Co-Investments in AIFs: Navigating SEBI’s Proposed Regulatory Changes

CCL NLUO
Jun 23
6 min read

Updated: Jun 25

Fifth year law student at O.P. Jindal Global University, Sonipat

I. Introduction

SEBI in its recent consultation paper is mulling to introduce co-investment opportunities within an AIF structure to better enhance the investing landscape. Even though this move is in the right direction still there are some impending concerns that arise. The present blog post critically analyses the present scenario with respect to co-investing alongside an AIF. It even draws a parallel from the US approach addressing a similar problem.

II. Basic Background

Alternate Investment Fund (AIF) is defined under Regulation 2(1)(b) of the SEBI (Alternative Investment Funds) Regulations, 2012. It is specified as a privately pooled investment vehicle which collects funds from investors for investing it according to a defined investment policy. Under Category I, AIFs invest in venture capital funds, SME Funds as has been laid down in Regulation 3(4)(a) of SEBI AIF Regulations. Category II is for private equity funds or debt funds. While Category III AIF Funds comprise of hedge funds or funds which trade with a view to make short term returns as provided in Explanation to Regulation 3(4)(c) of the AIF Regulations.

III. Evolution of Co-Investment in AIF landscape

Co-investment opportunity is primarily offered in unlisted securities specifically for Category I and II AIFs. However, notification dated 16.01.2020 of SEBI (Portfolio Managers) Regulations, 2020 only allowed investing in listed securities. This was the case with a discretionary portfolio manager. Under Regulation 24(4) of the same notification, investment advisory in unlisted securities was capped at 25% for non-discretionary portfolio manager. In other words, advisory pertaining to investment in unlisted securities was either prohibited or capped. Hence, the portfolio managers were restrained from providing co-investment opportunities to their investors. However, SEBI introduced an amendment in August 2021 by introducing sub-regulation 4A to regulation 24. As a result, discretionary and non-discretionary portfolio managers were allowed to invest 100% of the assets under management in unlisted securities. Hence, investors who were part of an AIF had to undertake the PMS route to co-invest. There were certain consequences that emerged due to this Amendment. Portfolio Managers were required to undergo SEBI registration. Such registration incurred costs. Moreover, each co-investor has to undertake rigorous documentation which slows down the closing of deals. Under the PMS route, co-investors are mandated to have similar timing of exits as that of the AIF. However, in practice, it is restricting the investor’s decisions. This is because every investor desires to retain the right not to exit, as they may like to exit based on their own strategy.

IV. Benefits of Co-investment in AIFs

Co-investing can be specifically beneficial for institutional investors and family offices who may wish to put money in a company directly along with the AIF in which they are a part of. This allows them to avoid paying any additional management fees that are associated with an AIF. Investors can increase their net returns specifically in asset classes that possess high management fees. Additionally, co-investment is an opportunity to pour money in companies which are carefully selected by the fund. For highly sophisticated investors such as family offices, co-investment would serve as a better approach than investing in a fund. This is because co-investing allows the prospect of entering into club deals which are preferred by family offices. Club deals refer to transactions where multiple investors pool their money to initiate a transaction that would be burdensome for a single entity. Additionally, it provides a higher negotiating power

V. US Approach to Co-investing

It is critical to look at global events where co-investments are being allowed to better assess the regulatory measures proposed by SEBI. Hence, reliance is placed on the US approach to co-investing, which is home to highly sophisticated investors.

US is propelling to enhance access to its alternative investment markets. It has brought in certain reforms to reflect this approach. For instance, any person having 5% or more voting power is considered as an affiliate under S.2(3) of Investment Company Act, 1940. Uunder the current US framework, if an affiliate has an investment in a company then the Fund is barred from investing in the same company. This is stipulated in Section 17(d) of Investment Company Act of 1940 and Rule 17d-1 of Investment Company Act Rules. This proscription is to address a situation where a fund is pumping money into the company only to make the initial investment by the affiliate look better. Being a blanket ban without any de minimis exception, it often leads to loss of attractive investment opportunity. Additionally, when the same investee is proposing a follow-on investment i.e. looking to raise money by issuing more securities then also Funds cannot participate due to a pre-existing affiliate investor. However, Securities and Exchange Commission has brought in a reform where the Fund can invest in a company where an affiliate has already invested. This can be done only if an independent board members of the Fund give their approval for such an investment. As a consequence, the concept of follow-on investment has been erased as all the transactions are now individually assessed as long as they meet the approval requirement.

VI. SEBI's Suggestions

To resolve these problems in AIFs, SEBI has sought to establish a separate Co-Investment Vehicle (CIV). Such a CIV would be attached to a fund to allow co-investments within an AIF structure itself. These can be registered either as Category I or Category II AIF depending on the main fund it is attached to. In other words, the CIV would be registered as the same category as the main fund. The diversification norms would not apply to these CIVs to ensure that CIVs are flexible enough to invest their 100% money in one investee company. However, SEBI is proposing to align the tenure of the CIV with that of the main AIF. There is a persisting problem with this. Co-investors would need to exit along with the fund. Hence, they would not be able to follow their internal exit timeline.

VII. Impending Concerns

There may be situations where the managers may wish that a third party invests as a co-investor. One of the possible reasons is that the third party acts as a lead investor in an investee company for a fundraising round. Another reason may be that the third party was critical to the fruition of the deal. It needs to be answered whether such third parties are allowed to participate as a co-investor with an AIF or not.

There may be instances when multiple AIFs have one common manager. Then it needs to be clear if an investor in one AIF can enter into a co-investment opportunity with another AIF in which he is not an investor.

The taxation burdens also need to be clarified. It needs to be explicitly mentioned whether these co-investors would be taxed as an Association of Persons (AOP) under Income Tax Act. The term AOP is not defined explicitly under any law. However, the case of CIT v Indira Balkrishna provides some guidance. It mentions that AOP refers to an association comprising of 2 or more persons who come together for a common purpose to perform a collective action with the object of creating income. If the co-investors in the CIV are taxed as an AOP then this would create additional tax burden. Category I and Category II AIFs are granted pass-through status currently. If this status is not granted to a CIV, then it would mean double taxation first at the AOP level and then at the individual investor level.

VIII. Conclusion

Over the years, SEBI had brought in necessary amendments to allow co-investing along with AIFs. However, there were problems that remain unaddressed through PMS route. Seeing the benefits of co-investing, SEBI has suggested a novel move to create a separate CIV. This regulatory shift aligns with the recent US approach of opening the alternative investment opportunities. Even though SEBI has taken a step in the right direction, there are some practical limitations such as taxation that need to be tackled. Hence, it is critical that the regulator implements the CIV measure keeping in mind the challenges that investors would possibly face.

Note: This article has been reviewed by Mr. Anshuman Vikram Singh (Partner, AZB and Partners), at the Tier II Stage.