How Sebi is all set to make AIFs more investor-friendly

AIFs—an investment avenue for high net worth individuals that has so far enjoyed light-touch regulation—are privately pooled investment vehicles that collect funds from sophisticated investors, requiring a minimum investment of ₹1 crore in most cases. They are governed by Sebi regulations and are classified under three categories - I, II, or III (see graphic).

What’s coming?

Sebi’s first and most significant proposal is that all AIFs be mandated to offer investors a lower-cost direct plan option that does not include any distribution or placement fees. The AIF Regulations of 2012 support direct plans, but this is optional. As a result, there are hardly any AIFs that offer them.

Second, Sebi wants AIFs to adopt the trail model of commissions (wherein commissions are paid over a period of time) for distributors, instead of the widely prevalent upfront payment of commissions which have resulted in widespread mis-selling of the schemes. According to one industry person who did not wish to be named, distributors are now rushing to push AIF schemes that have large upfront commissions before Sebi’s proposals turn into regulations.

Current AIF regulations do not have any restrictions on the extent of commissions that can be paid upfront. Sebi’s moves are set to bring AIFs on a par with mutual funds (MFs) and portfolio management services (PMS)– both of which have to offer direct plans and follow the trail model of commissions.

Third, Sebi has also proposed mandatory dematerialization of AIF scheme units—conversion of securities held in physical paper form into electronic form—to enable investors to conveniently track them. This is to be implemented in phases, with AIFs having corpus of over ₹500 crore offering the demat format by 1 April 2024.

Fourth, to provide AIFs with an additional option in situations where they are unable to encash illiquid investments, Sebi has proposed that such investments be transferred to a new scheme, with investor approval.

Direct plans, trail commissions

At present, in the absence of direct plans, irrespective of whether you invest in an AIF scheme via a distributor or directly through an AIF, there is no cost difference. In the latter case, the fund retains the amount that would have been paid to the distributor. Those investing in AIFs based on advice from financial advisors end up being charged twice—by way of advisory fees, and for AIF distribution fees. Once direct plans are introduced, those investing in such plans will not have to bear the distribution cost. Sebi has proposed that AIFs must ensure that any investor coming to them via investment advisors must invest only via the direct plan route.

Munish Randev, founder & CEO, Cervin Family Office & Advisors, says that the key thing to watch out for is whether the difference between the regular and direct plans will truly reflect what was being paid to distributors or placement agents. For Dipen Ruparelia, head- products, Vivriti Asset Management, Sebi’s proposal that AIF direct plan investors be given a higher number of units (to account for lower expense) instead of a lower NAV may result in operational challenges for investors and AIF managers. “Just like in mutual funds where regular plan and direct plan investors have two different sets of NAVs, the same can be done for AIF investors".

On the issue of upfront distribution commissions, the Sebi paper notes that in some cases, these have gone up to around 4-5% of the committed amount (total money that an investor has committed to invest in a scheme over time, in tranches). When contrasted with other products such as MFs and PMSes that have trail commissions, the existence of large upfront commissions provides an incentive for the mis-selling of AIFs. This is similar to earlier instances of close-ended MF products where such commissions played a strong role in garnering new investors. “There was 3-4% exit fee. Hence, chances were high that investors won’t exit once they had invested, thereby allowing upfront commissions to be paid. Similarly large upfront commissions are providing an incentive to push certain AIF products" says Randev. Typically, these are paid upfront out of the management fees that will be collected from investors over time. In some cases, distributors also get a cut from the set-up fee (see graphic).

To curb this practice, Sebi has proposed the trail model of distribution commission for category III AIFs. For the other two categories, the regulator has suggested some leeway. To incentivize investments into category I and II funds (that in turn invest in privately owned companies), one-third of the total distribution fees may be paid upfront with the rest on a trail basis. “Category III is relatively small. Category II which is close to ₹ 5.6 trillion in size (commitments raised) is where most of the mis-selling is happening. My view is that having only trail commissions here will change the entire marketing game and introduce an even-playing field," says Randev.

Dematerialization of units

Unlike MFs where investors hold their units in demat form, an overwhelming majority of AIF scheme investors hold units in physical form. Dematerialization will make it easier for investors to keep track of their AIF investments as it will form part of their consolidated account statement (CAS) from the depositories, CDSL or NSDL. Most importantly, transmission of the AIF units to the next of kin on the death of an investor will become easier.

Today, AIF units can be transferred from one investor to another only with the investment manager’s approval. With dematerialization, this process is expected to become easier. Randev, however, highlights an important point in this context. “Despite dematerialization, the transfer is likely to be a controlled process that will involve the fund manager." He draws similarities with how it is for startups that have demat shares. “These shares are not freely transferable and are subject to certain restrictions from the founders, or subject to approval from the company whose shares are being sold. I am assuming a similar process will apply to AIF units," says Randev.

According to Ruparelia, the logical next step to dematerialization of AIF units will be their listing. That will give investors in close-ended schemes an easier exit route in the secondary market.

Illiquid investments

While AIFs can invest in listed securities, a significant proportion invest in privately held companies. In certain situations, say, when an AIF is unable to exit an investment, the fund may be unable to return investor money even on expiry of its tenure. Current regulations do give AIFs a few options to deal with illiquid investments. The AIF can extend a scheme’s tenure by up to two years (one year at a time) with approval from two-thirds of investors. Alternatively, the AIF assets may be disbursed after approval from at least 75% of investors. If neither option works, or if the two-year extension is completed with no approval for distribution, then the AIF has to fully liquidate the scheme within a year’s time.

Sebi has now proposed a third option —transferring the illiquid investments to a new scheme, subject to conditions, including consent from 75% of investors. It has laid out several conditions relating to valuation of investments to ensure that investors are not short-changed.

A few questions, however, remain unanswered. What will be the fees, and the tax implications of the transferred investments? “Ideally investors should not be charged the full management fee for these investments, but there are operational costs that will have to be incurred. This is open to discussion," says Rohan Paranjpe, managing director, head-alternative investments, Waterfield Advisors..

Once Sebi’s latest proposals translate into regulations, AIF investors are set for a complete overhaul of their investing experience.