Priority Distribution By AIFs: What's SEBI's Problem?
AIF is a product for sophisticated investors. So, why is SEBI bothering with how different classes of investors are treated?
In a recent directive to alternative investment funds, market regulator SEBI asked that the industry stop treating investors differently when it comes to sharing losses.
Some AIFs have adopted a distribution waterfall, known as the priority distribution model, that allows a class of investors to share loss more than pro rata to their holdings when compared to other investors, according to the regulator.
AIFs, which have adopted this model, have been asked to pause fresh commitments and investments until SEBI takes a view on the matter.
Priority distribution can be best explained by looking at the amount, return and investment horizon of different classes of investors, according to Siddharth Shah, senior partner at Khaitan and Co.
Say there is one class that has a relatively lower appetite for risk but is willing to compromise and cap its return. Versus another set of investors, who may be willing to take a higher risk by deferring their return in favour of the other class with the expectation of potentially a higher return, Shah said.
Even simpler would be to look at different series of debentures issued by a company where the senior class would have a priority over principal and interest as compared to the subordinate class.Siddharth Shah, Senior Partner, Khaitan & Co.
SEBI’s idea has always been equal exposure for all investors, except for the sponsor or manager of the AIF, as Ruchir Sinha, managing partner at Resolut Partners, highlighted.
A similar approach exists for infrastructure investment trusts, which are also meant for sophisticated investors, he said.
SEBI has had its reservations with respect to the senior/junior structure with respect to investors other than sponsors. The only difference, and a big difference, is that no such express language exists in the AIF regulations—what’s not prohibited is permitted.Ruchir Sinha, Managing Partner, Resolut Partners
So, is it just a matter of tweaking the language of the regulations, or is there a larger reason for SEBI's discomfort with priority distribution? And now that the regulator is deliberating on the issue, are there commercial realities it should account for?
BQ Prime asked both experts.
Why is SEBI concerned about priority distribution, especially since an AIF is a product for sophisticated investors?
Siddharth Shah: SEBI has never clearly spelled out its concerns on priority distribution except in the recent circular, where it has referred to ‘equal distribution of losses'.
The genesis of the issue seems to be that SEBI believes that an AIF is a pooled structure, akin to mutual funds. And within the pool, each investor can only have an equal right to distribution. Hence, there cannot be a priority inter se between the unit holders, as that would create an arbitrage of returns amongst investors in an AIF.
Secondly, their concern also seems to be whether such structures can be abused by NBFCs to restructure their stressed assets. The stressed assets, if left unattended, would run the risk of ultimately turning into NPAs. NBFCs may want these to go off the balance sheet, as stressed loans to be potentially replaced as investments in an AIF.
If SEBI says there can be no waterfall mechanism with priority distribution, then it would be difficult to find investors for these stressed assets with little or no credit enhancement through subordination.
SEBI's current approach appears to be more of a 'shotgun approach' rather than a 'rifle approach' in dealing with the issue, resulting in other casualties involving genuine senior-subordinate structures linked to risk-reward appetite.Siddharth Shah, Senior Partner, Khaitan & Co.
What's the level of disclosure to investors on priority distribution?
Ruchir Sinha: Investors in AIFs that have priority distribution know about it. SEBI had the chance to pick this up at the private placement memorandum stage, but when it didn’t, one took comfort that regulatory blessing was received.
SEBI wants distribution by AIFs to be like mutual funds. This doesn’t quite add up considering the investor class and the private nature of the vehicle. Somewhere, you’ll see principles of listed equity and protection of retail investors percolating to all vehicles, despite the huge variance in the nature of the vehicles.
Siddharth Shah: The terms and distribution waterfall is an important clause which has to be disclosed in the private placement memorandum and, by and large, investors participating in the AIF would always be familiar with the class of units that they are participating in and the priority of distribution that those class of units have in the waterfall.
In fact, this is one of the most important term that any participating investor would look at in the fund documents.
And given that typically those who are participating in an AIF would be contributing a minimum of Rs 1 crore, and, in most cases, typically have much larger commitments, and hence could surely be considered sophisticated enough to read the terms of the offer and also understand the risk and return ratio while subscribing to their respective class of units.
The issue will now be examined by the Alternative Investment Policy Advisory Committee in consultation with various stakeholders. What are the commercial requirements of this product that should be factored in?
Ruchir Sinha: SEBI didn’t really pick on priority distributions until about two years ago, and only in the last 12–18 months, it actually started to raise questions. Personally, I don’t agree with that approach.
AIFs are not retail vehicles. Structuring flexibility needs to be given if we want institutional participation, every large Limited Partner (investor) asks for certain priority rights. AIFs need to adapt to rules of global deal-making.Ruchir Sinha, Managing Partner, Resolut Partners
At the very least, for accredited funds, there could be relaxation, And even for AIFs, which are attracting only foreign capital. This product is not a mutual fund. There’s a high entry barrier—Rs 1 crore ticket size is not retail. Finally, if SEBI decides to change anything, it should ideally only be prospective.
Siddharth Shah: AIFs are a very efficient product for capital raising, whether it's debt or equity. They are a duly regulated structure, too, and meant for sophisticated investors.
Taking away the flexibility in designing the product to cater to a certain investor risk appetite, may result in loss of interest amongst global investors in such products.
Secondly, allowing such priority distribution would also pave the way for making available the ‘last mile funding’ for projects/entities, which may otherwise turn NPAs as existing investors/lenders are unable to provide additional funding.
The way SEBI needs to look at this issue should be:
If there is a priority in distribution, does each investor in the AIF understand the distribution rights associated with their respective class of unit.
There should be no segregation of returns linked to segregation of underlying portfolio, since that would clearly go against the spirit of pooled assets, unlike a PMS for example.
If at all believed necessary, a higher minimum threshold may be prescribed for funds where senior-subordinate class of units are proposed to be offered.
