Sebi curbs AIF schemes with priority distribution model


NEW DELHI : The Securities Exchange Board of India (Sebi) has halted alternative investment funds (AIFs) with a priority distribution model from accepting fresh commitments, the markets regulator said on Wednesday evening.

A priority distribution model allows some investors to exit a scheme ahead of others, which is currently not explicitly restricted in AIF Regulations mandated by the regulator.

Some AIFs offer select limited partners, or investors, in AIFs a priority payout, whereby they get their principal investment back before other investors. This may especially happen in the case of distressed funds, where there may be greater investment risks.

However, this is likely to change. On Wednesday, Sebi noted that some schemes of AIFs have been allowing a waterfall distribution in such a way that a set of investors “share loss more than pro rata to their holding” in comparison to other investors as the latter is allowed to exit the AIF earlier than the former.

While this is not a violation of the Sebi AIF regulations according to the current regime, the “regulator believes it is unfair and unethical,” a person familiar with the regulator’s thinking said. This allowed losses to be passed on to others in a disproportionate manner if some other investors within the AIF had been allowed to exit on priority.

“We have seen that sometimes one class of investors have a better bargaining power than another, and hence they can secure better rights through waterfall mechanisms. This is generally not asked for by the former class to provide undue advantage to the latter class but to ensure that their investments are protected. However, eventually, it may become disadvantageous to one class,” said Dipti Lavya Swain, founder and managing partner at DLS Law Offices.

“The aforesaid matter is being examined by Sebi in consultation with the Alternative Investment Policy Advisory Committee, AIF industry associations and other stakeholders. Meanwhile, it has been decided that schemes of AIFs which have adopted aforesaid priority distribution model, shall not accept any fresh commitment or make investments,” Sebi said in its circular. Sebi’s adverse stance on “priority payouts” was first reported by Mint on 14 September.

“Why should priority payouts happen? Don’t you want AIFs to be as safe as other equity investments?” Ashwani Bhatia, a whole-time director, Sebi, said in an interview on the sidelines of an event organized by the Federation of Indian Chambers of Commerce and Industry on 14 September.

At the time, Mint also reported that the regulator is probing as many as 20 AIFs for a series of violations, including dividend stripping, inadequate diversification, abrupt change in control at AIFs, non-adherence to stated investment mandate, conflicts of interest, valuation policies, priority payouts, and outsourcing management (of investments) to other entities.

“Instead of prohibiting such junior/senior class structures, to address commercial requirements of the AIFs certain ground rules such as proper disclosures by AIFs, prudent requirements on asset mix and express investor consent may be some of the measures that Sebi may prescribe to balance the interest of junior class investors and at the same time the AIF is not left with inferior assets which does not even return capital back to such investors,” said Suneet Barve, independent Funds Lawyer, SSB Legal.

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