[By Debangana Nag]
The author is a student of the West Bengal National University of Juridical Sciences.
Introduction
In its recent board meeting on 30th September, SEBI outlined maintaining pari-passu rights of the investors in Alternate Investment funds to maintain a level playing field among them. The Board approved proposals to amend the AIF Regulations to state that, in all other respects (barring specified exemptions), investors’ rights in an AIF scheme shall be pro-rata and pari-passu, meaning investors must have equal rights (pari passu) in all investments within the scheme, thereby stating that no investor will be prioritised over another. Additionally, any returns or distributions from the scheme will be allocated proportionally (pro rata) based on the amount each investor had contributed, ensuring that their share of returns is directly in line with their investment. However, to prevent existing investments from being disrupted, the SEBI has allowed them to continue.
In May 2023, a consultation paper was released by SEBI seeking comments from the public. This paper emphasised that the pro-rata principle should be regarded as of utmost importance in AIFs, highlighting it as crucial for maintaining fairness. In contrast, the pari-passu principle was highlighted as a means to guarantee equality in economic rights among all investors. SEBI identified key issues concerning the use of the Priority Distribution Model by AIFs, which classifies investors into distinct groups, raising concerns about its implications for equitable treatment.
By examining this decision in light of SEBI’s consultation paper on pro-rata and pari-passu rights, this article shall critically analyse how the decision fails to balance investor protection and flexibility required by managers for creating innovative investment products along with emphasising the need to prevent regulatory arbitrage.
Understanding SEBI’s Decision on Pro-Rata and Pari-Passu Rights
Although the pro-rata is not explicitly stated in the AIF Regulations, ensuring proportional rights for investors particularly in the distribution of investment proceeds is a fundamental feature of the AIF framework. However in a PD Model in the event of a loss, money from the residual capital of junior-class investors could be utilised to reimburse the senior-class investors. A hurdle rate is a performance-based benchmark for a fund that guarantees minimum returns. Senior class investors have lower hurdle rates which are prioritised during the payment. In the event of a profit, the senior class investors receive distributions until their hurdle rate is satisfied, after which the junior class investors get any residual funds.
As discussed in the Introduction, this decision by SEBI aims to uphold equitable distribution of profit and loss to ensure fairness and investor protection while emphasising that the principle of fairness that must be secured in a pooled investment like AIF.
Furthermore, SEBI granted exemptions from these regulations to certain entities like those owned by the Government, multilateral development financial institutions, State Industrial Development Corporations and other specified entities as designated by SEBI. Importantly, only these entities will be allowed to give less than pro-rata rights to persons who subscribe to junior-class units of the AIF scheme. This exemption has also been granted to Large Value Funds (LVF) but only if each investor explicitly agrees to waive off their Pari-passu rights. According to SEBI regulations, Section 2(1)pa, an LVF is an AIF where each investor commits a minimum of ₹70 crore.
It is pertinent to mention here that the SEBI Board has authorised that only in the above-mentioned AIFs, certain differential rights can be granted to some investors while the rights of other investors remain unaffected. The permitted terms for offering differentiated rights will be determined by the Standard Setting Forum for AIFs in collaboration with and certain principles outlined by SEBI.
Critical analysis of SEBI’s stance on the Priority Distribution modelSEBI has categorically banned AIFs following the Priority Distribution model (PD Model) from raising fresh commitments or making investments in a new investee company. In its consultation paper, SEBI identified that in a PD Model, investors are categorised into senior and junior groups. Senior investors are accorded priority in the distribution of returns, typically enjoying reduced risk and assured repayment before any allocation is made to junior investors. Junior investors, by contrast, assume a higher level of risk as they are compensated only after the senior class has been fully satisfied. This often results in the junior class disproportionately bearing losses in adverse scenarios. However, in exchange for this elevated risk, junior investors may realise greater returns contingent upon the overall performance of the fund. This hierarchical structure prioritises the protection of senior investors while exposing junior investors to greater risk for potentially higher rewards.
In addition, SEBI noted that this model led to a regulatory arbitrage which is prone to misuse for unethical financing like evergreening of loans.
A Working Group had recommended allowing the PD Model in limited scenarios; however, SEBI decided against this, stressing that the model’s risks outweigh its benefits.
Balancing flexibility and investor protection: Differential Rights and Operational Flexibility for AIFs
To balance investor protection with operational flexibility, SEBI has allowed AIFs to offer certain differential rights to certain investors provided that they do not affect the rights of other investors to prevent conflict of interests. The rationale for this decision, highlighted earlier, was to prevent scenarios similar to those that led to the 2008 financial crisis, where investors were disproportionately impacted by differential tranches in collateralized debt obligations (CDOs), causing widespread financial instability. In such cases, investors, particularly those holding junior tranches often did not fully understand the associated risks. Junior tranche holders were typically the last to receive payments and the first to absorb any losses, making these tranches riskier.
However, it is important to underscore the trade-off between providing investors with choice and regulating AIFs, especially for those seeking opportunities through differential tranches that offer higher risk and potentially greater rewards. AIFs are investment products specifically designed for people who are considered experienced enough to negotiate their own terms. The move to prohibit fresh investments into AIFs following these structures signals SEBI’s low tolerance for financial innovation in a move towards strict regulations over risk-laden flexibility. Units with differential returns attract multiple investor groups with varying risk tolerance. This diversity usually widens the total investor base for AIFs, thereby increasing the overall capital accessible by AIFs, including foreign inflows.
While SEBI must ensure that investors are fully informed with transparent disclosures, it should not stifle innovative financial structures that increase liquidity and investment flows based on the investors’ risk appetite.
Although SEBI’s concerns about regulatory arbitrage, asset classification, and valuation transparency are valid, it does not warrant a blanket restriction on differential rights. A more effective solution to the issues identified could be ensuring strict disclosure requirements and independent valuations that could mitigate these risks without stifling flexibility. This approach ensures transparency and compliance while allowing experienced investors the discretion to engage with customised investment structures, aligning more closely with international best practices.
Global Standards vs. SEBI’s Isolationist Policy
In the US, the Security and Exchange Commission (SEC) allows fund managers to structure funds using waterfall models and tranches with various levels of priority. However, these structures are subject to strict disclosure requirements such as standardised reporting and increased transparency by mandating auditing but are not outright prohibited.
Under Regulation D, Rule 506(b) and Rule 506(c) private equity funds are allowed to offer customised investment terms to accredited investors. An individual qualifies as an accredited investor if they have an annual income over $200,000 (or $300,000 with a spouse) for the preceding two years possessing a net worth of minimum $1 million (excluding primary residence) or hold specific financial certifications. There is no specific minimum investment amount requirement to qualify as an accredited investor in the US. These amounts are determined by the individual fund or issuer, not by the SEC.
Similarly, the Alternative Investment Fund Managers Directive (AIFMD) in the EU permits the use of differential returns through classes of units or tranches. Article 106 of AIFMD emphasises transparency, requiring detailed disclosures to all investors while Articles 110 and 111 of the Level 2 regulation outline reporting obligations of the AIF. SEBI’s pro-rata-only approach contrasts with the EU’s principle-based regulation, which emphasises fair treatment without outright banning these structures. Such a blanket ban goes against globally accepted norms that recognise sophisticated investor discretion.
While SEBI has approved differential rights for certain investors, it does so with restrictions that are not typically seen in U.S. or EU markets. For example, the U.S. and EU allow accredited investors to negotiate via side letters and differential rights, without the need for formal waivers. SEBI’s reliance on the Standard Setting Forum to define permissible terms could introduce bureaucratic delays, making Indian AIFs less agile compared to their global counterparts.
Although the decision to exempt large-value funds from adhering to pro-rata principles acknowledges that institutional investors and ultra-HNI individuals possess greater expertise and are inclined to negotiate different terms is welcomed. However, SEBI has overlooked the reality that any investor committing over ₹1 crore in an AIF is also capable of making informed decisions regarding priority distribution models, thus taking away their opportunity to invest in products that they find suitable for themselves.
Conclusion: The Path Forward for SEBI
In a globalised financial environment, this policy shift casts India’s AIF regulations into the shadow of disadvantage, when compared to liberal international practices. While it is crucial to prevent regulatory arbitrage to safeguard investor interests, SEBI must avoid using paternalistic measures, such as blanket bans, to protect sophisticated AIF investors who are fully capable of understanding the associated risks. Undermining investor discretion goes against globally accepted norms. However, managers must still adhere to stringent compliance standards to maintain transparency, which the SEBI should actively oversee.
It will be interesting to look at the permitted terms for offering differential rights that will be established by the Standard Setting Forum, where the SEBI must strive to align with international standards.