the additional capitalisation needed to ensure the minimum capitalisation of the AMC to acquire an existing AMC. The sponsor must also demonstrate a firm commitment to the aggregate par value or market value of the shares to be acquired, whichever is higher.
  • Fit & proper requirements applicable under the existing eligibility route also apply to the proposed sponsors under the alternate eligibility route. 

Additionally, the SEBI consultation paper, among other things, recommended the following additional criteria/ safeguards to be made applicable to PE Funds to qualify as mutual fund sponsors: 

Additional criteria proposed

  • The private equity funds or their managers must have a minimum of five years of experience as a fund or investment manager and in making investments within the financial sector. Additionally, the manager must have managed and drawn down capital totaling at least INR 5,000 as of the application date.
  • “Associate” or “Group Company” of the Manager of the sponsor PE Fund; Investee companies in which the shareholding held by the Funds or Schemes which are managed by the fund manager of the proposed sponsor PE Fund is 10% or more; and Any investee company in which sponsor PE Fund has more than 10% investment or the directors of sponsor PE Fund/ corporate sponsor has board representation will be included in the definition of “Associate” or “Group Company” in case of a mutual fund where a PE Fund owns the majority. 
  • Off market transactions will not be allowed between the mutual fund schemes and the sponsor PE funds or between the schemes/funds managed by the manager of the sponsor PE funds or investee companies of the schemes/funds of sponsor PE funds where the sponsor holds more than a 10% stake or has board representation.
  • The mutual fund sponsored by the private equity funds are prohibited from participating as an anchor investor in the public issuance of a company where any of the schemes or funds managed by the sponsoring PE fund have an investment of 10% or more or have board representation.

Conclusion

The new eligibility will allow new players, including private equity funds previously ineligible to act as sponsors, to enter the mutual fund market. This change will facilitate increased capital flow into the industry, enhance and encourage competition, foster innovation and provide easier consolidation and exit options for existing sponsors.

In order to ensure a balanced transition, SEBI has to devise several provisions that would accommodate private equity participation, ease the sponsor exit and safeguard unitholders’ interests against potential market imbalances and disruptions. As the Indian mutual fund industry evolves, the implementation of these proposals will be highly crucial and important, considering the established operational dynamics of the market.

References

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