NISM-Series-XIX-A: Alternative Investment Funds (Category I and II) Distributors Certification Workbook

Chapter 8: Fund Due Diligence – Investor Perspective (Part 1 of 5)

The Investor Perspective & Fund Selection Criteria in AIF Due Diligence

Alternative Investment Funds (AIFs) are complex, high-risk, and comparatively illiquid financial vehicles tailored specifically for sophisticated investors. Unlike traditional mutual funds, which are highly regulated and public-facing, AIFs operate through private placements with unique investment strategies, commercial structures, and governance terms. Consequently, conducting a rigorous Fund Due Diligence (FDD) process from the investor’s perspective is a vital prerequisite to committing capital.

This study guide—Part 1 of a 5-part series—covers the foundational elements of the investor perspective (Section 8.1) and the core fund selection criteria (Section 8.2), detailing how distributors and investors evaluate ownership, alignment of interest, and competing structures.

1. Understanding the Investor Perspective

In the AIF ecosystem, the distributor or placement agent serves as a crucial link between the investment manager and the investor. To perform this role ethically and effectively, distributors must move away from a transactional sales approach and instead focus on establishing a deep, qualitative understanding of the investor.

The Three Pillars of Investor Assessment

A distributor's comprehensive evaluation of a prospective investor is structured around three key criteria:

1. The investor's unique risk-return profile and specific investment requirements.
2. The fund's structural, legal, and governance frameworks.
3. The professional profile, operational credentials, and performance track record of the investment manager.

Formulating the Customer-Specific Risk Profile

Before showcasing any AIF product, a distributor must engage in detailed discussions with the client to formulate a unique, customer-specific risk profile. A robust risk-profiling questionnaire should be deployed to capture critical investor variables, which include:

• Core Investment Objectives: What are the client’s capital appreciation or wealth preservation goals?
• Intended Investment Tenure: AIFs under Category I and II are close-ended and usually carry a minimum tenure of three years. The investor must have an investment horizon aligned with these long gestation periods.
• Risk Appetite: Can the investor absorb high volatility, potential capital loss, and the "J-Curve" effect?
• Return Expectations: Are the investor’s target IRR expectations realistic in comparison to historical asset class returns?
• Liquidity Requirements: Does the investor require periodic income or payouts, or can they keep capital locked in for the entire life of the fund?

Strategic Product Mapping & Wish List Formulation

Once the investor's profile is established, the distributor designs a "wish list" of ideal scheme characteristics. This wish list acts as a blueprint to identify and filter compatible AIF schemes.

Key Takeaway: One size does not fit all in AIF marketing. Distributors must map specific fund structures (debt vs. equity, sectoral vs. sector-agnostic, Category I vs. Category II) to individual investor realities.

2. Core Fund Selection Criteria

After narrowing down the universe of available funds to a shortlist of compatible products, the investor—often guided by the distributor—must apply rigorous selection criteria to choose the final fund. At the highest level, three fundamental factors dictate the fund selection process:

Pillar A: Ownership Structure & Continuing Interest

The constitutional design of an AIF directly impacts its tax treatment, operational liability, and governance oversight.

Constitutional Structuring Options in India

Most domestic AIFs in India are established under one of three constitutional legal structures:

1. Irrevocable Determinate Trust (Most Common): Set up under the Indian Trusts Act, 1882. This is the most popular structure because it permits flexible pooling of capital, clear separation of fiduciary duties (via trustees), and optimal pass-through tax neutrality.
2. Limited Liability Partnership (LLP): Regulated under the Limited Liability Partnership Act, 2008. Investors are admitted as partners. It provides limited liability but offers less flexibility in capital restructuring compared to trusts.
3. Company: Registered under the Companies Act, 2013. Since share allotments, application monies, and capital redemptions are highly regulated and rigid under corporate law, this structure is rarely used for AIFs in India.

Sponsor/Manager "Skin-in-the-Game" (Continuing Interest)

Under the SEBI (AIF) Regulations, 2012, sponsors or managers must maintain a mandatory, ongoing financial commitment to ensure their interests are directly tied to the fund’s performance.

• Regulatory Threshold (Category I & II AIF): The Sponsor or Manager must maintain a continuing interest of at least 2.5% of the corpus or INR 5 crore, whichever is lower, in each scheme of the fund. This interest must be in the form of actual capital investment and cannot be structured through a waiver of management fees.
• Mitigating Moral Hazard: The verification of this commitment is a primary checkpoint during fund due diligence. First-time fund managers often commit capital above the regulatory minimum to signal high conviction and build trust with institutional LPs.

Pillar B: Alignment of Interests

The economic terms in an AIF’s Contribution Agreement and Private Placement Memorandum (PPM) must align the financial incentives of the investment manager with the return expectations of the investors. Misaligned terms are a primary source of investor-manager conflict.

Key Financial Touchpoints for Alignment

• Sponsor Commitment: Ensuring the manager’s own capital is at risk alongside investors.
• Management Fee Structures: Investors closely scrutinize management fees to ensure they are intended to cover the actual operating and administrative overhead of the fund, rather than serving as a major profit center for the AMC. Due to hard negotiations, fee terms are being driven down globally.
• Hurdle Rate / Preferred Return: This is the minimum annual compounded rate of return that the fund must deliver to investors before the manager is entitled to receive performance incentives (carried interest). In the Indian context, the preferred return is typically set around 8% to 15% depending on whether it is a debt or equity strategy.
• Carried Interest ("Carry") and Super-Carry: Carried interest is the manager's share of profits (typically 20%) once the hurdle rate is met. Highly sought-after managers with exceptional track records may negotiate a "super-carry" (higher incentive percentages).
• The Catch-up Clause: If a fund has a "catch-up" clause, once the hurdle rate is satisfied and investors have received their preferred return, the manager receives a disproportionate share of subsequent distributions until they have "caught up" to their agreed profit-sharing ratio (e.g., 20% of all distributed profits).
• Clawback Provisions: If a fund utilizes an American waterfall (deal-by-deal distributions), the manager might receive carry early in the fund's life on profitable exits. If subsequent deals result in losses, a clawback clause legally obligates the manager to return excess carry to ensure the overall profit-sharing over the fund's life matches the agreed-upon split.

Key Performance Indicators (Ratios) to Evaluate Alignment

During fund selection, distributors assess historical alignment by analyzing both gross metrics (pre-fees and pre-carry) and net metrics (actual returns received by investors):

Pillar C: Competing or Outside Interests

A critical risk in AIF selection is manager bandwidth and potential conflict of interest. Investors must ensure that the fund manager's time, resources, and deal-sourcing capabilities are dedicated to the scheme in which they are investing.

Core Conflict Areas & Risk Management Practices

1. Multiple Scheme Management: If a fund manager operates multiple funds with overlapping investment mandates, they may face the temptation to direct the most attractive, "sweet spot" investment deals to one preferred scheme over another. The PPM must explicitly outline deal allocation policies to prevent this.
2. Nominee Directorship Conflicts: Fund managers often take nominee board seats in portfolio investee companies. A clear nominee directorship policy must be established to outline fiduciary duties and address liabilities arising from litigations, product defects, or environmental issues at the portfolio level.
3. Disclosing Ancillary Fees: Any transaction, advisory, or underwriting fees received by the AMC or its employees from investee companies must be fully disclosed to investors.
4. Co-Investment Terms: While co-investments offer investors direct exposure to attractive deals alongside the main fund, the selection and allocation of these opportunities must be transparently governed to ensure no select class of LPs receives unfair preferential treatment.

3. Section Summary & Core Learnings

Important Terms

• AIF (Alternative Investment Fund): A privately pooled investment vehicle, established in India as a trust, company, or LLP, which collects funds from sophisticated Indian or foreign investors for deployment under a defined investment policy.
• Continuing Interest: The mandatory, ongoing capital commitment that sponsors/managers must maintain in the scheme (2.5% of corpus or INR 5 crore, whichever is lower, for Cat I & II AIFs) to ensure alignment of interests.
• Determinate Trust: A legal trust structure under the Indian Trusts Act, 1882 where the beneficial interests of the unit holders are predefined and clearly identifiable, crucial for achieving tax pass-through status.
• Skin-in-the-Game: An industry term referring to the personal capital invested by fund managers and sponsors into their own funds, serving as a measure of commitment and risk alignment.
• Super-Carry: Performance incentives exceeding the standard 20% threshold, typically negotiated by highly successful, oversubscribed fund managers.

Key Exam Takeaways

• Distributor's Role: Distributors must develop a customized, investor-specific risk profile using detailed questionnaires rather than mass-marketing AIF schemes.
• Continuing Sponsor Commitments: Continuing interest of 2.5% of corpus or INR 5 crore (whichever is lower) for Category I and II AIFs is a regulatory requirement under SEBI and cannot be waived or structured via fee reductions.
• Pass-Through Status: Trust structures are highly favored in India because they provide optimal legal and tax pass-through neutrality for Category I and II AIFs (except for business income, which is taxed at the fund level).
• Clawback Enforcement: Clawback mechanisms protect investors from overpaying carry to the AMC during the early profitable phase of a fund's life cycle.

4. Practice Questions

Question 1

Under the SEBI (Alternative Investment Funds) Regulations, 2012, the mandatory continuing interest of the Sponsor or Manager in a Category II AIF scheme must be:

a) At least 5% of the corpus or INR 10 crore, whichever is lower
b) At least 2.5% of the corpus or INR 5 crore, whichever is lower
c) At least 1% of the corpus or INR 1 crore, whichever is lower
d) Entirely waiver-based and settled against future management fees

Question 2

Which of the following constitutional structures is most commonly adopted by domestic Alternative Investment Funds in India due to operational flexibility and tax pass-through benefits?

a) Public Limited Company
b) Private Limited Company
c) Irrevocable Determinate Trust
d) General Partnership Firm

Question 3

An investor seeks to assess the actual cash returns distributed by an AIF scheme relative to the capital they have paid in. Which of the following metrics should they primarily compute?

a) RVPI Multiple
b) DPI Multiple
c) TVPI Multiple
d) PIC Multiple

Question 4

A contract clause that legally obligates the investment manager to return excess performance fees (carry) to investors upon the final winding up of a fund is known as a:

a) Catch-up Clause
b) Clawback Provision
c) Key Man Clause
d) Hurdle Rate Provision

Answer Key & Explanations

1. Correct Answer: b)
   Explanation: Under SEBI (AIF) Regulations, for Category I & II AIFs, the Manager or Sponsor must have a continuing interest of not less than 2.5% of the corpus or INR 5 crore, whichever is lower, which cannot be met through fee waivers.

2. Correct Answer: c)
   Explanation: Almost all domestic AIFs in India choose the irrevocable determinate trust structure because it allows clear delegation of powers via trustees and achieves tax pass-through status.

3. Correct Answer: b)
   Explanation: DPI (Distributed to Paid-In Capital) is the realization multiple that measures the actual distributed cash returns relative to the paid-in capital.

4. Correct Answer: b)
   Explanation: A clawback clause ensures that overpaid carried interest is returned to the investors upon fund liquidation, netting off all profits and losses over the fund’s life.