The Securities and Exchange Board of India (Sebi) has codified the ‘excuse and exclude’ norms used by alternative investment funds (AIFs) such as private equity and venture capital (PE/VC) for managing portfolio companies. The move is expected to avoid conflicts, restrain investment breaches and bring more transparency in dealings.
While the ‘excuse and exclude’ provisions are widely being followed by the PE/VC industry, Sebi’s new guidelines will formalise the process and bring uniformity, said industry players.
Sebi has mandated submission of legal opinions, reviewing disclosures in the contribution agreement, and giving rationale and documents before granting such flexibility.
At present, such exclusions are being used in some cases to benefit a section of investors, thanks to varying interpretations by PE/VC funds. Limited parties (LPs) or investors in the fund will now be able to excuse themselves out of certain deals based on the opinion of a legal advisor, confirming that their participation would be a violation of a law or regulation.
For instance, certain LPs don’t allow investments in liquor firms, gaming companies, and sometimes even NBFCs due to internal restrictions. Such LPs can excuse themselves even as other LPs in the AIF invest. AIF are pooled-investment vehicles, with some structured on blind-pool basis, some on a deal-by-deal basis and some hybrids.
Sebi has laid down the ground for exercising the excuse and exclude clause.
An investor will be able to opt out from a deal by the AIF if it had disclosed in its contribution agreement that such an investment would contravene its internal policy. Any change in the terms of this agreement will have to be informed to the AIF manager within 15 days.
“The new guidelines bring more transparency with a requirement of recording reasons for each segment along with limiting the terms for being excused from a deal or excluding an investor. This has rightfully been extended to even the fund of funds or other investment vehicles investing into AIFs, on a pro rata basis,” said Sahil Shah, counsel, Khaitan & Co.
“With excuse provisions being crystallised, it prevents LPs from cherry-picking deals under the guise of excuse rights. LPs may have religious reasons such as not investing in alcohol and gambling–industries which can be well defined as internal policies upfront,” added Shah.
Further, if the AIF manager believes that there could be a violation—regulatory or taxation—or a material adverse effect on the fund, then they will be able to exclude an investor from the deal.
However, the manager will have to record the rationale for such exclusion, along with the documents relied upon.
Industry players said that an AIF manager may decide to exclude an overseas investor if it is in grey geographies in regulatory terms or may lead to a breach in investment threshold by an FPI.
“Apart from providing flexibility to AIFs in their investment decisions, this circular shall provide regulatory support and much-needed clarity to many current practices. Foreign investors cannot breach the 10 per cent holding limit in a firm. If, by virtue of holding AIF units, they are breaching the limit, there will be an opportunity to plug it. But the onus will still lie with the AIF to give the rationale. That said, a lacuna remains on the regulatory support of identifying FPIs that have reached this limit,” said Neha Malviya Kulkarni, chief growth officer, SuperNAV.
Legal experts said that in cases where an investor may be subject to insider trading regulations or investments indicating a conflict of interest, then they may request to be excused from such deals. It could be something similar to the negative list of securities provided to the portfolio managers.
“In certain cases, if there was a loss in certain investments, some managers excluded particular LPs to give them benefit—which was a wrong practice. The new guidelines curb this too with additional disclosures,” said another legal expert.