The Securities and Exchange Board of India (SEBI) vide the SEBI (Alternative Investment Funds) (Fifth Amendment) Regulations, 2024 (Amendment Regulations) notified on November 18, 2024, amended Regulation 19B and Regulation 20 of the SEBI (Alternative Investment Funds) Regulations, 2012 (AIF Regulations). Under the new sub-regulation 21 of Regulation 20, rights of the investors of a scheme of an Alternative Investment Fund (AIF) shall be pro-rata to their commitment to the scheme, in each investment of the scheme and in distribution of proceeds of such investment. The aforementioned restriction would not be applicable to angel funds.
In addition, the aforementioned restriction would not be applicable in terms of its circular dated December 13, 2024 (Circular) if an investor: (i) has been excluded/excused from participating in the investment; or (ii) has defaulted in providing pro-rata contribution to the investment. Distribution of proceeds of an AIF scheme are not required to be undertaken on pro-rata basis if the investor will be sharing returns or profits with the manager or sponsor.
Additionally, certain entities such as manager/sponsor of AIF, multilateral or bilaterial development financial institutions, state industrial development corporations, or entities owned or controlled by central or state government, government of foreign country (including central banks and sovereign wealth funds) may accept lesser returns or share losses more than their pro-rata rights in investment. This would permit an AIF to issue classes of units which are subordinate to other classes of units to such entities. However, if a manager/sponsor of AIF subscribes to subordinate classes of units of an AIF, then investee company cannot use the amount invested by AIF to repay its obligations or liabilities towards manager/sponsor of AIF or their associates.
In terms of the Circular, for schemes of an AIF: (i) issued prior to the notification of the Amendment Regulations i.e. prior to November 18, 2024, where rights of investors are not pro-rata to their commitments to the scheme and are not subject to exemptions by SEBI; or (ii) issued prior to November 23, 2022 that have adopted a priority distribution model (i.e. have issued senior or junior/subordinate classes of units), will now not be allowed to accept any fresh commitments or make investments in any new investee company (directly or indirectly). If such existing schemes breach the investment limits under AIF Regulations to ensure compliance with this rule, then this shall be recorded in the compliance test report by the manager and the breach will not be considered a non-compliance of AIF Regulations.
The new sub-regulation 22 of Regulation 20 states that the rights of the investors of a scheme of an AIF other than those specified in Regulation 20(21) of AIF Regulations, shall be pari-passu in all aspects. Moreover, instead of pari-passu rights, differential rights (DR) may also be offered to select investors of the scheme according to the directions of SEBI, on the condition that such rights do not affect the interests of other investors of the scheme. Accordingly, SEBI has specified following guidelines for issuance of DR:
- investor receiving DR to not bear liability accrued/accruing to other investors;
- DR should not provide an investor with control to make decisions of AIF/scheme of an AIF unless the investor or its nominee is part of the AIF investment committee;
- rights of other investors under their respective agreements should not be altered; and
- details of the DR and eligibility to avail DR should be disclosed in the private placement memorandum (PPM) of AIF/ scheme of AIF.
Standard setting forum of AIF (SFA) is required to, in consultation with SEBI, formulate an implementation standard to prescribe the list of specific DR that may be offered. Whenever necessary, such list will be reviewed and updated.
AIF, manager of AIFs and their key managerial personnel to ensure that: (i) DR is issued in accordance with SFA’s implementation standards; and (ii) the eligibility criteria to hold DR and any investor meeting such criteria may opt for DR is disclosed in the PPM.
Large value funds (LVFs) for accredited investors whose PPMs are filed post December 13, 2024 may be exempted from maintaining pari-passu rights if: (i) appropriate disclosure in this regard is made in PPM; and (ii) an undertaking is obtained from each of the accredited investors (under paragraph 4.1 of Annexure 8 of SEBI master circular for AIF) at the time of their onboarding ensuring that each investor is aware that LVF may obtain exemption from providing pari-passu rights to investors and issue DR which may affect rights of other investors. Even existing LVFs may avail this exemption if each investor gives the waiver required under (ii) above.
For existing schemes of an AIF which already issued DR to investors through separate classes of units or side letters/arrangements were required to disclose the DR in their PPM as per the standard template for PPMs (prescribed by SEBI in its circular dated February 05, 2024) and that the DR will not have any adverse impact on rights of other investors. Such AIFs whose PPMs have been filed with SEBI post March 01, 2020, shall report to SEBI (in the format given under Annexure I of the Circular) details of DRs which do not fall within the implementation standards formulated by SFA. Additionally, if any such reportable DR affects the rights of other investors, manager must immediately terminate/discontinue such DR.
Conclusion:
The Amendment Regulations and the Circular aim to bring in transparency and fairness to the rights of the investors while also extending flexibility to select investors. The Circular provides much needed clarity on issue of subordinate classes of units and DR to the investors by AIFs.