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

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

Illustrative Fund Due Diligence Questionnaire, Operational Audits, and Document Review Checklist

In the Alternative Investment Fund (AIF) sector, conducting a rigorous due diligence review requires digging beneath the high-level disclosures of a Private Placement Memorandum (PPM). Since AIFs are privately pooled, long-gestation, and relatively illiquid investment structures, a prospective investor must systematically audit the fund manager’s organization, historical track record, risk mitigation policies, and compliance history.

This study guide—Part 5 of our 5-part series—dissects Annexure 8.1 (Illustrative Fund Due Diligence Information and Questionnaire). It provides an exhaustive guide to the technical questions, qualitative investigations, and document review checklists that investors and distributors utilize during the final stages of the due diligence process.

1. The Strategic Role of the Due Diligence Questionnaire (DDQ)

A standardized yet comprehensive Due Diligence Questionnaire (DDQ) serves as the operational baseline of the Fund Due Diligence (FDD) process. Because unlisted asset data is private, the DDQ forces the investment manager to disclose highly sensitive and non-public operational parameters.

Why the DDQ is Crucial for Investors & Distributors:

1. Uncovering Operational Red Flags: Standardized checklists help identify hidden operational risks, such as high staff turnover, poor accounting controls, or unresolved regulatory investigations.
2. Validating Marketing Claims: It requires the fund manager to back up their marketing material with verified, audited historical numbers (such as Net IRR vs. Gross IRR and realized exit cash flows).
3. Assisting with Product Mapping: For distributors, reviewing the completed DDQ provides the granular details needed to ensure the AIF is a true match for the client's risk-return profile, preventing mis-selling.
4. Negotiating Side Letters: It equips large institutional limited partners (LPs) with the information needed to negotiate preferential terms, fee discounts, or seat eligibility on the Investor Advisory Committee (IAC) via side letters.

2. Deep Dive: Dissecting the Eight Key Questionnaire Categories

Category A: Fund Structure & General Information

This category maps the constitutional and organizational design of the sponsoring entity and the Asset Management Company (AMC).

• Sponsor & Manager History: The manager must outline the founding and subsequent history of the AIF Sponsor and the Investment Manager. This includes any predecessor or parent firms, ownership changes since inception, and future expansion plans for additional schemes or growth.
• Legal & Tax Structure: Details the legal setup (Trust, LLP, or Company) and the associated tax structuring. Managers are typically asked to provide an external legal counsel's tax-structuring opinion outlining the fund's tax pass-through treatment under the Income Tax Act, 1961.
• Organizational Architecture: Includes a detailed organizational chart of the AMC, mapping out front-office, middle-office, and back-office personnel, their job descriptions, delegation of authority limits, and succession plans.
• Investor Advisory Committee (IAC): Outlines the proposed formation, operational rules, and seat eligibility criteria for the IAC.

Category B: Track Record, Performance, Governance, & Compliance

This is a highly scrutinized section where the manager's historical capacity to manage capital, execute valuations, and maintain legal integrity is audited.

. Performance & Track Record Metrics

• Granular Returns: Investors demand performance metrics broken down by vintage year, including portfolio-level gross IRR, net IRR (after fees and expenses), and actual investor-level net IRR (reflecting the impact of the carry waterfall).
• Realization and Multiples: Audits round-wise details of past investments, focusing on the Total Value to Paid-In Capital (TVPI) ratio. The manager must disclose all investments with a TVPI above and below 1.0x, providing case studies of underperforming assets, lessons learned, and when outside turnaround experts were brought in.
• Repeat Investor Ratio: Measures the number and committed capital volume of LPs who have committed to successive funds managed by the same AMC, which serves as a key indicator of investor satisfaction and trust.

2. Accounting, Audits, and Valuation Policies

• Audit Exceptions: The manager must disclose any qualified audit opinions received by the fund, the AMC, or its underlying portfolio companies during their ownership period.
• Internal Controls: Audits the AMC's accounting policies, internal audit practices, and proprietary or governance audit functions. Any major control weaknesses identified during previous audits must be disclosed, along with the corrective actions taken to resolve them.
• Valuation Policy Consistency: Measures alignment with the International Private Equity and Venture Capital (IPEV) Valuation Guidelines. The manager must detail any historical changes to their valuation policy or any deviations from established regulatory guidelines.

3. Compliance, Investigations, and Litigation

• Past and Ongoing Proceedings: Outlines any historical or active criminal, civil, or statutory proceedings, demand notices, show-cause notices, or prosecution actions initiated by SEBI, tax authorities, or other regulators against the fund, the AMC, its affiliates, or individual investment team members.
• Fraud and Ethical Conduct: Discloses any active or past accusations, charges, or convictions of fraud, misrepresentation, or ethical misconduct against any current or former investment team members, associates, or engaged third-party service providers.
• Conflict Management: Evaluates policies regarding employee personal investments, related-party transactions, and how the firm handles potential conflicts of interest when employees sit on the boards of portfolio companies.

Category C: Additional Track Record Information for Debt Funds

For credit and debt-oriented Category II AIFs, the DDQ shifts from growth metrics to downside credit protection and collateral security.

Category D: Proposed Fund / Scheme Details

This section audits the specific operational parameters of the fund currently raising capital.

• Sizing and Closings: Reviews the target corpus size, green shoe options, and the fundraising timeline. This includes details on capital already committed by institutional investors (distributing between soft and hard commitments) and proposed closing schedules.
• Drawdown Dynamics: Analyzes the indicative drawdown schedule (periodic vs. ad-hoc) to help LPs plan their cash requirements and minimize cash drag.
• Co-Investment Terms: Details the fund's policy regarding co-investment opportunities. The manager must explain how these deals are allocated among the main fund, affiliates, and select LPs to ensure no class of investors receives unfair preferential treatment.
• Subsequent Closings: Evaluates the entry terms for investors joining in subsequent closings after the First Close, focusing on the calculation of compensatory interest or entry loads.

Category E: Investment Strategy

This section verifies whether the fund's strategy matches its stated thesis and complies with SEBI regulations.

• Strategy Parameters: Outlines target transaction sizes (the fund's "sweet spot"), anticipated holding periods, geographic focus, target sectors, and the development stage of target companies (early-stage vs. growth/buyout).
• Diversification and Exposure Limits: Verifies concentration risk parameters, including single-company and single-sector exposure caps, ensuring compliance with SEBI's 25% investee limit for Category I and II AIFs.
• Follow-On Funding Policy: Details the capital reserves held for follow-on investments in existing portfolio companies, outlining how the manager protects the fund's stakes from dilution in later rounds.
• Investment Control Preference: Outlines the manager's preference for taking control, joint-control, or minority stakes, detailing the board representation and veto rights they routinely negotiate.

Category F: Investment Process

Audits the day-to-day transaction workflows of the investment team.

• Deal Sourcing Funnel: Details the deal generation pipeline, assessing the sustainability of the manager’s proprietary contact network versus their reliance on external investment banks and intermediaries.
• Deal Filtering Metrics: Reviews the historical ratio of sourced deals that pass initial screening compared to those that undergo full due diligence and final execution.
• The Investment Committee (IC) Workflow: Audits the composition of the IC, the decision-making process (unanimous, consensus, or simple majority), and whether IC minutes are formally documented.
• Portfolio Bandwidth: Details the number of active portfolio companies and active deal pipelines assigned to each investment professional to evaluate team bandwidth and prevent key personnel fatigue.

Category G: Investment Team

Audits the talent continuity and financial incentives of the professionals managing the capital.

• Team Longevity: Discloses the background of team members and the number of years they have actively worked together as a cohesive unit.
• Attrition History: Outlines any departures of key investment professionals or partners over the past five years, assessing the impact of those departures on previous fund lifecycles.
• Alignment and Incentives: Details the team's internal compensation structure, specifically focusing on the split of carried interest (carry) among partners and employees to ensure long-term talent retention.

3. Category H: Core Documents to be Reviewed

A successful Fund Due Diligence process is incomplete without a comprehensive audit of the AIF's core legal, constitutional, and financial documents. Investors and distributors must compile and review these documents to ensure the fund's operational terms match the disclosures in the PPM.

1. Constitutional & Investor Agreements:

   • The Indenture of Trust / LLP Deed: Establishes the legal existence of the fund and defines the trustee's fiduciary duties.
   • The Subscription (Contribution) Agreement: The binding contract between the investor and the fund detailing capital commitments, drawdown rules, and the distribution waterfall.
   • Side Letters & MFN Clauses: Supplementary agreements containing customized terms negotiated by select investors.
   • SEBI Registration Certificate: Confirms the fund's registered category and regulatory standing with SEBI.

2. Operational & Advisory Agreements:

   • The Investment Management Agreement (IMA): The contract delegating investment powers to the AMC and defining management fees and carry structures.
   • The Custodian Agreement: Establishes the relationship with the registered custodian for the safekeeping of the fund's securities.
   • The Distributor/Placement Agent Agreement: Defines the commissions and service scope of the distributor.
   • The Investment Advisory Agreement: Regulates the relationship with offshore or domestic advisors.

3. Financial, Valuation, & Compliance Reports:

   • Audited Annual Accounts: Sourced at both the fund level and the portfolio company level.
   • Compliance Test Reports (CTRs): The annual compliance report filed by the manager with the sponsor and trustees.
   • PPM Audit Reports: The annual independent audit verifying the fund's compliance with its PPM disclosures.
   • Valuation Reports: Sample valuation reports of portfolio companies to review the application of fair value principles.
   • Investment Committee (IC) Minutes: Documented minutes of previous IC meetings to evaluate decision-making rigor.

4. Important Terms and Glossary

• Due Diligence Questionnaire (DDQ): A highly structured, exhaustive set of questions used by investors to gather non-public qualitative and quantitative information from a fund manager before committing capital.
• Compensatory Contribution / Entry Load: An additional financial charge levied on investors who enter an AIF in subsequent closings after the First Close, designed to equalize costs with early-stage investors.
• Side Letter: A bilateral legal agreement executed between an AIF manager and a specific investor that modifies the standard terms of the Contribution Agreement for that investor.
• Most Favoured Nation (MFN) Clause: A contractual protective covenant in a side letter ensuring that if any other investor receives more favorable terms, those same terms must be offered to the MFN holder.
• PPM Audit: An annual independent audit mandated by SEBI to verify that the AIF is being operated in strict accordance with the terms disclosed in its Private Placement Memorandum.
• Compliance Test Report (CTR): An annual report compiled by the investment manager detailing the fund's adherence to SEBI regulations, submitted to the sponsor and trustee.

5. Key Exam Takeaways

• PPM Disclosure Exemptions: The standard SEBI PPM template and annual PPM audit requirements do not apply to Angel Funds or schemes where each investor commits a minimum of INR 70 crore and signs an express waiver.
• Sponsor/Manager Continuing Interest: Under SEBI rules, the manager or sponsor's mandatory continuing interest in a Category I or II AIF is 2.5% of the corpus or INR 5 crore (whichever is lower), which must be committed in cash as actual capital at risk and cannot be settled via management fee waivers.
• Employee Co-Investments: Any employee or director of the AMC choosing to invest in the fund in their individual capacity must commit a minimum of INR 25 lakh.
• Subsequent Closing Entry Loads: Subsequent investors joining after the First Close may be charged compensatory entry loads or interest to align their capital contributions with early-stage investors.
• Exits on Material Changes: Dissenting investors who object to a material change in the PPM must be offered an exit option, with the units valued as the average of valuations provided by two independent valuers. The manager is solely responsible for arranging the exit, and all associated costs must be borne by the manager or sponsor rather than being charged to the fund.

6. Practice Questions

Question 1

The annual PPM audit and the standardized SEBI PPM disclosure template are NOT mandatory for which of the following AIF categories?

a) Special Situation Funds
b) SME Funds
c) Angel Funds
d) Infrastructure Debt Funds

Question 2

An employee of an AIF's Asset Management Company wishes to participate as an investor in the fund in their individual capacity. Under SEBI regulations, their minimum capital contribution must be:

a) INR 1 crore
b) INR 50 lakh
c) INR 25 lakh
d) INR 10 lakh

Question 3

If a close-ended AIF scheme proposes a material change to its PPM, and dissenting investors choose to exit, their units must be valued at:

a) The historical cost of acquisition
b) Not less than the average of valuations conducted by two independent valuers
c) The net asset value computed on the immediate preceding September 30 cycle
d) A mutually agreed discount of 20% to the latest published book value

Question 4

A protective clause in an investor's side letter that prevents subsequent investors from receiving more favorable commercial terms without offering those same terms to the original investor is known as a:

a) Drag Along Clause
b) Clawback Provision
c) Most Favoured Nation (MFN) Clause
d) Key Man Covenant

Answer Key & Explanations

1. Correct Answer: c)
   Explanation: Under SEBI (AIF) Regulations, the standardized PPM templates and annual audit of PPM terms are explicitly not applicable to Angel Funds. They are also exempt for schemes where each investor commits a minimum of INR 70 crore and signs a waiver.

2. Correct Answer: c)
   Explanation: While the standard minimum investment for external investors in an AIF is INR 1 crore, employees or directors of the fund or the investment manager are permitted to invest a lower minimum amount of INR 25 lakh.

3. Correct Answer: b)
   Explanation: SEBI's prescribed exit process for dissenting investors during material PPM changes mandates that the valuation of units must be undertaken by two independent valuers, and the exit must be at a value not less than the average of those two valuations.

4. Correct Answer: c)
   Explanation: A Most Favoured Nation (MFN) clause is a protective side letter covenant that prevents later investors from negotiating better terms (such as lower management fees or faster waterfalls) without those same benefits being extended to the existing MFN holder.