The Securities and Exchange Board of India (“SEBI”) through its circular dated December 13, 2024 (“Circular”), along with Implementation Standards issued by the Standard Setting Forum for AIFs (“SFA”), introduced guidelines to ensure fair and equitable treatment of investors in alternative investment funds (“AIFs”), making pro-rata and pari passu rights an essential feature of AIF structures.
In 2022, SEBI identified certain AIFs adopting priority distribution model to attract certain classes of investors, leading to disproportionate sharing of profits and losses vis-à-vis other classes of investors/ unit holders and prohibited such schemes of AIFs from accepting any fresh commitments or making an investment in a new investee company. Consequently, SEBI has now introduced fresh guidelines, making it clear that such differential/ special rights to a class of investors cannot be granted at the cost of other investors and prescribed the positive list of specific differential rights that may be offered by AIFs.
Key Principles:
Pro-Rata Rights
SEBI has mandated that all the investors of an AIF to hold their rights on a pro-rata basis to their “commitment” in both investments and “distributions” of proceeds. However, a general exception shall apply if an investor is excused or excluded from a particular investment or has defaulted on its contribution to the AIF.
In this regard, SEBI has clarified in the Circular that the obligation to maintain pro-rata rights does not apply to an investor when:
- an investor has been excused or excluded from participating in the said investment; or
- an investor has defaulted on providing his/ her pro-rata contribution for the said investment,
- returns or profit on the investments is shared by an investor with the manager or sponsor of the AIF, in terms of contribution agreement.
Furthermore, in order to facilitate flexibility in fundraising for investors with different risk appetites, certain entities are allowed to choose to accept lower returns or absorb greater losses than their pro-rata share by subscribing to junior/subordinate units in an AIF or its scheme. These entities are:
- AIF manager or sponsor;
- Multilateral or Bilateral Development Financial Institutions;
- State Industrial Development Corporations;
- Entities that are established/ owned or controlled by a Central, State or foreign country government, including Central Banks and Sovereign Wealth Funds.
With reference to the above, it is to be noted that in case an AIF manager or sponsor subscribes to junior/ subordinate class(es) of units of the AIF/scheme of the AIF, it shall be ensured that the amount invested by the AIF/scheme of the AIF is not utilised by an investee company, directly or indirectly, to repay any of its obligations or liabilities towards the manager or sponsor of the AIF or their associates.
Impact on Existing Schemes
SEBI has mandated existing AIFs/ schemes of AIF to stop accepting any fresh capital commitments or make new investments, directly or indirectly, in case such AIFs/ schemes are not providing pro-rata rights to its investors. SEBI has, however, clarified that pursuant to this, where investment limits, specified under the AIF Regulations, are breached, it shall not be considered as non-compliance by SEBI.
While an AIF/ scheme is prohibited from accepting capital commitments or making fresh investments, there is no express restriction on the ability of such AIF/ scheme to continue to distribute carried interest to investors, other than the investment manager or sponsor.
Pari-Passu Rights
Regulation 20(22) of the SEBI (Alternative Investment Funds) Regulations, 2012 (“SEBI AIF Regulations”) provides that investors in an AIF must have equal rights in all respects and must comply with the pari-passu principle safeguarding the rights of other investors of an AIF equitably.
Accordingly, SEBI has clarified that AIFs may offer differential rights to selected investors, subject to the following conditions:
- Any such right should not result in any investor bearing liability accrued or accruing to other investors of the AIF/ scheme of AIF (template PPM provided that differential rights should not have any adverse impact on economic rights or any other rights of other investor);
- In terms of non-monetary/non-commercial rights, SEBI has provided that such rights should not give investors any decision-making rights in the AIF/scheme of AIF;
- Any such right shall not alter the right(s) available to other investors under their respective agreements with the AIF/manager (provided in the SEBI template PPM as well); and
- Any such right and eligibility to avail the same shall be transparently disclosed in the PPM of the AIF/scheme of the AIF.
Reporting of Existing Differential Rights
AIFs/ schemes of AIFs whose PPMs were filed with SEBI on or after March 1, 2020, shall comply with the following:
- The manager shall report the details of differential right(s), which do not fall under the implementation standards formulated by SFA, to SEBI in the prescribed format, by emailing to it SEBI, on or before February 28, 2025.
- Out of the rights reported to SEBI as per above, the manager shall immediately terminate/ discontinue those differential rights that are ascertained to be affecting the rights of other investors.
Notably, Large Value Fund for Accredited Investors (LVFs), whose PPMs are filed with SEBI for launch of scheme post the date of issuance of this circular, may avail exemption from the requirement of maintaining pari-passu rights among investors, subject to making appropriate disclosures in the PPM of the scheme; and obtaining undertaking from accredited investors at the time of on-boarding to LVF regarding the fund’s ability to offer differential rights.
Going Forward Permissible Differential Rights:
The AIF regulations had been silent on differential rights, which could be offered to a select set of investors. The SEBI, vide its recent Circular and guidelines, now prescribes proportionate rights to investors, except LVFs, in all aspects.
List of rights released by the SEBI, in consultation with the SFA, is as follows:
- Fund Expenses: Fund managers, at their own discretion, may waive or reduce fees for select investors. However, any additional expenses arising out of these benefits cannot be shifted to other investors, they must be absorbed by the manager/sponsor.
- Management Fees: AIFs can charge different management fee structures to different investors based on investor size, tenure, or commitment level of the select investors.
- Hurdle Rate of Return: Fund managers may define customised hurdle rates for different investors, impacting carried interest payouts.
- Carried Interest: Select investors may have different carried interest calculations.
- Co-Investment Rights: Select investors may be offered preferential co-investment opportunities. However, such co-investment expenses must be fairly allocated between the AIF and select investors opting for co-investment.
- Reporting & Information Rights: Fund managers may provide additional disclosures or more frequent reports to select investors. However, legally required disclosures shall be made available to all investors. Any extra reporting costs (if any, with reference to disclosures to select investors) must be borne by the investor requesting it or by the manager/ sponsor.
- Representation on Committees: Select investors may be given the right to appoint representatives on AIF investments or advisory committees. However, such rights must comply with the SEBI’s existing governance regulations on fund control and decision-making.
- Most Favoured Nation Clause: Investors may be given the right to elect superior beneficial terms provided to other investors in the same fund.
- Confidentiality & Investor Details: AIFs can disclose select investor details to other investors, only with explicit consent of the respective investors whose details are to be shared.
- Representations & Warranties: AIFs may offer custom representations and warranties to select investors (e.g., assurances on governance, investment focus), subject to representations/ warranties not resulting in any right being provided to such investors.
Conclusion:
It is pertinent to note that AIFs are typically seen as an investment avenue for sophisticated investors and given that these are privately placed instruments, market participants, especially from the limited partner side, see this exhaustive list of differential rights as an excessive restriction on the flexibility of LP-GP negotiations. In the future, market participants expect the SEBI and the SFA to consider broadening this positive list of differential rights to ensure that AIFs retain their flexibility and space for LP-GP negotiations.
SEBI’s move to introduce Implementation Standards, in consultation with the SFA, intends to strike a balance by allowing investors to have limited differential rights, but strictly restricting the preferential distribution framework posing some practical/operational challenges. While the reporting requirements for certain AIFs to report all differential rights to SEBI by February 28, 2025, in the manner prescribed by it, may feel burdensome to the managers, SEBI has ensured that the anonymity of the investors who have received such rights is/will be maintained.
