Many PE and VCs – or, alternative investment funds (AIFs), the regulatory term for such pooled vehicles – have been told to spell out the details of these differential rights given to certain investors.
In a communique to many AIFs about a week ago, the Securities & Exchange Board of India (Sebi) asked fund managements to submit documents like ‘side letters’ and ‘contribution agreements’ that provide special rights to investors. The regulator may compare a side letter, which is an agreement between a fund house and some investors, providing rights and obligations which are outside the standard investment document, with the fund’s private placement memorandum (PPM) – the disclosure document used for fund raising through private offering.
“A demat of AIF units, as Sebi wants, means a ISIN specific degree of homogeneity. However, side letters, which inherently provide differentiated rights – whether economic or governance-driven – for investors, represent the opposite end of the spectrum. Indeed, how Sebi navigates these differing objectives could potentially shape the future of the fundraising process for the AIF as a platform,” said Richie Sancheti, founder of the law firm Richie Sancheti Associates.
More than 1200 AIFs have raised close to₹5 lakh crore till now from local and offshore investors comprising individuals and institutions.
Sebi got a greater sense of these practices -though some of which are quite prevalent in the PE-VC industry worldwide -after AIFs submitted details to depositories for dematerialising the units (or shares) issued to investors in the funds. The regulator, it appears, is uncomfortable with situations where better rights given to some investors undermine the rights of others. However, multiple funds have been offering differential rights on the grounds these would ‘not be prejudicial to the interest of other investors.’
Differential rights
More than a discount on management fee -where few large investors may pay 1.5% of their contributions to the fund manager as against the customary 2% charged to other investors -there are other differential rights like equalisation premium where an investor entering later pays an extra that the fund passes on to early investors which came in early and therefore took a higher risk.
Some bulk investors may negotiate a better deal for themselves. This could be lowering the carry -the slice of the extra return a manager earns after crossing an agreed hurdle rate of return -arising from temporary investments to park money in the runup up to a strategic deal or following an exit.
Side letters are a crucial feature for any mature fundraising exercise where illiquid strategy funds seek commitments from segments of investors with varying levels of sophistication and ticket size. “So far, we have seen scrutiny only on those side letter terms that could negatively impact other investors,” said Sancheti.
Sebi is also conducting an impact assessment by collecting information from AIFs that have “excused or excluded investors” from various investments. AIFs, apart from angel funds, are intended to be blind pools with the fund manager having full discretion on the portfolio. There may be occasions where an investor may inform the fund manager upfront about its inability to take exposure to certain sectors or geographies.
In this context, AIFs were asked by Sebi (in a separate communication this month) on whether PPMs have disclosure with respect to excuse or exclusion of investors from investments of the fund; how is the shortfall in drawdown amount met when an investor is excused or excluded; whether a particular investor has been excused or excluded from multiple investments of a fund; whether the exclusion of one investor is informed to other investors.
The present developments have their origin to the 2020 initiative of Sebi when the regulator insisted that funds must have standard format for PPMs. This is being extended to ensure uniformity in offerings and dealings with investors. However, the industry is divided on the matter as PEs and VCs attracting savvy investors enjoy greater regulatory latitude than other pooled entities like mutual funds handling the money of households and smaller investors.