Chapter 11: Governance of Funds and Due Diligence — Short Notes (Part Three: Conflict Mitigation, Co-Investments, and Conduct Rules)

This is Part Three of the comprehensive study notes for Chapter 11: Governance of Funds and Due Diligence, focusing on the crucial areas of conflict of interest mitigation, the co-investment framework, the code of conduct for fund managers and investment committees, and standard industry best practices.

11.4 Role of Human Capital in Avoiding Conflict of Interests

Human capital plays a pivotal role in maintaining robust fund governance by identifying, managing, monitoring, and transparently disclosing conflicts of interest. Because alternative investments often operate as blind pools with complex structures, the investment manager must implement strict operational controls to mitigate conflicts of interest.

Structural Conflict Mitigation Measures

The fund manager must implement four essential operational measures to mitigate conflict-of-interest risks:

1. Policy Enforcement: Putting in place clear internal policies and procedures to manage conflicts of interest.
2. Chinese Walls: Establishing appropriate "Chinese walls" to protect the confidentiality of sensitive or proprietary deal data.
3. Upskilling and Training: Mandating regular training and upskilling of team members on ever-evolving market dynamics and regulatory changes.
4. Diligence in Outsourcing: Applying due skill, care, and diligence when selecting and monitoring third-party outsourcing companies.

Alignment of Interests: Core Fiduciary Obligations

An AIF investment manager has a fiduciary duty to safeguard the interests of the fund's investors. To ensure that the interests of the investment manager are closely aligned with those of the investors, the fund's governance policies should incorporate the following requirements:

• Time Dedication Disclosure: Apart from the mandatory minimum sponsor commitment, the sponsor and fund manager must list all other fund management activities they carry out in a year to indicate the amount of time dedicated to the fund, its predecessors, and successor funds.
• Rules of Coexistence: Clear rules must be established regarding the circumstances under which the setting up, marketing, and investment period of a new scheme can be undertaken, alongside the precise allocation of management fees.
• New Scheme Launch Restrictions: The sponsor must not set up a new scheme with similar target investments until the investment period of the ongoing scheme has ended, or until the capital of the active scheme has been substantially invested.
• First Close Timelines: The manager must make reasonable efforts to achieve the first close within a reasonable time once the PPM has been filed with SEBI, rather than waiting for the maximum 12-month limit to expire.
• Equal Treatment: The manager must offer equal terms and treatment to all investors in the fund.
• Tenure Extensions: If a proposed extension of the fund's tenure is not approved by the investors, the manager must immediately proceed to wind up the fund. If an extension is pursued, the manager must provide investors with clear details of the extension conditions and the reasons for it.
• Fee Transparency: Regular investor updates must clearly specify the basis of calculation for both management fees and performance-based fees. Triggers that attract a clawback provision must be clearly defined.
• Reinvestment Limitations: If the manager retains sales proceeds for the purpose of reinvestment, the terms and quantitative/time limitations of the reinvestment must be communicated to investors. Crucially, the reinvestment amount cannot exceed the original capital invested (or the acquisition price) in the asset that generated the distribution.
• Portfolio Company Fees: The manager must provide full disclosures if any fees are paid directly or indirectly by portfolio investee companies to the manager or its affiliates.
• Expense Caps: The manager must clearly identify and limit the types of organizational, marketing, and operating expenses (such as auditing, legal advice, taxes, and service provider payments) that are borne by the fund versus those borne by the manager itself.
• No Conflicted Deals: Managers must refrain from co-investing in deals that generate potential conflicts of interest with the fund's investors.
• Regular Reporting: Investors must receive quarterly and annual reports containing comprehensive details of investments made, financial statements, the fund leveraging plan, material changes in investments, and valuation mechanisms.
• Side Letter Justification: Any side letter executed with an investor must have a clear, objective justification.

11.5 Co-investments in AIFs

Co-investments are structured arrangements within the AIF ecosystem where investors choose to invest directly into an investee company alongside the AIF, rather than routing all their capital solely through the pooled fund.

Strategic Benefits of Co-investment

• Offshore Structuring: It is highly beneficial for offshore investors who do not wish to pool their funds with a domestic manager and prefer the freedom to shortlist and invest in target companies directly.
• Increased Control & Lower Fees: It provides large institutional investors with greater control over the selection of specific assets while saving on standard fund management fees.
• Alternative to Blind Pools: Standard blind-pool arrangements can sometimes lead to friction due to high management fees or the underperformance of fund managers. Co-investments act as a hybrid model to address these limitations.

Core Regulatory Conditions for Co-investment

To prevent managers from favoring co-investors over the main fund, SEBI mandates strict parity guidelines:

• Interest Alignment: The interests of the fund/blind pool must be tied directly to the co-investors to prevent divergent incentives.
• Parity of Investment Terms: The terms of a co-investment in an investee company by a manager, sponsor, or co-investor must not be more favourable than the terms of investment offered to the main AIF.
• Identical Exit Terms: The terms of exit from the co-investment—specifically including the timing of the exit—must be completely identical to the terms applicable to the exit of the main AIF.
• No Preferential Allocations: The manager is prohibited from offering preferential terms to co-investors that could dilute or prejudice the interests of the main fund.

11.6 Code of Conduct for Investment Managers and Investment Committee

Fund managers and Investment Committees are subject to a strict fiduciary code of conduct to ensure transparency, compliance, and ethical asset management.

The SEBI Stewardship Code

All AIF managers must adhere to SEBI's Stewardship Code when investing in listed equities. The code is built on five core principles:

• Principle 1: AIFs must formulate a comprehensive policy on how they discharge their stewardship responsibilities, publicly disclose it, and update it periodically.
• Principle 2: AIFs must maintain a clear, publicly disclosed policy on how they manage conflicts of interest in fulfilling their stewardship duties.
• **Principle 3: AIFs must continuously monitor their investee companies.
• Principle 4: AIFs must have a clear policy on intervention in investee companies and on collaboration with other institutional investors to safeguard the interests of ultimate investors.
• Principle 5: AIFs must maintain a clear policy regarding voting and the public disclosure of their voting activities.

Allocation of Compliance and Governance Responsibility

1. Joint and Several IC Liability: The members of the Investment Committee (IC) are jointly and severally responsible for all investment decisions taken by the committee and must ensure that all decisions strictly comply with the SEBI (AIF) Regulations.
2. Compliance Accountability: The Investment Manager, the Trustee, and Key Management Personnel (KMPs) of the AIF bear joint and several responsibility for ensuring overall compliance with all statutory processes, including the filing of Compliance Test Reports (CTRs) and in-specie distribution rules.

11.7 Industry Best Practices

To maintain market trust and protect investor capital, leading AIF managers adopt several voluntary and regulatory industry best practices:

• Regularisation of Side Letters (MFN Provision): Sponsors and investment managers must regularize the use of Most Favoured Nation (MFN) provisions in side-letters to prevent special rights from being granted arbitrarily to select large investors.
• Separation of NAV Calculation: For Category III AIFs, the NAV calculation must be independent of the fund management function to ensure unbiased, objective valuation reporting.
• Adherence to Global Standards: AIF managers are encouraged to adopt internationally recognized standards of performance reporting and transparency, such as:
  • Global Investment Performance Standards (GIPS) by the CFA Institute.
  • Institutional Limited Partners Association (ILPA) guidelines.
  • International Private Equity and Venture Capital (IPEV) Valuation Board standards.
• Direct Plan On-boarding: Investors who approach an AIF directly (without an intermediary charging advisory or portfolio management fees) must be on-boarded via a Direct Plan involving zero placement or distribution commissions.
• Trail-only Distribution Fees: For Category III AIFs, any distribution or placement fees must be charged only on an equal trail basis (no upfront commissions are permitted), and these fees must be paid solely out of the management fees received by the manager.
• Secure Virtual Data Rooms (VDR): Managers must utilize secure, access-controlled virtual data rooms to conduct due diligence, ensuring that constitutional, financial, tax, and employment records are shared safely.
• Investor Confidentiality: Investors must maintain strict confidentiality regarding all material, non-public information they receive by virtue of being unit-holders of the fund.

Key Terms & Exam-Relevant Definitions

• Most Favoured Nation (MFN) Provision: A contractual clause in an investor's side letter that entitles them to opt into more favorable terms (such as lower fees or better information rights) offered to other investors in the same scheme.
• Side Letter: A bilateral agreement entered into between a specific investor, the AIF, and the investment manager that grants customized, individual rights that do not impact the general operations of the fund.
• Clawback: A protective contractual mechanism requiring the investment manager to return previously distributed performance fees (carry) if the fund subsequently incurs losses before liquidation.
• Blind Pool: An investment structure where investors commit capital to a fund without knowing the specific assets or companies the manager will ultimately invest in.
• Chinese Wall: An information barrier established within an organization to prevent the exchange of confidential information between different departments (e.g., between the advisory team and the trading desk).
• Reinvestment Cap: A regulatory limit stating that any sales proceeds retained for reinvestment by the manager cannot exceed the original capital invested or the acquisition price of the underlying asset.

Key Takeaways

1. Fiduciary Alignment: Effective fund governance relies on aligning the manager's incentives with investor capital through detailed disclosures of fees, other business activities, expense caps, and reinvestment rules.
2. No Better Terms for Co-investors: Co-investment terms must never be more favorable than those of the main AIF, and exit timelines must be perfectly identical to protect the fund's pooled investors.
3. Active Stewardship: Under SEBI guidelines, managers cannot remain passive; they must actively monitor investee companies, vote in key matters, and maintain clear policies on intervention.
4. MFN Regularisation: MFN clauses must be carefully regularized in side letters to ensure that preferential rights are not distributed arbitrarily or in a manner that prejudices other unit holders.
5. Global Compliance Alignment: Implementing global standards (such as GIPS and ILPA) and separating the NAV calculation from the deal-making team are fundamental best practices for modern fund governance.