Human Capital, Co-Investments, and Ethical Standards in AIF Management

This fifth and final part of the Chapter 11 study notes examines the human element of fund management, the mechanics of co-investment, the regulatory code of conduct, and emerging industry best practices such as cybersecurity.

11.8 Role of Human Capital in Avoiding Conflict of Interests

Human capital is the core of an AIF, encompassing the Investment Manager, the deal team, and all support staff involved in decision-making. Effective governance relies on these individuals making unbiased decisions that align strictly with the interests of the fund's investors.

11.8.1 Fiduciary Duty and Mitigation Measures

The Investment Manager holds a fiduciary duty to safeguard investor interests. To identify, manage, and disclose potential conflicts, the following measures are implemented:

• Internal Policies: Robust procedures for managing conflicts of interest at all levels (employees, service providers, sponsors, and managers).
• Chinese Walls: Establishing information barriers to protect confidentiality and prevent the unauthorized flow of sensitive data.
• Training: Regular upskilling of team members on market and regulatory changes.
• Due Diligence on Outsourcing: Applying high standards of care when selecting third-party service providers.

11.8.2 Alignment of Interests

To ensure the manager's incentives are aligned with those of the investors, AIFs typically adopt specific rules:

• Successor Funds: Sponsors generally should not set up a new scheme with a similar target investment mandate until the investment period of the current scheme has ended or its capital has been substantially invested.
• Time Commitment: Managers should disclose other fund management activities to indicate the actual amount of time dedicated to the current fund.
• Transparency: Promptly informing the Supervisory Committee of any transactions during the investment period that could give rise to potential conflicts.

11.9 Co-investments in AIFs

Co-investment involves raising capital in separate investment pools—typically one domestic and one offshore—to invest alongside each other in the same target companies.

11.9.1 Co-investment Structure

• Pooling Vehicles: Separate vehicles are established in India (Onshore Fund) and a foreign jurisdiction (Offshore Fund).
• Advisory Arrangements: The offshore manager may enter into an Investment Advisory Arrangement with the domestic manager to provide recommendations on Indian market opportunities.
• Exit Equality: Terms of exit for a co-investor (including timing) must be identical to the terms applicable to the AIF itself.
• Preferential Treatment Prohibition: Terms of co-investment offered to a Manager, Sponsor, or co-investor shall not be more favourable than the terms of investment of the AIF.

11.10 Code of Conduct for Managers and Investment Committees

All AIFs must adhere to a strict Code of Conduct as specified in the Fourth Schedule of the SEBI (AIF) Regulations.

11.10.1 Core Ethical Principles

• Integrity and Fairness: Operating in the best interest of all investors rather than a select class.
• Disclosures: Ensuring the dissemination of adequate, accurate, and timely information to investors.
• Risk Management: Implementing an effective risk management process and appropriate internal controls.
• Professionalism: Avoiding unethical means to sell or market units and ensuring compliance with all anti-money laundering laws.
• Conflict Monitoring: Maintaining written policies to identify and mitigate conflicts of interest through the entire scope of business.

11.11 Industry Best Practices: Cyber Security and Resilience

As AIFs manage significant capital and sensitive data, SEBI has introduced the Cyber Security and Cyber Resilience Framework (CSCRF) to protect the integrity of data and assets.

11.11.1 Graded Approach to Cyber Security

The applicability of cybersecurity standards is based on the fund's Assets Under Management (AUM):

• Self-certification REs: AIFs with AUM less than INR 100 crore.
• Small-size REs: AIFs with AUM between INR 100 crore and INR 500 crore.
• Mid-size REs: AIFs with AUM between INR 500 crore and INR 1000 crore.
• Qualified REs: AIFs with AUM of INR 1000 crore and above.

11.11.2 Key Security Measures

Managers must provide essential facilities to guard against privacy breaches and perform critical functions in the securities market. This includes identifying Key Persons or executives and ensuring they are covered by Keyman Insurance and Indemnity Insurance.

Key Takeaways for Part 5

• Fiduciary Duty: The manager's primary obligation is to act in the best interest of the unit holders.
• Co-investment Parity: Co-investors cannot receive better terms than the fund and must exit simultaneously with the AIF.
• Code of Conduct: Ethical marketing and transparent reporting are mandatory regulatory requirements.
• CSCRF: Cybersecurity compliance is mandatory and scaled according to the fund's AUM.

Important Terms:

• Chinese Walls: Policies preventing the flow of confidential information between different departments of a firm.
• Pari-Passu: A Latin phrase meaning "on equal footing," used to describe the equal rights of investors in a scheme.
• Keyman Insurance: A life insurance policy taken out by a business on the life of a crucial employee.
• CSCRF: The Cyber Security and Cyber Resilience Framework mandated by SEBI.