Highlights

This update analyses the following regulatory proposals for domestic alternative investment funds as suggested by SEBI vide a Consultation Paper:

•       Standardization of Private Placement Memorandum (“PPM”);

•       Performance benchmarking; and

•      Audit of PPMs, ‘with special emphasis on impact of side letters on other investors’.

Background

The Securities and Exchange Board of India (“SEBI”) has released a consultation paper dated December 4, 2019 (“Consultation Paper”) proposing to (i) introduce minimum performance benchmarking disclosures for registered alternative investment funds (“AIFs”); (ii) standardise the format of PPMs; and (iii) audit PPMs on an annual basis with special emphasis on impact of side letters on other investors of AIFs. SEBI has invited comments from public on the Consultation Paper by December 25, 2019.

Our analysis of the SEBI’s Consultation Paper is provided below.

Part 1 – Minimum Performance Benchmarking

SEBI has proposed a framework for compulsory performance benchmarking for AIFs by certain ‘benchmarking agencies’ (“Agencies”). The Consultation Paper provides that any association of AIFs, which in terms of membership represents at least 50% of the registered AIFs, may propose one or more Agencies, which will carry out performance benchmarking for AIFs. SEBI proposes to mandate the following:

(i)    AIFs registered with SEBI for at least 3 years will be required to report their audited performance data to the concerned Agency. Each Agency will need to ensure that such performance benchmarking is based on objectively verifiable parameters like instrument of investment, tenure/vintage of the fund, focus sectors, etc.

(ii)   The Agencies will provide a benchmark report to the individual AIFs vis-à-vis comparable industry benchmark. All marketing / promotional material of AIFs specifying the performance of the fund or past experience of the manager will need to be accompanied by the benchmark report.

(iii)  Unregistered funds, including foreign funds, will have to provide the data on their investments in Indian companies to the Agencies, as and when they seek registration as an AIF.

(iv) AIFs will need to provide audited data on cash flows and valuation of their scheme-wise investments to the Agencies in the format required by them.

(v)   AIFs will provide the historical data of valuation of investments to the Agency as a one-time exercise. Periodicity of valuation of investments will be as provided in the PPM of the AIF and any change in valuation approach will be notified to the Agency.

(vi)   The performance data and benchmarks will be reported in both INR and USD terms, based on the denomination of currencies of the capital drawn down by the relevant AIF. Performance benchmarking will be undertaken on a half yearly basis;

(vii)  Assets under Management for the purpose of benchmarking will be the value of total capital draw down of a scheme through private placement. The performance reporting and benchmarking will be carried out on pre-tax net asset value of such scheme.

Analysis

SEBI’s intent behind proposing performance benchmarking by AIFs is to facilitate informed investment decisions by investors and to minimize mis-selling of AIFs as investment products. This certainly is a welcome move and would bring about transparency and credibility thereby boosting investor confidence in the long run.

Importantly, the Consultation Paper acknowledges that since diverse investment strategies could be deployed by funds operating within the same category of AIFs; the Agency may prescribe additional objective parameters for benchmarking like instrument of investments, vintage of fund, focus sector etc. Considering that the AIF regulatory platform is conducive to a wide range of funds including VC funds, PE funds, real estate funds, PIPE funds, credit funds, impact funds, hedge funds etc.; from a practical standpoint, it would be critical to review the benchmarking parameters prescribed by the Agencies to ensure that the benchmarking is amongst the ‘peer group’.

Particularly in case of VC and PE funds, internal rates of returns (“IRR”) may depend on factors like timing of contributions by investors. Further, for such funds IRRs may not be an accurate indicator of performance during the initial phases of their life cycles as compared to funds focused on investments in public equities. We expect that the benchmarking process would be finalised by the Agencies based on the feedback received from the domestic fund industry on such aspects while devising the final benchmarking methodology.

Part 2- Standardisation of PPMs

PPM is a marketing document and forms the basis of an investor’s decision to invest in an AIF. While the SEBI AIF Regulations identify broad heads of disclosures required to be made under a PPM, no standard format for PPMs is was prescribed in this respect. SEBI has now proposed to introduce a standard template PPMs for Category I and Category II AIFs, and separately for Category III AIFs.

Analysis

The format of the PPM as prescribed by SEBI lays down the various heads under which disclosures are required to be made in respect of an AIF. The disclosures prescribed by SEBI are broadly in line with the current best practices adopted by AIFs.

At this stage, it is not entirely clear whether the AIFs which have filed their PPMs with SEBI along with their application for registration with SEBI, and the ones which are currently engaged in fundraising after obtaining the said registration, will need to revise their PPMs according to the format prescribed by SEBI. A clarification in this respect would be helpful to avoid revising of PPMs for registered funds.

Part 3: Auditing the PPM

Interestingly, the Consultation Paper proposes an annual audit of the terms of PPM ‘with special emphasis on impact of side letters on other investors’. The findings of such audit must be communicated to the trustee, board of the investment manager and SEBI, along with the corrective steps taken in case of any adverse findings. Further, summary of audit findings with respect to compliance with terms of the PPM will be shared with all investors.

While, initially the audit is proposed to be carried out by an internal or external auditor, SEBI has reserved its discretion to have such audits conducted by external auditors only.

Analysis

Globally, the terms of the side letters executed with an AIF’s investors are treated as confidential. From a disclosure standpoint, PPMs of AIFs generally provide for an indicative list of rights which may be offered to specific investors under side letters. Investment Managers endeavour to create an intelligible differentiation between investors while offering special rights under side letters (like, size of commitments made, internal policies of investors, reporting requirements, etc. The proposal to audit the impact of side letters on other investors of an AIF, and communicating the findings thereof to the regulator, is a substantial departure from the current industry practice.

Authors:

Pallabi Ghosal, Partner
Vivaik Sharma, Partner
Hetvi Doshi, Associate