Private funds blend capital from investors of varying risk-reward profiles. In several foreign jurisdictions, including UK, US, Japan and Germany, fund managers have the flexibility to set up and operate funds with differentiated distribution models for different investors (i.e. where specific investors may get distributions from the fund in priority over other investors up to a specified extent or degree), as long as appropriate risk disclosures have been made.
In India too, a few private funds set up under the aegis of the alternative investment funds (AIF) framework of the Securities and Exchange Board of India (Sebi) have explored this model in the past. However, in recent times, there has been a subtle regulatory shift on this issue. In a circular issued on 23 November 2022, the market regulator has temporarily restricted AIFs with priority distribution models from accepting fresh capital commitments or deploying capital in new portfolio entities.
Sebi’s discomfort was that the distribution of funds to one section of investors ahead of others would pass the losses, if any, to the latter in a disproportionate manner. While such apprehensions are understandable, any dictum by Sebi on this matter is bound to have market implications. Indeed, the circular has dissuaded fund managers from structuring investment vehicles that are out of the ordinary, and investors are now wary of the regulatory ambiguity surrounding the priority distribution model.
One could argue that the use of the priority distribution model in AIFs is imperative for commercial reasons. For one, this model affords the flexibility to investment managers to create bespoke, complex transaction structures to accommodate the needs of a diversified range of investors, each with a different risk appetite, in order to amass a larger and resilient pool of capital. A priority distribution waterfall is central to the distressed assets industry because it accommodates the stakeholders’ varied ability to absorb risk. This philosophy is also reflected in the framework put in place by the central bank under its Reserve Bank of India (Securitisation of standard assets) directions, 2021, which acknowledges senior and junior tranche of pass-through certificates.
From the investor’s standpoint, it is the stark rationale of ‘higher the risk, higher the reward’ that underpins the priority distribution model – while the investors in the subordinate class carry the risk of bearing a higher proportion of losses than their priority class counterparts, there is also the possibility of them getting a higher multiple on returns due to their continued investment in the AIF over a longer period of time. Senior class investors can seek certain protection on their risk and return profile through the cushion provided by the subordinate tranche, while continuing to infuse capital and invest in the desired asset class. The priority distribution model, therefore, accurately reflects market forces.
Sebi has repeatedly noted that AIFs are a high-risk asset class, where participation is restricted to sophisticated and well-informed investors. With a minimum ticket size of ₹1 crore, it is not intended to be an avenue for retail investors. In fact, AIF investors would be provided full and complete disclosure of the distribution waterfall mechanisms and all commercial terms through the private placement memorandums/offering documents of the AIFs, which are mandatorily circulated to prospective investors.
Fund managers today seek finality on Sebi’s viewpoint regarding funds with differential return structures. The regulatory parallels and commercial justifications available provide strong arguments to allow such funds and foster innovation in the Indian private funds industry. To assuage concerns around AIFs taking undue advantage of the regulatory arbitrage due to differential norms, Sebi may prescribe mandatory disclosure of the end-usage the fund’s commitments in its placement memorandum. Such reforms would improve transparency and facilitate innovative usage of fund platforms for the benefit of all stakeholders, which may not be the case if funds with differential distribution models are purged altogether.
Vivaik Sharma is a partner and Divya Laxman is an associate at Cyril Amarchand Mangaldas. Kartik Dhir, an associate, also contributed to the article.