A consultation paper by the market regulator Securities and Exchange Board of India (SEBI) last week deliberated on some critical matters pertaining to Alternative Investment Funds (AIFs), especially with regard to ‘preferential distribution model’.

It was observed that certain schemes of AIFs have adopted a distribution waterfall in such a manner that one class of investors (junior class/tranche), other than sponsor/manager, share loss more than pro-rata to their holding in the AIF vis-à-vis other classes of investors/unit holders (senior class/tranche), since the latter has priority in distribution of proceeds over former due to priority distribution (PD) model.

Skewed benefits

In case of loss scenario, the senior class investors may be compensated for the loss out of the residual capital of the junior class investors. Similarly, in case of profit scenario, distribution is first made to senior class investors till their hurdle rate is met, and the remaining amount, if any, is distributed to junior class investors.

SEBI was alerted on the potential exploitation of regulatory arbitrage by AIFs utilising the PD model. These funds might be structured in a way that aims to exploit regulatory loopholes to fulfil other compliance requirements. This type of structuring could potentially facilitate the practice of extending loans by regulated lenders (such as banks, non-banking financial companies, and microfinanciers) with the intention of probable ever-greening.

The recognition of deteriorating creditworthiness of the investee company may also get deferred.

In both the scenarios, the pro-rata return of capital to all investors is affected.

These structures lead to a lack of transparency for investors, much like that of collateralised debt obligations (CDOs) did during the 2008 financial crisis, SEBI observed.

Conflict of interest

“Further, considering that AIFs/schemes with PD model are intended to cater to different set of investors with different risk appetite with the same pool of underlying investments, the said structure has significant scope for conflict of interest issues,” SEBI said while differing with most proposals of the working group.

SEBI’s contention is right given that a huge sum is at stake posing systemic risks, too. As of March 31, 2023, AIFs have commitments worth ₹8.33-lakh crore and raised ₹3.65-lakh crore.

“While on one side investor parity needs to be preserved, on the other side certain practicalities arise considering various investor strata. Both need to be balanced to ensure optimum governance level yet keeping the required pragmatism,” Madhu Lunawat, CIO, India Inflection Opportunity Fund.

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