NISM Series-XIX-A AIF Certification Study Notes

Chapter 7: Investment Process and Governance of Funds (Part 5 of 5)

This study note covers Section 7.5 (Co-investments in AIFs) and Section 7.6 (Regulation on Governance Structure in AIFs) in complete detail, providing a comprehensive analysis of the co-investment regulatory framework, Stewardship Principles, the Compliance Test Report (CTR) protocol, the liabilities and constitution of the Investment Committee (IC), and the statutory dispute resolution mechanisms (SCORES and ODR) in India.

Co-investments in Alternative Investment Funds (AIFs)

Co-investment is an integral investment paradigm in the unlisted private capital space, offering unique transaction structures for sophisticated investors seeking direct exposure to high-conviction deals.

Definition and Rationale of Co-investments

• Definition: Co-investment refers to an investment made by a Manager, Sponsor, or investor of a Category I AIF or Category II AIF in an investee company where such Category I AIF or Category II AIF also makes an investment.
• Investor Rationale: Investors demand co-investment rights to participate directly alongside the blind pool. This hybrid structure provides investors with:
  • Greater control over the selection of specific high-potential target companies.
  • Higher direct capital exposure to highly attractive deals without diluting returns across the broader fund portfolio.
  • Material savings on management fees and carried interest, which are often reduced or waived for co-investments.

The Regulatory Framework for Co-investments in India

To prevent unfair treatment of general unitholders and maintain strict alignment of interests, SEBI enforces rigid regulations on all co-investments executed after December 08, 2021:

1. Mandatory Portfolio Manager Route: Co-investment by investors of Category I and Category II AIFs must be executed only through a Co-investment Portfolio Manager registered under the SEBI (Portfolio Managers) Regulations, 2020.
2. No Favourable Terms: The commercial terms of the co-investment offered to the Manager, Sponsor, or co-investor shall not be more favourable than the terms of the investment applicable to the Category I AIF or Category II AIF itself.
3. Identical Exit Terms: The terms of exit from the co-investment, including the precise timing of the exit, must be identical to the exit terms applicable to the Category I or Category II AIF.
4. Advisory Services Restriction: The AIF manager is strictly barred from providing investment advisory services to any investor other than the clients of the Co-investment Portfolio Manager for investments in securities of the fund's investee companies.
5. Joint Decision-Making: To ensure the interests of the blind pool remain fully aligned with the co-investors, all key post-investment decisions in relation to the co-investment are taken by the investment manager jointly alongside the fund.

Regulation on Governance Structure in AIFs

SEBI places significant regulatory emphasis on fund governance and the mitigation of conflicts of interest to safeguard investor capital.

1. Fiduciary Roles: Trustees vs. Board of Directors

• The Trustee: In a trust-based fund structure (the most common structure in India), the Trustee is responsible for the overall administration of trust matters and acts in a strict fiduciary capacity towards the investors.
• The Board of Directors of the AMC: The Board of Directors of the Investment Management Company (or Asset Management Company) is entrusted with the overall supervision and oversight of the investment management functions of the AIF trust.
• The Investment Manager: Concerned with all active operational and commercial activities of the fund, including sourcing, executing, and harvesting investments, addressing investor complaints, and ensuring absolute regulatory transparency.

2. Stewardship Principles for AIFs

To promote active corporate governance in portfolio companies, institutional AIF investors are expected to adhere to stewardship guidelines, which include:

• Clear Voting Policy (Principle 5): Institutional investors must formulate a clear policy on voting and active disclosure of voting activity. Rather than blindly supporting corporate management, they must make independent, analytical voting decisions. Voting policies and activities must be disclosed to investors annually and published on the AIF's website.
• Stewardship Reporting (Principle 6): Institutional investors must report periodically on their stewardship activities to their investors.

The Compliance Test Report (CTR) Protocol

The Compliance Test Report (CTR) is a vital regulatory reporting document that serves as the fund manager's annual declaration of statutory adherence to SEBI rules.

The CTR Timeline and Operational Workflow

The timeline for compiling, reviewing, and correcting the CTR is strictly regulated to prevent compliance delays:

• Step 1 (Submission): The fund manager must prepare and submit the CTR to the Sponsor (and the Trustee if the AIF is structured as a Trust) within 30 days from the end of the financial year.
• Step 2 (Review): In case of any observations or comments on the CTR, the Trustee or Sponsor must officially intimate these findings to the manager within 30 days from the date of receipt of the CTR.
• Step 3 (Resolution): The manager must make the necessary changes in the CTR or submit an official reply to the Trustee/Sponsor within 15 days from receiving their comments.
• Escalation: If any material violation of SEBI (AIF) Regulations or circulars is observed during this process, the Trustee/Sponsor must intimate the violation to SEBI as soon as possible.

The Investment Committee (IC): Rules, Consent, and Liabilities

The Investment Manager may constitute an Investment Committee (IC) to review, screen, and approve the investment and divestment decisions of the AIF.

Investment Committee Constitution and Approvals

• Proposal Screening: Investment proposals are compiled by the fund's transaction deal team and submitted to the IC for structured screening. Each proposal must detail the executive summary, company operations, valuation methodologies, exit options, and deal structures.
• Theme Alignment: The IC evaluates each proposal to ensure it aligns perfectly with the fund's primary investment strategy, sector caps, and risk profile.

Liability of Investment Committee Members

• The General Rule: Under standard SEBI regulations, the members of the Investment Committee are held jointly and severally responsible for the decisions taken and must ensure that all transactions comply strictly with the SEBI (AIF) Regulations and the fund's Code of Conduct.
• The Accredited Investor Exemption (LVF Exemption): A highly critical statutory exception exists for Large Value Funds for Accredited Investors (LVFs).
  • Members of an IC set up by an LVF—where each investor (excluding the Manager, Sponsor, and fund/manager employees or directors) is an Accredited Investor and commits to invest at least Rs. 70 crore (or equivalent foreign currency)—shall be exempt and not held responsible for the fund's investment decisions, provided the members have obtained a formal, signed waiver of liability from the accredited investors.

External Members and the 75% Investor Consent Rule

To protect investors from undisclosed conflicts of interest, SEBI mandates strict rules regarding the appointment of external professionals to the Investment Committee:

• The Consent Rule: Any external member whose name is not disclosed in the Private Placement Memorandum (PPM) or the initial subscription agreement at the time of onboarding investors can only be appointed with the formal consent of at least 75% of the investors by value of their investment in the AIF scheme.
• The Exemption: This investor consent requirement does not apply to changes in ex-officio external members nominated by the Manager, such as representatives from the Sponsor, Sponsor Group, Investment Manager Group, or investors acting in their official capacity.

Investor Grievance Redressal and Dispute Resolution

To ensure a robust dispute resolution mechanism, SEBI provides investors with access to both administrative and digital grievance systems.

1. SEBI Complaint Redress System (SCORES)

• What is SCORES? SCORES is a centralized, web-based platform launched by SEBI to facilitate the lodging and tracking of investor grievances against registered AIFs and managers.
• Grievance Redressal Timeline: All registered AIFs are statutorily mandated to resolve and redress investor complaints received on the SCORES platform within 21 calendar days from the date of receipt of the grievance.
• Action Taken Report (ATR): Upon resolving the complaint, the AIF must file an Action Taken Report (ATR) through the SCORES portal to officially close the case.

2. Online Dispute Resolution (ODR) and Mediation

• The ODR Mechanism: For complex contractual disputes, SEBI has implemented a structured Online Dispute Resolution (ODR) portal, which integrates mediation, conciliation, and binding arbitration.
• Disposal of SCORES Complaints: If a complaining investor chooses to opt for the ODR mechanism or initiates other civil legal remedies while their complaint is still pending on SCORES, the complaint is treated as officially disposed of and closed on the SCORES portal, shifting the dispute entirely to the ODR/civil forum.

Summary of Co-investments, Compliance, and Governance

Key Exam-Relevant Terms

• Co-investment Portfolio Manager: A specialized registered entity under SEBI Portfolio Manager Rules through which all investor co-investments must be routed.
• Compliance Test Report (CTR): An annual report detailing AIF statutory compliance, reviewed and executed by the manager, sponsor, and trustee.
• Large Value Fund (LVF): A highly regulated, close-ended AIF scheme dedicated to accredited investors with a minimum investment ticket size of Rs. 70 crore.
• Joint and Several Liability: A legal doctrine holding all Investment Committee members collectively and individually responsible for the compliance and consequences of their decisions.
• SCORES (SEBI Complaint Redress System): SEBI’s centralized web portal that legally binds AIFs to redress investor grievances within 21 calendar days.
• Online Dispute Resolution (ODR): A specialized, SEBI-designated platform for resolving investor-AIF disputes through mediation and arbitration.

Practice Questions for Review

1. Co-investments made by investors in Category I and Category II AIFs are subject to which of the following mandatory regulatory conditions?

• (a) They must be routed through a registered Mutual Fund distributor.
• (b) They can only be executed in entities listed on the main board of the National Stock Exchange.
• (c) They must be executed solely through a registered Co-investment Portfolio Manager under SEBI regulations.
• (d) They are exempt from all exit-lock-in requirements.
• Answer: (c)

2. Which of the following statements is TRUE regarding the terms of a co-investment in an investee company?

• (a) The exit terms for the co-investor can be negotiated independently and completed prior to the fund's exit.
• (b) The commercial terms of the co-investment can be more favourable than the terms of the main AIF.
• (c) The terms of the co-investment, including exit timing, must be identical and not more favourable than the main AIF's terms.
• (d) Co-investments are only permitted in Category III hedge funds.
• Answer: (c)

3. Under the SEBI (AIF) Regulations, the manager must submit the annual Compliance Test Report (CTR) to the sponsor and trustee within how many days from the end of the financial year?

• (a) 15 days
• (b) 30 days
• (c) 60 days
• (d) 180 days
• Answer: (b)

4. If a trustee or sponsor has comments or observations on the annual Compliance Test Report (CTR) submitted by the manager, within how many days must the manager make the necessary modifications or submit a reply?

• (a) 7 days
• (b) 15 days
• (c) 30 days
• (d) 45 days
• Answer: (b)

5. Members of an Investment Committee set up by a Large Value Fund (LVF) are exempt from personal liability for the committee's decisions, provided they obtain a waiver and each investor contributes a minimum of:

• (a) Rs. 1 crore
• (b) Rs. 20 crore
• (c) Rs. 50 crore
• (d) Rs. 70 crore
• Answer: (d)

6. To appoint an external member to the Investment Committee whose name was not disclosed in the PPM or subscription agreement, the manager must seek the consent of:

• (a) At least 51% of the investors by value of their investment
• (b) At least two-thirds (66.7%) of the investors by value of their investment
• (c) At least 75% of the investors by value of their investment
• (d) 100% of the trustees of the AIF
• Answer: (c)

7. An Alternative Investment Fund (AIF) is statutorily mandated to redress investor grievances received through the SCORES platform within how many calendar days?

• (a) 7 days
• (b) 15 days
• (c) 21 days
• (d) 30 days
• Answer: (c)