The case for precedence distribution mannequin in AIFs

Private funds mix capital from buyers of various risk-reward profiles. In a number of overseas jurisdictions, together with UK, US, Japan and Germany, fund managers have the pliability to arrange and function funds with differentiated distribution fashions for various buyers (i.e. the place particular buyers could get distributions from the fund in precedence over different buyers as much as a specified extent or diploma), so long as applicable threat disclosures have been made.

In India too, a couple of non-public funds arrange underneath the aegis of the choice funding funds (AIF) framework of the Securities and Exchange Board of India (Sebi) have explored this mannequin prior to now. However, in current instances, there was a refined regulatory shift on this challenge. In a round issued on 23 November 2022, the market regulator has quickly restricted AIFs with precedence distribution fashions from accepting recent capital commitments or deploying capital in new portfolio entities.

Sebi’s discomfort was that the distribution of funds to at least one part of buyers forward of others would go the losses, if any, to the latter in a disproportionate method. While such apprehensions are comprehensible, any dictum by Sebi on this matter is certain to have market implications. Indeed, the round has dissuaded fund managers from structuring funding autos which might be out of the extraordinary, and buyers at the moment are cautious of the regulatory ambiguity surrounding the precedence distribution mannequin.

One may argue that the usage of the precedence distribution mannequin in AIFs is crucial for industrial causes. For one, this mannequin affords the pliability to funding managers to create bespoke, advanced transaction buildings to accommodate the wants of a diversified vary of buyers, every with a special threat urge for food, so as to amass a bigger and resilient pool of capital. A precedence distribution waterfall is central to the distressed property business as a result of it accommodates the stakeholders’ diversified capability to soak up threat. This philosophy can also be mirrored within the framework put in place by the central financial institution underneath its Reserve Bank of India (Securitisation of normal property) instructions, 2021, which acknowledges senior and junior tranche of pass-through certificates.

From the investor’s standpoint, it’s the stark rationale of ‘higher the risk, higher the reward’ that underpins the precedence distribution mannequin – whereas the buyers within the subordinate class carry the danger of bearing a better proportion of losses than their precedence class counterparts, there may be additionally the potential of them getting a better a number of on returns on account of their continued funding within the AIF over an extended time period. Senior class buyers can search sure safety on their threat and return profile via the cushion offered by the subordinate tranche, whereas persevering with to infuse capital and put money into the specified asset class. The precedence distribution mannequin, subsequently, precisely displays market forces.

Sebi has repeatedly famous that AIFs are a high-risk asset class, the place participation is restricted to stylish and well-informed buyers. With a minimal ticket measurement of ₹1 crore, it isn’t supposed to be an avenue for retail buyers. In truth, AIF buyers can be offered full and full disclosure of the distribution waterfall mechanisms and all industrial phrases via the non-public placement memorandums/providing paperwork of the AIFs, that are mandatorily circulated to potential buyers.

Fund managers as we speak search finality on Sebi’s viewpoint concerning funds with differential return buildings. The regulatory parallels and industrial justifications accessible present robust arguments to permit such funds and foster innovation within the Indian non-public funds business. To assuage issues round AIFs taking undue benefit of the regulatory arbitrage on account of differential norms, Sebi could prescribe necessary disclosure of the end-usage the fund’s commitments in its placement memorandum. Such reforms would enhance transparency and facilitate progressive utilization of fund platforms for the advantage of all stakeholders, which will not be the case if funds with differential distribution fashions are purged altogether.

Vivaik Sharma is a companion and Divya Laxman is an affiliate at Cyril Amarchand Mangaldas. Kartik Dhir, an affiliate, additionally contributed to the article.

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