On Feb 3, 2023, the Securities and Exchange Board of India (SEBI) came up with five consultation papers proposing changes in regulatory norms for Alternative Investment Funds (AIFs). The release of the consultation papers reflects SEBI’s continued focus and interest in developing AIFs since it came up with its first AIF regulations over a decade ago.
The papers suggesting the next generation of reforms for AIFs are aimed at bringing fairness and transparency to investors. We believe if the proposals in the papers are implemented it would bring forth a massive shift in the AIF industry with respect to (i) Transparency and (ii) Transferability for investors.
1. Transparency
a) Investor participation via ‘direct plan’ and payment of distributor commission on a trail basis
The recent papers seeking feedback from industry participants include a two-fold objective –
1. AIFs to offer the option of a direct plan to its investors and
2. Creating trail model for distributor commissions in AIFs.
Similar practices have already been implemented in the mutual fund industry and which has received positive feedback from both investors and the mutual fund community. Mutual funds offer both regular plans and direct plans. In the case of a regular plan, the investor invests via an intermediary and has to bear a higher expense ratio than if he would have directly invested in the schemes due to the additional fee charged by the intermediary. The direct plan entails no distribution or placement fee.
With the release of this consultation paper, it has become apparent that the regulator is seeking changes in line with the mutual fund industry to allow for more transparency in the operations of AIFs. Offering participation in AIFs through direct plans will not only attract more investors but will also help the distributors in the long term by adopting the trail model of commissions that SEBI has proposed.
In the mutual fund industry, Trail Commissions are calculated as a percentage of the assets under the management of the distributor and are payable quarterly. Since these are calculated on net assets, distributors benefit from the rise in their assets in the form of a higher NAV of funds or the sale of more units. An investor doesn’t need to worry about trail commissions because these are factored into the expense ratio which is explicitly stated by all funds. These are not any hidden costs affecting the NAV.
SEBI’s proposal to pay 1/3rd of the (present value of) distribution fee upfront (acknowledging the need for some reasonable incentives) and the rest 2/3rd on trail basis is expected to benefit the industry on a medium to long-term perspective. The proposal is expected to significantly reduce the chances of mis-selling AIF schemes and bring transparency to investors.
b) Conflict of interest
AIFs are allowed to deal with their associates for investing in associates, buying/selling securities to/from, availing services of them, etc. However, such related party transactions could give rise to conflicts of interest. While current regulations already have provisions to address such conflicts of interest, SEBI in the consultation paper has proposed specifically that AIFs cannot undertake such related party transactions without the approval of 75% of investors, calculated by the value of their investment in the AIF, in (a) associates; or (b) units of AIFs managed or sponsored by its Manager, Sponsor or associates of its Manager or Sponsor.
We appreciate the move since the existing industry and regulatory issues around related party transactions will be resolved. The larger point of this proposal is to ensure that investors are not left in a state of oblivion by the asset manager for any investments in bad assets of the associates.
2. Transferability – Dematerialisation of units
SEBI noted that despite the regulation of issuance of AIF units in place, most of the AIF scheme units are not yet dematerialised and are held in physical form. Henceforth, the market regulator has proposed that dematerialisation of units of AIFs shall be made mandatory wherein all schemes of AIFs with a corpus of more than INR 500 crores shall compulsorily dematerialise their units by April 1, 2024.
The marketability of any instrument is severely impacted if the instrument is maintained in a physical form. Therefore, it is a crucial step that can promote AIF products and create accessibility to the larger market. It will also enable adequate monitoring of investments in AIFs by investors as they would get higher visibility of cash flow and returns making their decision to sell or transfer units easier.
The next logical step in this regard would be the listing of units because dematerialisation would enable the viewing of holding units, but investors won’t be able to trade the units in the open market unless they are listed.
The development of a secondary market for AIFs is essential to ensure liquidity in the AIF industry. As per Section 14 of SEBI’s AIF regulations, units of close-ended AIFs may be listed on a stock exchange subject to a minimum tradable lot of INR 1 crore, after the final close of the scheme. The listing of AIF units would allow investors an easy exit opportunity (subject to KYC) and enable price discovery in a demand-supply mechanism.
Source: Mint, dated February 21.02.23
