The Securities and Exchange Board of India (Sebi) has given relief to alternative investment funds (AIFs) on how to apply the new “proportional rights” rule introduced in December 2024, in a consultation paper released on Friday.
The market regulator is seeking to clarify how alternative investment funds should retain investors’ proportional rights to invest and distribute returns, a requirement that has raised concerns in the industry about operational implementation. Proportional rights require that profits and losses be shared in proportion to each investor’s committed capital.
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The document suggests that AIFs can interpret an investor’s “commitment” as either the total amount pledged to the fund or as an “undrawn commitment” – the portion not yet claimed by the fund – when drawing capital and distributing investment returns. This flexibility is expected to help funds better align their investment cycles with investor commitments without breaching proportional requirements.
According to the 2024 circular, all investors in the AIF scheme were to receive returns in the same proportion to their commitment. The lack of clarity on how to implement these rules has led to uncertainty across the industry. AIFs raise funds from investors to invest in assets beyond traditional financial assets such as shares, bonds or mutual funds.
Sebi has also clarified that existing AIF schemes, which already follow a specific drawdown structure, can continue this approach till the end of their tenure. Those following other methodologies must adapt to one of the approved methodologies for new money or future capital calls.
The regulator also clarified that AIFs that made investments on or before December 13, 2024, the date of the previous circular, can distribute the proceeds of those investments according to the terms already disclosed in their private placement memorandum (PPM) and other fund documents. This clarification ensures that funds are not forced to retroactively change distribution waterfalls, which could lead to legal and operational issues.
A distribution waterfall refers to the order and manner in which an investment fund shares returns among its investors.
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The consultation paper also provides relief to open-ended Category III AIFs, where investors can enter or exit the scheme at any time. Sebi has now said that the pro rata drawdown rule does not apply to such schemes as they issue and redeem units at the fund’s net asset value (NAV). Instead, these funds must ensure that any distribution of income is made in proportion to the units held by each investor at the time of payment.
However, if such open schemes invest primarily in unlisted securities, they will still have to meet the broader conditions for proportionate investment and distribution.
Alternative investment funds collect funds from other investors to invest in companies or projects. Category I AIFs include venture capital funds and infrastructure funds, while private equity and debt funds fall under Category II AIFs. Category III AIFs, such as hedge funds, have a higher risk appetite with aggressive investment strategies such as the use of algorithms for automated high-frequency stock trading.
Although the clarifications and changes have brought relief to officials in the AIF industry, some issues remain unresolved.
“The new consultation paper from Sebi addresses many of the issues facing AIFs. But investors with differential fee arrangements are concerned that the new rule on income proration will undermine their fee advantage,” a senior lawyer said on condition of anonymity.
While such differential fees are permitted as a matter of law, the pro rata requirement effectively nullifies them. These investors may also never be fully depleted, which can cause potential accounting complications.
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Finally, AIFs with previously compliant but different structures and distribution models are now in limbo awaiting guidance on how to unwind existing arrangements. “The previous flexibility of the structure is now removed, leading to tough discussions between AIFs and investors. Many hope that the SFA (Standard Setting Forum for AIF) implementing standards will address these concerns,” said the lawyer quoted above. The deadline for public comments is the 28th.
