The Securities and Exchange Board of India (Sebi) has come out with a final set of regulations for alternative investment funds. These are very different from the draft regulations the regulator came out with last August. Based on public comments and feedback, Sebi has, in fact, rationalised the regulations not just substantially but wholly.
In fact, the departure from its draft form put out for public comment is a triumph of the open process of regulation making Sebi subscribes to, where it actually listens to others’ views rather than hosting draft regulations merely for formality. There are many regulators who put out exposure drafts for comments but go ahead and do what they had in mind in the first place. I can’t think of too many regulators who would so freely take public comment.
So, besides the process, why are these regulations important? Because they create a regulatory route for large investors to pool money and invest in companies. Not only does this pool impact capital formation in young and seasoned companies and allow them to grow, it is also some of the smartest money chasing bright ideas. Any regulatory scheme that creates an enabling umbrella for this kind of an ecosystem is good for the Indian economy.
Before the regulations were notified in May this year, the regulatory regime for pooling of money was quite hazy and unclear. Some avenues were also open for pooling under a portfolio management scheme; however, that window is now shut to pooling of funds. Sebi’s informal view was that one could pool money for investment and registration with the regulator was really optional. Further, Sebi’s registration was only under venture capital regulations rather than all types of investment pools.
In other words, Sebi had till now only thought about regulating pools of capital (that too optionally) that invested in unlisted and, often, early-stage companies rather than mature or listed companies. For those eligible, there were investment restrictions and also some benefits from lock-in requirement, certain exemption under takeover law and tax pass through benefit. This created a regulatory environment where anyone wishing to invest mainly outside the venture companies would be forced to remain unregistered.
And those eligible, depending upon whether or not they register, took on both the regulatory burden and benefits. This has now been done away with. A pool can be created for any kind of investment, whether venture capital, private equity, real estate only, mezzainine debt or any other combinations possible.
Under the new regime, Sebi has created three types of pools. The first category is a pool that invests in socially beneficial firms like welfare companies, venture capital companies etc. These would then be given targeted benefits like tax exemptions. Category II are those funds that can invest anywhere in any combination but are prohibited from raising debt (except temporarily in limited quantity). The third category can invest anywhere it wants and also can raise debt. This category can be termed as domestic hedge funds. Since the third category can pose systemic risk, additional reporting and other regulatory burdens have been imposed on them.
Since the regulatory scheme has been drastically modified and given that people had invested money under the old regime that was mainly based on contract, there are provisions that permit the old funds to continue upto their contractual commitments with some limitations (the grandfathering regulations in legal jargon).
Since the venture capital regulations stand repealed, there is a provision for transitioning from the old regime to the new one if two-thirds of the investors by value vote in favour of a new regime registration. Alternatively, they can continue till their contractual maturity date.
The new regulations do impose some restriction on pooling of money, though. In line with the requirements of corporate law, there can be no public offer to invite investments. Offers must be made privately and the minimum contribution is #1 crore per person. This is intended to exclude un-sophisticated investors from investing in often risky ventures — of course, the assumption is that very rich people are also very sophisticated.
Then there is a requirement of #20 crore (in each scheme) for the fund to register. This requirement is presumably introduced to allow only credible people to manage the pool, as not everyone would be able to raise such a large amount from sophisticated investors.
Managers of the pool are also expected to shell out 2.5% of the size of the pool, that is, a minimum commitment of #50 lakh. While this is supposed to ensure that managers also have skin in the game, the rule is likely to exclude very smart people from managing money who don’t have their own money to invest as co-investors. A smart manager doesn’t necessarily need to have a large amount of money to invest. The commitment amount is double in Category III pools.
While previously governed by contract, now the regulations provide a level of disclosure, particularly of any conflict of interest that the fund manager may have towards the investors. There is a need to be transparent about the fund manager’s background and experience, the fees being charged by the manager, the tenure and strategy of the fund and conflict of interest situations. These are welcome additions to the cowboy regulations previously in place. Since the marketing material is to be filed with Sebi, the chance of a fund manager taking liberties is substantially reduced.
The regulations permit the listing of most funds after they have raised money, but to protect unsophisticated investors, the minimum lot size of trading must be #1 crore. These kinds of markets are common in the West and are known as big-boy markets where only highly sophisticated people trade. Listing with such large lot sizes ensures both liquidity and protection of the small investor at the same time and this is a great compromise thought up by Sebi.
There are several other prudential investment restrictions, like the maximum percentage of capital of one company a fund can hold and restrictions on related-party transactions. There are provisions of investor protection like valuation on a periodic basis, addressing of investor complaints and record keeping that have been introduced.
On the whole, the regulations introduce the concept of a regulated pool of capital and with few silly rules. Most people have welcomed the introduction. Most importantly, investors who previously found the unregistered trust structure somewhat dubious would now invest much more freely as they invest under the protective umbrella of Sebi to whom they can complain if there is any kind of mis-conduct by the fund manager. The regulations would indeed increase the costs of compliance for previously low-cost investment pools governed by contract alone, but the benefits easily out-weigh the costs.
Unfortunately or fortunately, these have come at a time when the India story is at one of its worst periods. Unfortunately because, despite the enabling environment, not many people can raise funds from investors to invest in the Indian economy and that, too, investment in companies that would bear the brunt of any reduction in growth in the economy. Fortunately because, when everyone believes it is the end of the world that is often a good time to buy shares, just as when your paanwala talks of stocks being a great investment, it is probably a great time to sell.