Market regulator SEBI’s proposed regulations to monitor all classes of Alternate Investment Funds (AIF) seeks to make major changes in the way private equity firms operate in India. Vijay Sambamurthi of Lexygen gives a legal eagle’s perspective.
SEBI has recognised that the investment philosophies of different kinds of funds vary from one another, which is a good step. While, in principle, formulating regulations based on the investment philosophies of various AIFs may be a good thing, ultimately, it all comes down to how investor-friendly and in-touch with industry practice the regulations are. A quick read of the draft regulations reveals some good news (e.g., the proposal to exempt PIPE deals from applicability of Insider Trading restrictions, which will help funds conduct due diligence for PIPE deals), but also a lot of potential bad news. Unfortunately, in my view, the bad news seems to far outweigh the good news.
Here goes some quick notes on the proposed changes:
* There are too many categories of AIFs sought to be created, with separate registrations for each of the category, and a restriction that an entity registered in one category may not undertake other types of deals. I think many PE funds may find this rather unappealing, as they will have to create, maintain and register multiple entities just to ensure that they have maximum flexibility in their investment strategy. For example, most growth equity funds will want to invest in infrastructure companies as well, infrastructure being a booming sector. In the context of the draft regulations, such funds will have to set up two different funds – a ‘Private Equity Fund’ and an ‘Infrastructure Fund’ – to fully implement their India investment strategy. I think the heads of classification adopted by SEBI are way too many, and tantamount to regulation entering the realms best left to fund documentation. Such a classification will only increase the cost of doing business for PE firms, and also place a huge strain on SEBI’s own regulatory bandwidth. My suggestion will be that the only categories of AIFs should be: (i) Private Equity funds (ii) Venture Capital funds and (iii) Residuary Funds (hedge funds, commodities funds etc).
* I find it a little concerning that the language of the draft regulations appears to indicate that the various governance and disclosure provisions set out therein also apply to pure offshore funds, i.e., funds which have only foreign investors. While the SEBI has rightly expressed concerns over the possibility of private equity funds tapping a retail investor base, the same could have been addressed merely by prescribing that investments may only be raised from sophisticated institutional and HNI investors, rather than prescribing detailed reporting and corporate governance requirements. SEBI’s role as the Indian capital markets regulator is to protect the interests of Indian investors and the Indian capital markets. All the funds that raise funds from non-Indian investors are already subject to a host of regulations in their home markets, apart from under the fund documentation, which adequately safeguards the interests of such investors. I think SEBI need not add one more layer of regulation and compliance to this ecosystem. Some of the restrictions prescribed by the SEBI may be harsher than the norms fixed by offshore funds’ home jurisdiction regulators (for example, the limit on the number of investors), and as such, make regulatory compliance even more complex for such funds. Many of these restrictions do not add any value to the Indian market. Rather, they may adversely affect the appetite of the foreign investment community in the Indian market on account of perceived excessive compliance requirements.
* While so many different categories of AIFs are sought to be created, the draft regulations don’t make clear if the same fund sponsor group can operate various investment businesses under different AIF entities. Most reputable and large asset management businesses worldwide have multiple streams of investment businesses under the same umbrella group. Many of these highly successful groups are listed entities, which need to consolidate the value of these various streams so as to enhance shareholder value. I hope that should the draft regulations be passed, the SEBI will at least make it clear that fund sponsors will be permitted to own and manage different AIFs under the same entity or group. Otherwise, it may disincentivise some highly reputable fund houses from investing in India.
* The restriction that ‘PIPE Funds’ can only invest in small companies that don’t form a part of any of the stock exchange indices is a very worrying proposal. Listed companies of all shapes and sizes require growth/expansion capital as much as smaller companies do, and such a restriction will severely cramp the avenues for funding for large companies, which can only be detrimental to our economy. Needless to say, it will make the universe of listed company investment opportunities in India very limited and unappealing to private equity funds. Also, what about secondary/buyout transactions? They, too, need a fair space to thrive in the market as such deals also bring in foreign exchange and immensely benefit Indian entrepreneurs by providing them profitable exits. If the ability to invest in listed companies is limited to small companies, it will severely affect the interest levels of reputable foreign funds in investing in India.
* Similarly, the restriction that “Venture Capital Funds” cannot have a corpus of more than Rs.250 crore is also undesirable. If one of the stated objectives of the categorisation of AIFs is to help attract more early-stage deals, why would we want to place a cap on the corpus of a VCF? I also disagree with the proposition that a ‘Private Equity Fund’ cannot invest in a VC- type deal. Apart from the fact that it would lead to a lot of confusion among the investor community, it also goes against the grain of encouraging more early-stage investments. If a growth-stage fund spotted a great opportunity to back a start-up and help grow it to be the next Google, shouldn’t that be encouraged rather than prohibited?
* The draft regulations propose that the current Venture Capital Regulations, 1996, will be repealed, but that existing investments made under the VCF Regulations will continue under the said VCF Regulations. But what about the existing FVCIs and their investments? What about the existing FIIs? Is the intention to have these registrations continue as before, or will the proposal completely replace the FII and FVCI regimes with the AIF regime? Several existing FIIs will, no doubt, be caught under one or the other heads of the proposed AIF regime. How will this conflict be addressed? All this needs to be clarified.
* While SEBI’s concept paper makes some points regarding under-regulation and its consequences, I think the draft regulations strongly veer towards over-regulation. Over-regulation of an industry, which has contributed more than $50 billion in capital to the growth of Indian entrepreneurship, might have a counter-productive impact on the Indian economy, by making Indian opportunities more expensive and more risky from a regulatory standpoint to the investment community. I think that any regulation of foreign PE and VC funds should be at the minimum, as most of their investors are non-Indians, and as they are already regulated by appropriate regulations in their home countries.