The fine line between regulation and over-regulation
Nupur Garg is founder of WinPE

There seems to have been a flurry of regulatory updates related to investments in private equity/venture capital and alternative investment funds (AIFs). Maybe it seems like that to me because I am an investor. Or maybe there have been a few developments.

I have welcomed most of them, especially the one that permitted certain types of pension funds to invest in AIFs. The asset class will benefit from the participation of experienced institutional investors, and it will definitely benefit from the formation of a domestic pool of investor capital. 

Institutional investors exercise rigor and discipline while making investment decisions, thereby encouraging target investees to adopt better practices that meet the test of rigor and discipline. As institutional investors become more prolific, good practices start to become the norm, benefiting the whole asset class and all categories of investors.

Now AIFs and private equity/venture capital as an asset class are relatively new for Indian investors. While regulatory structures existed earlier as well, like the SEBI (Venture Capital Funds) Regulations 1996 (VCF Regulations), it was really the AIF regulations that gave life to local pooling of domestic capital. They enabled fund managers to raise rupee capital, giving rise to a whole new set of funds that are raised only from local investors. And they allowed Indian investors to partake in the exciting Indian growth story. 

The logical continuation would have been to see institutional investors like pensions and insurance companies enter the asset class as investors, much like in large markets across the world. Sadly, that didn’t happen and the private equity/venture capital industry has not seen a meaningful participation from either. But what has happened is a surge in investors in the form of family offices and high net worth individuals. Sometimes, these investors are referred to as retail investors.

When public money and retail investors are involved, regulators tend to get more vigilant. Protecting the rights of the relatively unsophisticated investor, with smaller stakes and little influence, is a key responsibility. After all, the global financial crisis revealed that even the sophisticated investor could get carried away and make mistakes. 

And one of the tenets to address that is stronger governance, greater transparency, and better reporting/disclosures. So when the Securities and Exchange Board of India (SEBI) decided to focus on making the PPM (Private Placement Memorandum) more comprehensive, it was another move that I welcomed wholeheartedly. 

But then there were moves like making external members of investment committees liable to the same extent as the fund manager (this issue has been resolved subsequently) and, recently, norms dictating investment diversification. The latter is a little unwarranted as it seems to me that the regulator is trying to decide on behalf of the investors the risk-return profile that they should invest in.

Typically, every investor has an understanding of their own risk appetite and how each asset class sits within their own investment portfolio. So if a fund is offering a concentrated portfolio, yes, there is a risk of overexposure – putting all your eggs in the same basket. If the bet doesn’t pay off, you stand to lose big time. 

But if the bet pays off, the doubling down will yield significantly high returns. Putting it simply, it could be considered a high risk – high return strategy. And if an investor, with a conservative low yield portfolio or one with a high degree of confidence in the bet, wants to invest in this strategy, they should have the option without the regulator trying to decide on their behalf.

Private equity and venture capital have always been an asset class for the more experienced investor, known to be illiquid, and with investors having very limited ability to influence the final outcome. They have been vehicles for driving large investment capital into private businesses and, therefore, by definition, assume a certain level of information asymmetry and a certain level of risk. 

Investors, or limited partners as they are called, perform a thorough due diligence and negotiate the terms of the investment in great detail. Portfolio diversification is one of the things that they focus on.

It is true that when I am talking of limited partners here, I am talking about the experienced investor who builds their own investment portfolio with an eye on risk, returns and, yes, diversification. To that extent, private equity/venture capital funds are not designed for the retail investor in the way mutual funds are. 

And the AIF regulations have set an entry threshold by prescribing a minimum contribution amount of Rs 10 million I suspect for that very reason. It would be worthwhile for the regulators to focus on bringing more institutional and sophisticated domestic investors to drive up the governance levels. It would also be useful to review guidance around how advisors, wealth managers and distributors sell private equity and venture capital funds as an investment option to their clients. 

And it would also be worth considering if funds raising only “retail” investment capital should follow a set of specific processes related to governance, transparency, disclosure and reporting. What the regulator needs to ensure is that investors have all the information they need to make an informed decision. Making it on their behalf is not the answer.

Nupur Garg is founder of WinPE, a not-for-profit platform which promotes transformation in the investing world in favour of gender diversity. She is also a private equity investor and independent board member.

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