Exit Strategies and Commercial Realisation in AIFs (Part 3)

The ultimate objective of any Alternative Investment Fund (AIF) is the successful realisation of investments to return capital and profits to its investors. This part explores the various exit mechanisms available to AIFs, ranging from mandatory regulatory exit options for investors to the commercial routes used to harvest returns from portfolio companies.

15.4 Exit Options for Investors

Regulatory frameworks ensure that investors are not "locked into" an investment if there are fundamental changes to the fund that they did not initially agree to. SEBI provides a mandatory exit option for investors under specific circumstances.

15.4.1 Mandatory Exit Due to Material Changes

Material changes significantly influence an investor's decision to remain invested in the fund. These changes typically include alterations to the fundamental attributes of the fund or scheme as defined in the Private Placement Memorandum (PPM).

Manner of Dealing with Material Changes:

• Dissenting Opportunity: Existing unit holders who do not wish to continue following a material change must be provided with an exit option.
• Expression of Dissent: Unit holders must be given a minimum of one month to express their dissent regarding the proposed change.
• Exception: This mandatory exit process does not apply if the AIF obtains approval from at least 75% of unit holders by value of their investment.

15.4.2 Change of Sponsor, Investment Manager, or Control

A change in the entities managing the fund is considered a critical material change. "Control" in this context refers to the right to appoint the majority of directors or control management decisions, whether through shareholding (typically 50% or more of voting rights) or agreements.

Exit Process for Close-Ended Schemes:

• Buying Out Units: The manager or a designated person must provide an exit by buying out the units of dissenting investors.
• Independent Valuation: Before the buyout, the units must be valued by two independent valuers.
• Exit Price: The exit must be executed at a value not less than the average of these two independent valuations.
• Costs: All expenses for this exit process must be borne by the manager or sponsor and cannot be charged to the unit holders.
• Timeline: The entire exit process for dissenting investors must be completed within three months from the last date of the offer for dissent.

15.4.3 Commercial Exit Routes from Portfolio Companies

Commercial exits typically occur within a horizon of 3 to 7 years, depending on the fund category and market conditions. The investment manager must carefully plan these routes to maximize the internal rate of return (IRR).

Liquidation Preference in Exits

During a corporate liquidation—the least preferred "worst-case" exit—the AIF relies on liquidation preference rights. This contractual clause ensures the AIF can recover its invested amount (sometimes at 1.5x or 2.0x multiples) before any surplus is distributed to other shareholders.

Pure Debt Fund Exits

For debt-oriented AIFs, exits are structured differently:

• Covenants: Periodic servicing of debt is protected by covenants in the investment agreement.
• Charge on Assets: The AIF typically holds a charge or collateral on the company’s assets.
• Default Recovery: As a last resort, the fund may initiate proceedings under the Insolvency and Bankruptcy Code (IBC) 2016 to force a sale of assets and realise dues.

15.5 Secondary Exits (Secondaries)

A "secondary" involves an investor selling their unit capital or partnership interests to another investor rather than waiting for the fund to liquidate the underlying assets.

• Complexity: These are difficult to execute because AIF interests are inherently illiquid and close-ended.
• Transfer of Commitments: If the exiting investor has outstanding capital commitments, these are usually transferred to the incoming buyer.
• Valuation Challenges: Determining a fair price is complex as it is based on the valuation of unrealised, illiquid portfolio companies.
• Pricing: Secondaries often take place at a negotiated price, which may be at a substantial discount to the Net Asset Value (NAV).

Key Takeaways

• Investor Protection: Dissenting investors have a mandatory right to exit if the fund undergoes material changes, unless 75% of investors approve the change.
• Exit Timelines: Buyouts for dissenting investors must be completed within three months of the dissent period ending.
• IPO as Preferred Route: Listing a company on the public market remains the most attractive commercial exit for equity-oriented funds.
• Secondary Market: While evolving in India, the secondary market allows for the transfer of investor interests but often at a discount to NAV.

Important Terms

• Trade Sale: A commercial exit where an AIF sells its holdings in a portfolio company to another financial investor.
• Strategic Sale: An exit where the buyer is a corporate entity seeking industrial or operational synergy.
• Liquidation Preference: A contractual right that gives an investor priority in receiving proceeds during a sale or liquidation.
• Secondaries: Transactions involving the sale of existing AIF units/interests between investors.

End of Part 3. Part 4 will cover the Winding Up of an AIF, Liquidation Schemes, Dissolution Periods, and Mandatory In-specie Distributions.