SEBI formalises the use of coinvestments but leaves some question marks

Through a series of amendments to the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (the “AIF Regulations”) and the Securities and Exchange Board of India (Portfolio Managers) Regulations, 2020 (the “PM Regulations”), the Securities and Exchange Board of India (“SEBI”) has formalised the use of co- investments alongside an alternative investment fund (“AIF”). Although there was no specific bar on co-investments under the AIF Regulations, fund sponsors quickly discovered that they likely needed to obtain an additional licence to advise / manage a co-investment. Further, there was little prospect of aggregating capital from various co-investors into a single vehicle since doing so may have tantamounted to “pooling” of funds and triggered a requirement to register as an AIF, which in turn would have meant being subject to the diversification restrictions.

Against this backdrop, the co-investment framework introduced by the amendments to the AIF Regulations and the PM Regulations removes some of the uncertainty around co- investments and creates a pathway for co-investments in the private funds space.

Background

Co-investments are multi- purpose instruments that not only helps sponsors with capital management but also enables investors to invest a part of their capital on a low-cost basis. With the rollout of the “accredited investor” concept, it was hoped that SEBI might withdraw the diversification requirement for funds comprising accredited investors, thereby paving the way for the use of dedicated co-investment vehicles to invest alongside the primary fund. Whilst there was some movement in this regard (with the introduction of the concept of a “large value fund for accredited investors”), SEBI did not entirely lift the diversification limit.3 Consequently, it was left to SEBI to craft a special regime for co-investments.

Summary of the Amendments The new co-investment regime introduced by SEBI involves coordinated amendments to the AIF Regulations and the PM Regulations and as such, it is worth examining these together.

I. Investment Conditions

Amendments to both sets of regulations have laid down the following key aspects relating to the operation of co-investments:

1. the terms of Co-Investment in an investee company by a manager or sponsor or co- investor shall not be more favourable than the terms of investment of the AIF; and
2. the terms of exit from the Co-Investment in an investee company (including timing of exit) shall be identical to the terms on which the AIF exits its investment in the investee company.

It is also worth noting that SEBI has grandfathered the exit terms of co-investment arrangements entered into prior to the amendments.

II. Co-Investment

The amendments have defined the term ‘Co-Investment’ as follows:

“Co-investment means investment made by a Manager or Sponsor or investor of Category I and II Alternative Investment Fund(s) in investee companies where such Category I or Category II Alternative Investment Fund(s) make investments:

Provided that Co-investments by investors of Alternative Investment Fund shall be through a Co-investment Portfolio Manager as specified under the Securities and Exchange Board of India (Portfolio Managers) Regulation, 2020.”

Two things emerge from this definition: (1) a co-investment can be made by the manager, the sponsor or the investors of a Category I or II AIF; and (2) where a co-investment is proposed to be made by investors of an AIF, such co-investment must be made through a co-investment portfolio manager.

III. Co-Investment Portfolio Manager

The manager of a Category I or II AIF may act as the CIPM to the investors of the AIF as long as the investments are made in unlisted securities of investee companies in which the AIF is invested. Further, the CIPM may also provide similar services to investors of other Category I or II AIFs which share a common manager and sponsor.

The definition of a CIPM is as follows:

“Co- Investment Portfolio Manager means a Portfolio Manager who is a Manager of a Category I or II Alternative Investment Fund(s); and:

1. (i) provides services only to the investors of such Category I or II Alternative Investment Fund(s); and
2. (ii) makes investments only in unlisted securities of investee companies where such Category I or II Alternative Investment Fund(s) make investments:

Provided that the Co-investment Portfolio Manager may provide services to investors from any other Category I or Category II Alternative Investment Fund(s) which are managed by them and are also sponsored by the same Sponsor(s).”

IV. Qualification Requirement for CIPM

An applicant for a portfolio manager licence is required to meet certain eligibility criteria including with respect to ‘experience’ and ‘professional qualification’. Given that the manager of an AIF and the CIPM are the same entity and will operate in tandem, the amendments to the PM Regulations have streamlined the application process for CIPMs by effectively disapplying the ‘experience’ and ‘professional qualification’ requirements under the PM Regulations for CIPM applicants. In other words, as long as the key investment team of the manager of an AIF is fulfilling the ‘experience’ and ‘professional qualification’ requirements under the AIF Regulations, the CIPM applicant will not be required to separately fulfil the corresponding criteria under the PM Regulations.

V. No Net Worth Requirement

Similarly, the requirement for portfolio managers to have and maintain a minimum net worth of ₹5 crores does not apply to CIPMs (presumable because managers of AIFs are not under any obligation to maintain a minimum net worth).

VI. Restriction on advisory services by AIF Managers

Where an AIF manager proposes to offer co-investment opportunities, it will need to apply for registration as a CIPM. In such circumstances, the AIF manager is not permitted to provide advisory services to any person who is not a client of the CIPM with respect to any investment in an investee company in which the AIF makes investments.

VII. Waiver from requirement to appoint a custodian

The general requirement for portfolio managers to appoint a custodian does not extend to CIPMs.

Analysis of the Co-Investment Framework

A few aspects of the new Co-Investment framework merit a closer examination as they point to certain structural and commercial issues that may crop up during the rollout of the framework. These are set out below.

Structural Limitations

CIPMs are a class of ‘portfolio managers’ and fall within the purview of the PM Regulations. Under the scheme of the PM Regulations, it is the client that ultimately holds the investments and not the portfolio manager. This poses a few challenges from a commercial perspective. First, some investors may not actually want to take direct exposure to certain kinds of securities. Second, the scheme seems to preclude the use of aggregator or collect vehicles, which may result in the administration of portfolio holdings becoming scattered and unwieldy.

The diagram below illustrates the structural limitations under the new Co-Investment Framework.

Limited Co-Investor Base

Whilst co-investment opportunities are generally offered to existing fund investors, sponsors may, on occasion, invite a third party to co-invest for strategic reasons. For instance, the sponsor may be looking to tap the third party as a lead investor in a future fundraising. Another common scenario is where the third party has been crucial to the deal becoming available to the sponsor. However, the newly introduced Co-Investment framework would seem to exclude such third parties from participating in co-investment opportunities.

Under the new co-investment framework, a CIPM may, in addition to the investors of the primary AIF, provide services to investors of other Category I or II AIFs that share a common manager and sponsor as the primary AIF. It is currently unclear whether this only means that a CIPM may provide co-investment opportunities in respect of multiple funds having a common manager and sponsor or whether it includes the possibility of an investor in one AIF participating in a co-investment opportunity offered in respect of another AIF in which it is not an investor. Either way, third party investors are shut off from the co-investor base.

The diagram below highlights the uncertainty around the scope of co-investor participation under the new framework.

Restricted Securities List

The Co-Investment framework permits a CIPM to invest exclusively in “unlisted securities”,¹ whereas Category I and II AIFs are permitted to invest in a broader range of instruments. For example, Category II AIFs are permitted to take exposure to listed companies. It is not immediately clear why SEBI would draw a distinction between listed and unlisted securities as far as co-investments are concerned or whether there is in fact any reasonable basis to this distinction. Commercially, this is a significant restriction since it precludes the use of co- investments in listed debt, which is a popular investment structure for private funds. It also means that capital raised from co-investors cannot be used in ‘take-private’ transactions.

Issues relating to Syndication

As mentioned above, the amendments to the AIF Regulations and the PM Regulations crystallise two key operating principles of co-investments: (i) the terms of the coinvestment in an investee company must not be more favourable than those of the AIF; and (ii) the co- investment in an investee company and the AIF’s investment in the same investee company must operate in tandem (including with respect to the terms and timing of exit). These principles may come under pressure in some scenarios.

For instance, it is not always necessary that the AIF and the co-investors will deploy funds into the investee company at the same time. Often, the AIF will first complete the investment and then syndicate portions of the investment to co-investors over multiple rounds. At the second (or further) round of syndication, there is already a set of co-investors in play. It is unlikely to be the commercial intention for this initial set of co-investors to participate in the syndication process. However, not doing so may trip the requirement that the terms of exit (including timing) of a co-investment should be identical to that of the AIF.

To take another example, there may be a scenario in which the manager requires a co- investor to take up a larger chunk of the co-investment opportunity than the coinvestor actually wishes to take exposure to on the understanding that a portion of the initial chunk will subsequently be sold down to other co-investors. Such an arrangement would also fall foul of the requirement that the terms and timing of the exit of the coinvestment must be identical to that of the AIF.

The AOP Tax Risk

Under the Income Tax Act, 1961 (the “Tax Act”), an ‘association of persons’ (“AOP”) is a distinct taxable entity. Although the Tax Act does not specifically define an AOP, the Indian courts have held that the critical determining factor of an AOP is whether persons have joined in a common purpose or common action with the object of producing income. An AOP is taxed at the AOP level and the individual constituents of the AOP are not taxed separately.

The risk lies in the co-investors and the AIF being regarded as an AOP by the tax authorities on the basis that the co-investors and the AIF are both joined in a common purpose. If such a determination is made by the tax authorities, it would upend the current tax framework, which grants pass-through status to Category I and Category II AIFs. The likelihood of this risk may increase in circumstances where a co-investment agreement (or a parallel investment agreement) is put in place to coordinate the terms on which the AIF and the co- investors will interact with each other.

Onerous Disclosure Requirements

Investors of an AIF are given the opportunity to read and review a Placement Memorandum, which contains extensive disclosures. The amended regulations provide an additional obligation on the CIPM to provide a copy of the ‘Disclosure Document’ to each client (i.e. the co-investor) before concluding a written agreement with such client. Given the disclosures already being provided in the Placement Memorandum, it seems redundant and cumbersome to provide these additional disclosures.

Conclusion

The new Co-Investment Framework is a welcome development since it opens the doors for more capital deployment in India. The positive is that, theoretically, the rollout of a formal framework could encourage both sponsors and investors to use co-investments regularly. However, there may be some practical issues that could jeopardise the seamless integration of co-investments with AIF operations. These include the AOP tax risk, restrictions on third party co-investors, structuring limitations and syndication concerns. These aspects need to be ironed out before the many benefits of coinvestments are unlocked.

The future of co-investments and their role in the private funds space more generally will depend on how the framework evolves in the near future. Whilst SEBI is unlikely to adopt a ‘hands-off’, ‘light-touch’ approach to co-investments after having crafted such a detailed framework, it might be helpful for the regulator to proactively offer clarifications on operational issues with a view to settling uncertainty and boosting confidence in the use of co-investments.

¹As per SEBI FAQ dated 28.10.2020, “unlisted securities” for investment by portfolio managers includes units of Alternative Investment Funds (AIFs), Real Estate Investment Trusts (REITs), Infrastructure Investment Trusts (InvITs), debt securities, shares, warrants, etc. which are not listed on any recognized stock exchanges in India. Available at https://www.sebi.gov.in/sebi_data/faqfiles/oct2020/1603946323909.pdf