Private Funds: Corpus v Investible Funds – Need to reconsider SEBI’s penalty order?

Background

An Adjudicating Officer of the Securities and Exchange Board of India (“SEBI”) recently passed an order in the matter of Indgrowth Capital Fund – I (the “Indgrowth Fund”), which reflects the regulator’s thinking on the concept of ‘investible funds’ under the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (the “AIF Regulations”). As set out in this piece, SEBI has taken the position that the term ‘investible funds’ must be strictly construed, leaving no scope for commercial nuances.

Significance of ‘investible funds’

Regulation 2(1)(p) of the AIF Regulations defines “investible funds” to mean the “corpus” of the fund net of expenditure for administration and management of the fund estimated for the tenure of the fund. Regulation 2(1)(h) defines “corpus” to mean the total amount of funds committed by investors to the fund by way of a written contract as on a particular date i.e. the aggregate of capital commitments raised by the fund. The significance of these terms becomes apparent when one considers the regulatory framework applicable to AIFs.

Under the AIF Regulations, Category I and II AIFs are restricted from investing more than 25% of investible funds in a single investee company; the corresponding restriction for Category III AIFs is 10%.¹ This regulatory superimposition of diversity requirements (which is not common in the popular private fund jurisdictions) seems to have been introduced to prevent overconcentration of fund commitments in a single asset. Viewed in this context, it appears that SEBI drew a distinction between the terms ‘corpus’ and ‘investible funds’ to make it clear that not all capital commitments would be available for investment.

The Indgrowth Case

The Indgrowth Fund is a close-ended Category III AIF managed by Indgrowth Capital Advisors LLP (“Indgrowth Capital”). The Indgrowth Fund made an investment of ₹44.99 crores in an investee company called Ugro Capital Limited (“Ugro”). During the relevant years, Indgrowth Capital disclosed a corpus of ₹476 crores and investible funds of ₹456.76 crores, which implied that its estimated expenditure for administration and management of the fund was approximately ₹20 crores. If Indgrowth Capital’s calculation of investible funds was correct, then its investment in Ugro would have been in compliance with the diversity requirements for a Category III AIF.

However, when SEBI examined the affairs of the Indgrowth Fund more closely, it discovered that the estimated expenditure was actually ₹42.28 crores, which Indgrowth Capital had reduced by estimated dividend income and estimated income from temporary investments aggregating to approximately ₹22 crores. The SEBI Adjudicating Officer ultimately held that Indgrowth Fund’s investment in Ugro had violated the diversity requirements under the AIF Regulations. It is worth mentioning that the different methodology adopted for calculating ‘investible funds’ by Indgrowth Capital and SEBI resulted in an insignificant delta of ₹1.58 crores.

Two Competing Theoretical Frameworks

The principal question that arose for consideration was whether it was appropriate for Indgrowth Capital to effectively set off its estimated expenditure against estimated income streams arising in the form of dividends from portfolio companies as well as returns from temporary investments. Whilst the Adjudicating Officer seems to have answered this question in the negative, it is worth examining the theoretical framework underpinning each side of the argument.

1. Estimated expenditure should not include expenditure funded out of investment returns

When an investor makes a commitment to an AIF, it expects that all (or substantially all) of its capital will be deployed towards investments by the fund since this represents the best possibility for the investor to maximise its returns. In such circumstances, a commercial arrangement that provides for the payment of fund expenses out of returns arising from short-term (or temporary) investments may well be in the best interests of the investors since it allows a larger chunk of commitments to be applied towards the portfolio investments of the fund. Where such an arrangement is in place, the proportion of expenditure that an investor will be required to directly fund through capital contributions is likely to reduce. It therefore makes sense that such expenditure that is likely to be funded other than by way of direct capital contributions from an investor should be excluded from the estimated expenditure.

2. Investors should not be exposed to the risk of capital being concentrated in a single investee company

The opposite view is premised on investor protection i.e., no investor should be required to take disproportionate exposure to a single investee company beyond the limits permitted under the AIF Regulations. Under this view, the investible funds of an AIF is a static figure. The existence of a contractual arrangement permitting fund expenses to be defrayed against returns from short-term investments should not detract from the strict diversity limits calculated for an AIF. In any event, the practice of parking of capital in temporary investments is neither free from risk nor guaranteed to generate returns. As such, the strict diversity limits tend to discipline the operations of AIFs. In such circumstances, it is not prudent to invoke variables (such as estimated income from short-term investments) to interfere with such strict diversity limits.

Conclusion

In the dynamic world of securities regulation, it is generally accepted that it is not possible to legislate for every possible eventuality. Legislation (or more correctly, secondary legislation) in this sphere should therefore be given a purposive interpretation, allowing commercial nuances to be factored in. One may ultimately disagree with the particulars that were subtracted from the estimated expenditure in the Indgrowth case. For instance, one may conclude that it may not have been appropriate for estimated expenditure to be reduced by estimated dividend income from portfolio companies. The point, however, is that such an analysis is vastly different from the strict construction approach that was adopted by the SEBI Adjudicating Officer to preliminarily rule out the possibility for any set-off against estimated expenditure.

AIFs were intended to be a more sophisticated asset class than, say, mutual funds. After all, the entry point for most AIF investors is a minimum capital commitment of ₹1 crore. As the key stakeholders in an AIF are all ‘big boys’, it is scarcely appropriate to adopt a paternalistic approach to investor protection when dealing with AIFs.

¹ See Regulations 15(1)(c) and (d) of the AIF Regulations. The diversity requirement for large value funds for accredited investors is 50% in the case of Category I and II AIFs and 20% in the case of Category III AIFs. It is also worth noting that the original AIF Regulations had pegged these diversity restrictions to the “corpus” of an AIF rather than “investible funds”.