Investment Funds Monthly Digest: SEC Strengthens Norms for PE Funds

Investment advisors to a private fund are now required to:

1. Obtain majority consent of unrelated investor prior to allocating expenses associated with an investigation of the advisor; provided that the expenses related to an investigation that results / resulted in a sanction for a violation of the Advisors Act may not be allocated to the private fund;
2. Distribute a written notice to its investors (with the dollar amount) of any expenses charged to the private fund in relation to an examination of the adviser within 45 days of the fiscal quarter end;
3. Distribute a written notice to its investors informing them of the aggregate dollar amount by which an adviser clawback has been reduced by actual / potential taxes (if any) within 45 days of the fiscal quarter end;
4. For adviser to allocate expenses related to a portfolio investment on a non-pro rate basis when multiple entities advised by the adviser are involved, it would have to be:
   1. The non-pro rate charge should be fair and equitable; and
   2. Distribute to each investor a written notice of the non-pro rate charge and how the same is fair and equitable.

    

5. To borrow money / asset or receive a loan / line of credit from a private fund client, the adviser has to:
   1. Distribute to each investor a written notice describing the material terms of such borrowing / loan / credit line etc;
   2. Obtains a majority consent of unrelated investors in writing.

    

1. The AIF Regulations have been recently amended to prohibit investment managers from allocating losses / damages / expenses in incurred by them in relation to the resolution of investor claims in case the AIF is set up as a trust.⁸
2. The AIF Regulations necessitate AIFs to inform investors of any inquires / legal actions by regulatory bodies both within and outside India – as and when such inquires / legal actions arise⁹
3. The AIF Regulations currently do not have a specific provision that require a written notice to investors of reduced clawback due to tax implications however the provisions pertaining to clawback are required to be well-addressed as per the template private placement memorandum (“PPM”) mandated by SEBI.¹⁰
4. SEBI has recently released a consultation paper when seeks to ensure that the fund does not offer terms to any investors that would affect the pro-rata and pari-passu standing of all investors in the blind pool.¹¹ Further, the AIF Regulations provide that in case of co-investments, the terms offered to the manager / sponsor / co-investor should not be more favorable than what is offered to the AIF.¹² The nuances of co-investments have been previously covered by us here.
5. Category I and II AIFs are prohibited from employing leverage other than to meet except for meeting temporary funding requirements (< 30 days).¹³ Further, AIFs are required to annually disclose to its investors, information pertaining to leverage risk both at the fund level and at the portfolio company level.¹⁴

Whereas Category III AIFs are permitted to utilize leverage provided that investors are provided certain additional SEBI mandated disclosures such as the overall level of leverage and level of leverage arising from derivatives.¹⁵

To ensure that the investors in a similar pool of assets or the same fund managed by an investment adviser are not treated unequally, the investment adviser has to ensure that:

1. An investor is not provided an exit from a fund in instances wherein the adviser believes that there would be a material negative effect on the fund unless such an exit is due to a government order or in instances where such a right has been offered to all the investors of the fund.
2. Enhanced information rights regarding the portfolio holdings / exposure of the fund if the adviser believes that the same would have a negative impact on the fund except if such information is offered to all investors;

The investment adviser ought to ensure that a written notice capturing the above information to both current and prospective investors.

SEBI has recently released a consultation paper when seeks to ensure that the fund does not offer terms to any investors that would affect the pro-rata and pari-passu standing of all investors in the blind pool wherein certain differential economic rights may not be offered to select investors. The ramifications of mandating pro-rata / pari passu treatment of all investors are covered here.

Currently, the template PPM necessitates the disclosure (illustrative) of the differential rights offered (if any).

The investment adviser is obligated to ensure that every fund that it advises undertakes a financial audit and that such audited financial statements are distributed to its investors within 120 days of the fiscal year end¹⁸.

The abovementioned annual audit is to be conducted by an independent public accountant and is to be prepared in accordance with US GAAP.

AIFs are required to on an annual basis (within 180 days from year-end) provide investors with financial information of portfolio companies and material risks (and mitigation strategies) as week as undertake an annual audit by a qualified auditor.¹⁹

Investment advisers are required to, within the prescribed timelines, prepare and distribute quarterly statements for funds it advises that have two full fiscal quarters of operating results. This quarterly statement should, inter alia, contain the following:

1. Detailed accounting of expenses paid to the investment adviser;
2. Detailed accounting of expenses paid by or allocated to the fund;
3. Detailed accounting of compensation (if any) paid by the portfolio investments to the investment advisor;
4. Key financial metrics – IRR and MOIC; and
5. A statement of contributions and distributions (in case of an illiquid fund).

It is to be noted that the above disclosures are to be made in plain and concise English.

1. AIFs are required to periodically intimate its investors of fees ascribed to the manager / sponsor and / or fees charged to the AIF by the manager / sponsor;²¹
2. Please refer to point (i) above;
3. The AIF Regulations are currently silent on the disclosures pertaining to compensation received by investment managers from portfolio companies, however, the template PPM requires the investment manager to provide visibility on management fee offsets (if any);
4. AIFs are required to periodically provide the financial information of portfolio companies to investors, however, IRR and MOIC have not been specifically identified;²²
5. Information pertaining to contributions and distributions are provided to the investors in the quarterly reporting format.²³

For undertaking an adviser led secondary the investment adviser is required to:

1. Distribute to its investors a fairness opinion from an independent opinion provider;
2. Distribute to its investors a written summary of any material business relationship that it may have had with the independent opinion provider in the preceding two years.

The AIF Regulations are silent on IM-led secondaries, however, it provides for a liquidation scheme for holding unliquidated investments post the expiry of the AIF’s tenure.²⁵ To ensure fairness in the transfer of unliquidated investments into the liquidation scheme, the AIF Regulations provides that the valuation of such unliquidated investments be done by two independent valuers and the AIF manager arrange for at least 25% bids for the value of such unliquidated investments.²⁶ We have discussed the modalities of liquidation scheme in our previous digest here.

The extant recording keeping rules have been amended by the SEC to necessitate the preparation and retention following:

1. Quarterly statements;
2. Audited financial statements;
3. Fairness opinions (and summary);
4. Notices shared with current and prospective investors in relation to preferential treatment; and
5. Copy of consent document or intimation (as the case may be) shared by / with the investors.

The investment manager is obligated to maintain all the records specified by SEBI which include:

• Minutes of the meetings of decisions to address conflict of interest;²⁸
• Rationales of investment decisions;²⁹
• particulars of investors (including details of their contributions);³⁰ and
• Details of the assets held by the AIF (or the scheme therein).³¹

It is to be noted that SEBI has the right to inspect the AIF’s books of accounts and the onus is on the AIF (and its officers) to produce the same.³² We have also talked about the governance standards applicable to AIFs here.

Presently, the investment advisers are required to annually review and document in writing the adequacy of policies and procedures adopted by the private fund pursuant to the Final Rules.

The master circular for AIFs (“AIF Master Circular”) necessitates a legal audit of PPM to ensure that the AIF is in compliance with the AIF Regulations.³⁴