Chapter 5: Regulatory Framework (Part 4 of 6)

5.14 Guidelines on Operational, Prudential, and Reporting Norms

It is mandatory for all registered Category III Alternative Investment Funds (AIFs) to comply with the directions issued by the Securities and Exchange Board of India (SEBI) from time to time with respect to operational standards, conduct of business rules, prudential requirements, restrictions on redemptions, and conflict of interest. These disclosures and compliance parameters ensure that Investment Managers manage risk effectively, maintain appropriate leverage levels, and conduct the business of the fund solely for the benefit of the investors.

5.14.1 Risk Management and Compliance Framework

If a Category III AIF deploys leverage, the fund must establish a robust compliance and risk control ecosystem:

• Independent Risk Function: The fund must implement a comprehensive risk management framework with an independent risk management function that is commensurate with the size, complexity, and risk profile of the fund.
• Independent Compliance Function: The fund must maintain an independent compliance function supported by suitable operational resources, infrastructure, checks, and controls.
• Record Maintenance: The Sponsor or Investment Manager must maintain complete records of all trades and transactions performed by the fund and make them readily available to SEBI whenever required.
• Conflict of Interest Disclosures: The fund must provide full disclosures of present and potential conflicts of interest, along with their established resolution mechanisms, to both the investors and SEBI.

5.14.2 Redemption Norms

SEBI has specified distinct redemption norms applicable to all open-ended Category III AIFs. Notably, these specific operational norms do not apply to close-ended funds due to their unique, fixed-tenure structure.

• Liquidity Management Policy: Investment Managers of open-ended Category III AIFs must ensure there is sufficient liquidity in the fund or scheme to meet potential redemption obligations. The Investment Manager is required to establish and maintain an efficient liquidity management policy and process to ensure that the liquidity of the fund's assets remains consistent with the overall liquidity requirements of the fund when making investments.
• Suspension of Redemptions: Investment Managers must explicitly disclose the possibility of suspending redemptions in exceptional circumstances within the offering documents. Such a suspension can be justified only if it is deemed to be in the best interest of the investors or is explicitly required by SEBI.
• Operational Controls During Suspension: Investment Managers must build the required operational efficiency and capability to suspend redemptions smoothly. Once redemptions are suspended, the fund must not accept any new subscriptions or capital commitments during the period of suspension.
• Follow-on Action and Review:
  1. The decision to suspend redemptions, along with sufficient reasons and proposed future actions, must be formally documented by the Investment Manager and communicated immediately to SEBI and the investors.
  2. The Investment Manager must regularly review the suspension to evaluate if the conditions warranting it still exist.
  3. The Investment Manager must take all necessary steps to resume normal operations as soon as possible in the best interest of the investors. The final decision to resume normal operations must also be promptly communicated to SEBI and the investors.

5.14.3 Prudential Leverage Limits and Calculations

Category III AIFs are permitted to employ leverage, whether through investments in derivative contracts or by borrowing money, for the purpose of investing in the securities market. However, to preserve systemic stability, SEBI imposes strict limits on the total leverage a scheme can undertake.

The Regulatory Leverage Cap

The total leverage of a Category III AIF scheme must not exceed 2 times the Net Asset Value (NAV) of the fund.

Formula for Calculating Leverage

The ratio to compute the maximum permissible leverage of a scheme is written as follows:

Leverage = Total exposure (Long positions + Short positions (after offsetting as permitted)) / Net Asset Value (NAV)

Crucial Exposure Rules for Leverage Computation:

• Total Exposure: This is calculated as the sum of the market value of the long and short positions of all securities or contracts held by the fund.
• Cash Exclusion: Idle cash and cash equivalents are strictly excluded when calculating the fund's total exposure.
• Borrowing Exclusion: Temporary borrowing arrangements that relate to and are fully covered by capital commitments from the investors are excluded from the calculation of leverage.
• Offsetting Positions: Offsetting of positions is permitted for the calculation of leverage strictly in accordance with SEBI norms governing hedging and portfolio rebalancing.
• Inter-AIF Investment Exclusion: For Category III AIFs that invest in the units of other AIFs, the leverage limit of 2 times the NAV must be calculated by excluding the value of the fund's investment in the units of those other AIFs.

5.14.4 Leverage Breach Rectification and Reporting

Any active or passive market movement that causes a Category III AIF to exceed its permitted leverage limit triggers immediate, mandatory rectification and reporting actions.

1. Obligations of the Investment Manager

• Square-off Mandate: The Category III AIF must square-off (sell or buy, as applicable) the excess exposure taken in any security or derivative contract by the end of the next working day following the breach to bring the scheme back within the leverage limit.
• Investor Notification of Breach: The Investment Manager must send a report to all investors before 10:00 AM on the next working day informing them about the exact extent of the leverage breach and the reasons for it.
• Investor Notification of Rectification: A formal confirmation of the successful square-off of the excess exposure must be sent to all investors by the end of the same day on which the exposure is corrected.

2. Obligations of the Custodian

• SEBI Breach Report: The Custodian must send an independent report to SEBI detailing the name of the Category III AIF, the extent of the leverage breach, and the reasons for the breach before 10:00 AM on the next working day.
• SEBI Rectification Report: A final confirmation showing that the excess exposure has been successfully squared-off must be submitted by the Custodian to SEBI by the end of the same day on which the exposure is rectified.

5.14.5 Periodic Reporting to SEBI

All registered Category III AIFs must regularly submit activity reports to SEBI. The frequency of these submissions depends directly on whether the fund utilizes leverage:

• Non-Leveraged Category III AIFs: Funds that do not undertake leverage are required to submit activity reports on a quarterly basis. These reports must be filed within 10 calendar days from the end of each quarter in the revised format specified by SEBI.
• Leveraged Category III AIFs: Funds that undertake leverage are subject to tighter monitoring and must submit reports on a monthly basis to SEBI. These monthly reports must be submitted online through the SEBI Intermediary Portal within 15 calendar days from the end of each reporting period, in accordance with the revised format.

5.15 Category III AIFs: Participation in Credit Default Swaps (CDS)

A Credit Default Swap (CDS) is a credit derivative contract in which one counterparty (the protection seller) commits to pay the other counterparty (the protection buyer) in the event of a pre-defined credit event occurring with respect to a reference entity. In return, the protection buyer makes periodic payments (known as the premium) to the protection seller until the maturity of the contract or the occurrence of the credit event, whichever is earlier.

• Reference Entity: The specific corporate or sovereign entity against whose credit risk the credit derivative contract is entered into.

5.15.1 Regulatory Conditions for CDS Transactions

Category III AIFs can actively participate in the CDS market as either buyers or sellers, subject to strict prudential guidelines designed to manage risk:

1. Buying Credit Default Swaps (As Protection Buyer)

• Purpose: Category III AIFs are permitted to buy CDS either for the purpose of hedging their underlying debt portfolio or for taking additional credit exposure.
• Leverage Constraint: All CDS purchases made to take additional exposure are strictly subject to the overall permissible scheme leverage limit of 2 times the NAV.

2. Selling Credit Default Swaps (As Protection Seller)

• Leverage Limit: Category III AIFs may sell CDS protection, provided that the effective leverage undertaken at the scheme level remains within the permissible leverage limit of 2 times the NAV.
• Concentration Limit: The total credit exposure to a single investee company, including any synthetic exposure created through selling CDS protection, must remain within the standard AIF investment concentration limits (i.e., 10% of investible funds/NAV for standard schemes and 20% for Large Value Funds).
• Earmarking Liquid Assets: To back their obligations as protection sellers, Category III AIFs must earmark unencumbered Government Bonds or Treasury Bills (T-bills) equal to the full outstanding amount of the CDS exposure.
  • These earmarked liquid assets can be used to maintain the applicable margin requirements for the CDS contract.
  • Crucially, these earmarked assets shall not be considered when computing the total leverage limit of the AIF scheme.

5.15.2 Reporting and Compliance for CDS

• Custodian Reporting: All CDS exposures and transactions executed by a Category III AIF must be reported to the Custodian by the next working day.
• Monitoring Mechanism: The Custodian is required to put in place a robust operational mechanism to collect transaction details from Category III AIFs dealing in CDS. This allows the Custodian to actively monitor compliance with the permissible leverage and concentration limits.
• Breach Obligations: If a transaction in a CDS causes a breach of leverage limits, the primary reporting obligation and the responsibility to take corrective actions vest jointly on the Investment Manager of the AIF and the Custodian.
• Collateral Shortfall: If a Category III AIF has sold CDS protection by earmarking sovereign securities, and the market value of those earmarked securities subsequently falls below the outstanding CDS exposure, the fund is required to immediately top up the collateral pool to maintain full cover.

Key Terms and Concepts for Exam Prep

Independent Risk Function

The mandatory regulatory requirement for leveraged Category III AIFs to separate their risk monitoring operations from the day-to-day fund management team.

Leverage

The total exposure of a fund, including derivative and borrowed positions, divided by its Net Asset Value. For Category III AIFs, this is capped at 2 times the NAV.

Offsetting Positions

Opposite derivative or physical positions in the same underlying index, stock, or commodity that are operationally eligible to net out each other's exposure when calculating total leverage.

Credit Default Swap (CDS)

A credit derivative transaction used to transfer credit risk. Category III AIFs can buy CDS to hedge or sell CDS by earmarking Government Securities as collateral.

💡 Quick Revision Nudge

• Permissible Leverage Limit: Maximum of 2 times the NAV of the scheme.
• Leverage Breach Rectification: Excess exposure must be squared-off by the end of the next working day.
• Breach Notification: Investors must be reported by 10:00 AM on the next working day; Custodian must report to SEBI by 10:00 AM on the next working day.
• Reporting Frequency: Quarterly (within 10 days of the quarter) for non-leveraged funds; Monthly (within 15 days of the month/period) for leveraged funds.
• CDS Reporting: All CDS transactions must be reported to the custodian by the next working day.