This article is written by Suha, pursuing a Diploma in US Technology Law and Paralegal Studies: Structuring, Contracts, Compliance, Disputes and Policy Advocacy from LawSikho

Introduction


The Securities and Exchange Board of India (SEBI) introduced amendments to the SEBI (Alternative Investment Funds) Regulations, 2012, and SEBI (Portfolio Managers) Regulations, 2020 on November 9, 2021. The aforementioned amendments regulate co-investment opportunities provided by fund managers to investors (limited partners) of Category I or Category II alternative investment funds (Cat I/Cat II AIFs). 

The newly amended regulations introduce a new category of portfolio managers, i.e. co-investment portfolio managers. An alternate investment fund manager under Category I and Category II will be required to register as a Co-investment Portfolio Manager if he/she decides to offer. Before we understand what co-investments are, let’s look into Alternative Investment Funds.

What are alternative investment funds?

Alternative investments are financial assets that do not adhere to any specific investment category.  A financial asset that does not fall into any of the conventional equity, income, or cash categories is known as an alternative investment. Alternative investments include private equity or venture capital, hedge funds, real estate, commodities, and tangible assets.

Alternative investments, which were traditionally exclusively available to institutional or accredited investors, are now available to individual and retail investors through alternative funds.

Regulation 2(1) (b) of the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 defines alternative investment funds (AIFs) in India. Any privately pooled investment fund (whether from Indian or foreign sources) in the form of a trust, a company, a body corporate, or a Limited Liability Partnership (LLP) is referred to as an alternative investment fund. As a result, alternative investment funds are private funds that are otherwise not subject to the jurisdiction of any regulatory agency in India.

Alternative investment fund managers typically have greater experience than mutual fund managers in handling entrepreneurial funds and/or mutual funds, allowing them to provide superior management and innovation. Alternative investment funds offer High Networth Individuals (HNIs) the opportunity to produce greater returns through customized investments.

A private equity investment, by its very nature, is a blind pool investment vehicle for investors. Investors of an alternative investment fund, also known as Limited Partners (LP), do not enjoy the liberty of participating in the selection of transactions to be made by the alternate investment fund. Investment and transaction selections are made entirely by the alternate investment fund manager. 

What are co-investments?

Co-investments represent investments made alongside a ‘main fund.’ Co-investments are a mechanism for Limited Partners to put more money into deals alongside the main fund. As a result, the management fee and carry (a portion of the earnings) for Limited Partners or investors in funds are reduced. Over the last decade, the co-investment framework has picked up steam in the Indian fund management business. 

Co-investment is a parallel investment alongside the alternate investment fund. When an investment opportunity is being considered for the alternate investment fund by the fund manager, the fund manager may disclose the deal opportunity to the Limited Partners about investee entities of alternate investment fund requiring more capital in a given round. This allows the alternate investment fund manager to utilise a lesser amount of capital and consequently allows the alternate investment fund to participate in a larger number of investments. After the alternate investment fund manager informs the investors about the investment opportunity, it is up to the Limited Partners to make their own investment decision. The approach of co-investing through alternate investment funds goes against the pooling concept of the alternate investment fund.   

Limited Partners use funds as a source of diversification and discovery, especially in the unlisted market, and co-investments are an important aspect of the Limited Partner-General Partner relationship. Co-investments are not officially mentioned in India’s alternative investment funds legislation, which describes alternative investment funds as pooling vehicles. SEBI’s recent investigation appears to be a technique of better understanding market practices and their prevalence.

Co-investments are a significant component of private equity and venture capital funds around the world, and they serve a series of objectives for Limited Partners, including gaining access to deals and transactions, and lowering the fee and carry base. This also permits investors with small teams to benefit from a fund manager’s skill in due diligence and subsequently monitoring the investment till exit.

Limited partners in a typical co-investment do not pay a fee or carry to avoid creating biases or conflicts for the fund manager. When executed properly, co-investments can benefit all three parties involved: the corporation, the fund manager, and the Limited Partner.

Who is a Co-investment Portfolio Manager?

Limited Partners of an Alternate Investment Fund are obligated to make co-investments only through Co-investment Portfolio Managers licensed under the SEBI Portfolio Manager Regulations. 

AIF managers who are also registered portfolio managers and wish to provide co-investment services through the portfolio management route must notify SEBI in advance. SEBI has prescribed a separate registration form for a Co-investment Portfolio Manager. Co-investment Portfolio Managers are portfolio managers of a Category I or Category II Alternative Investment Fund that facilitate the option of co-investment.

Co-investment Portfolio Managers are required to provide services only to the investors of Category I or Category II Alternative Investment Fund; and provide services only in unlisted securities of investee companies where such Category I or Category II Alternative Investment Fund make investments. 

Any other manager who is not a registered portfolio manager and seeks to provide co-investment services through the portfolio management route must apply for portfolio manager registration with SEBI. If a portfolio manager wishes to provide portfolio management services (PMS) other than co-investment as a result of their registration, they must comply with all terms of the PMS rules, including eligibility criteria, as well as obtain SEBI’s prior approval. 

The co-investment structure and registration requirement after the amendment

1. Co-investment Portfolio Manager registration criteria

SEBI has set up a separate registration form for a Co-investment Portfolio Manager, which must be filed along with the draft disclosure document and draft client agreement with SEBI. SEBI Portfolio Management Regulations prescribe detailed requirements on mandatory contents of the client agreement.

2. Investments permitted to Co-Investment Portfolio Managers

Co-Investment Portfolio Managers shall invest 100% of the assets under management in unlisted securities of investee companies where Cat I and II AIFs managed by it as manager, has made investments.

3. The exception to net worth requirement

For Co-investment Portfolio Managers, the net worth requirement for registration as a portfolio manager has been lifted.

4. Non-applicability of minimum investment criteria

Co-investment Portfolio Managers are not subject to the minimum INR 50 lakh investment criteria that apply to the clients of a portfolio manager.

5. Principal officer

The Co-investment Portfolio Manager may appoint a member of the manager’s key investment team as the ‘Principal Officer’ (as specified by SEBI PM Regulations) who qualifies the SEBI Alternative Investment Funds Regulations’ criteria (i.e., 5 years of experience and professional qualifications). In this case, there is no requirement to designate a separate ‘Principal Officer.’ For the SEBI PM Regulations, the compliance officer’s duty can be fulfilled by the same individual.

6. Terms of co-investments

Investment by the co-investor should be on the same terms as Cat I or II AIF. The timing of exit by the co-investor has to be identical to that of the Cat I or II AIF.

The challenge is that, as stated previously, not all such co-investments would be under the alternative investment funds manager’s control to guarantee that the terms are identical to those of the alternative investment funds.

7. Documentation requirement

The amendment appears to indicate that the Disclosure Document (which portfolio managers are expected to prepare) is not required to be made available on the manager’s website. It is, nevertheless, still necessary to file it with SEBI.

8. Periodic reporting

Portfolio managers will be required to submit a monthly report, presented in the updated format, on their portfolio management activity on the intermediaries site within seven working days of the end of each month, according to the regulator.

9. Quarterly reports

Portfolio managers will be required to provide a quarterly report to their customers in accordance with the amended structure, which includes details of co-investment opportunities given by the portfolio manager.

From April 2022 onwards, reporting requirements in the updated reporting formats will apply to monthly reports to SEBI and quarterly reports to clients. 

10. Operating expenses

SEBI clarified that the provisions of the PMS rules concerning fees and charges, as well as portfolio managers’ direct onboarding of clients, will not apply to co-investment services. These provisions will not change for portfolio management services other than co-investment. Clients will not be charged any upfront fees by portfolio managers, either directly or indirectly, under the PMS Regulations.

Over and above the fees charged for portfolio management service, operating expenditures excluding brokerage will not exceed 0.50% per year of the client’s average daily assets under management (AUM). According to the guidelines, no costs will be assessed at the time of direct onboarding of clients other than statutory charges. 

11. Withdrawal

Since Cat I and II AIFs are close-ended funds having fixed tenures, investors engaging in co-investment concerning Cat I and II AIFs would have no regulatory right to withdraw from co-investments when the portfolio management services with the Co-investment Portfolio Manager were voluntarily or compulsorily terminated.

12. Appointment of a custodian

Custodians are only necessary for alternative investment funds with a corpus of more than Rs. 500 crore. The requirement to appoint a custodian separately for co-investments by Co-investment Portfolio Manager has been waived off otherwise.

13. Prohibition of B2B arrangements

Before the Amendment Regulations, an Indian entity that is also an alternative investment funds management could provide investment advice to an overseas fund manager, but this now seems to be prohibited. 

Conclusion

In addition to the existing compliance requirements as alternative investment funds managers, the Amendment Regulations appear to increase the compliance burden on alternative investment funds managers by requiring them to register as portfolio managers with SEBI to offer co-investment opportunities to the alternative investment fund’s investors.

The registration requirement will lengthen the time it takes for fund platforms to get up and running, as it will necessitate more filings with SEBI, as well as increasing compliance expenses for fund managers.

This raises the cost of offering co-investment management, which may dissuade fund managers from extending such a right to alternative investment fund investors, affecting Limited Partner sentiment when allocating to alternative investment funds.

References

  1. SEBI | Securities and Exchange Board of India (Alternative Investment Funds) (Fifth Amendment) Regulations, 2021
  2. SEBI | Securities and Exchange Board of India (Portfolio Managers) (Fourth Amendment) Regulations, 2021
  3. Latham & Watkins LLP- Private equity co-investment Article by David Greene and Amy Rigdon
  4. https://www.pelawreport.com/10645711/negotiating-co-investments-unique-features-and-considerations-in-co-investment-vehicle-documents-part-two-of-two.thtml 
  5. What are Alternative Investment Funds? Should HNIs invest in AIF? – The Financial Express
  6. Sebi lays steps for undertaking co-investment portfolio management service | Business Standard News
  7. New SEBI Rules For AIF LPs To Co-Invest – Finance and Banking – India 
  8. Indian AIFs, Limited Partners, wary of SEBI request for co-investment information | VCCircle 

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