SEBI’s contention on AIF is noteworthy
An advisory paper prepared by the market regulator, the Securities and Exchange Board of India (SEBI), last week discussed some important matters related to alternative investment funds (AIFs), particularly with regard to the “preferential distribution model”.
It has been noted that some schemes of AIFs have adopted a distribution cascade in such a way that one class of investors (junior class/tranch), other than the sponsor/manager, share a loss more than proportionate to their holdings in the AIF vs. other classes of investors/unitholders (senior class). / slice), since the latter has priority in the distribution of proceeds over the former due to the priority distribution (PD) model.
Perverted benefits
In the event of a loss scenario, Senior Tier Investors may be compensated for the loss from the remaining capital of Junior Tier Investors. Likewise, in the case of the profit scenario, distribution is made first to the large first-tier investors until their hurdle rate is met, and the remaining amount, if any, is distributed to the small investors.
SEBI has been alerted about the potential exploitation of regulatory arbitrage by AIFs using the PD model. These funds may be structured in such a way as to exploit regulatory loopholes to meet other compliance requirements. This kind of structuring can facilitate the practice of making loans by regulated lenders (such as banks, non-bank financial firms and microfinance financiers) with the intent of permanent greening.
Recognition of deterioration in the creditworthiness of the investee company may also be deferred.
In both scenarios, the proportional return to capital of all investors is affected.
SEBI noted that these structures lead to a lack of transparency for investors, as happened in collateralized debt obligations (CDOs) during the 2008 financial crisis.
Conflict of interest
“Furthermore, given that AIFs/schemes with PD model are intended to cater to a different group of investors who have different risk appetites with the same set of underlying investments, the said structure has significant scope for conflict of interest issues,” said SEBI while disagreeing with most of the proposals. work group.
SEBI’s argument is valid given that there is a huge amount at stake which also poses systemic risks. As of 31st March 2023, AIFs has liabilities of ₹8.33 crore and has collected ₹3.65 crores.
“While one side needs to maintain parity for investors, on the other hand, some practical measures arise given the different classes of investors. Both need balance to ensure optimum level of governance while maintaining the required pragmatism,” Madhu Lunawat, CIO, India Inflection Fund Opportunity Fund.