Checking Before Investing, and Governing After

Checking Before Investing, and Governing After

This chapter has two halves. The first is about the deal: how the manager checks a company before putting money in, and which agreements it signs. The second is about the fund: who watches the manager, and what rules the manager must follow.

11.1 Investor Due Diligence (IDD)

Investor Due Diligence (IDD), also called due diligence review (DDR), is the due diligence performed by the AIF's investment manager on the potential investee company before firming up the investment. Note the direction — the manager checks the company, even though the name says "investor".

When does it start? The due diligence process does not commence unless the term sheet is executed by both parties.

It is a comprehensive examination into the facts, representations and affairs of the company, so that the manager can take an informed decision. It has three parts:

How it runs

1. The company shares detailed confidential information in a virtual data room — memorandum and articles, board minutes, books of account, tax returns, invoices, payroll, statutory filings, property agreements, IP documents, employee lists and contracts, segment financials and historical audited financials.
2. The team schedules discussions with company officials, and holds follow-up calls with executive and non-executive management (supervised by the investment bankers).
3. The deal team brainstorms the critical issues needed to fine-tune the deal structure or conditions precedent.
4. The agency gives the manager a confidential report. A copy is generally not given to the company — at most, an extract for clarification, or a separate observation list from the manager.
5. The team refines the financial model with more realistic assumptions — price, volume, raw material cost, branches, customers, renewal rates, fixed versus variable costs.
6. This may lead to re-negotiation — revised valuation, stronger representations and warranties from founders and key management.
7. The final term sheet, executed again between the parties, becomes the basis for legal documentation.

11.2 Definitive agreements

Definitive agreements are the binding agreements signed between the investee company and the investment manager representing the AIF to complete the investment.

Points to remember:

• Where the promoter owns all the shares or controls the others, a combined SSA including SHA provisions may be used.
• Avoid multiple SHAs with conflicting terms — amend existing ones. Usually the latest agreement with all shareholder signatures supersedes all previous ones.
• The Articles of Association of the investee company are amended to include the SHA provisions so that it is enforceable.
• Other documents may include management contracts with the key team, additional financing agreements and undertakings from founders.

11.3 Governance of the fund

The regulation

The AIF Regulations say "the sponsor and manager of the AIF shall act in a fiduciary capacity towards its investors and shall disclose to the investors all conflicts of interests as and when they arise or seem likely to arise." The manager must have written policies and procedures to identify, monitor and appropriately mitigate conflicts of interest, and managers and sponsors must follow SEBI's high level principles on avoidance of conflicts with associated persons.

11.3.1 Why fund governance matters

At its simplest, fund governance means the control structure within which funds are managed, directed and controlled. Its central themes: manager oversight, outsourced independent valuation, segregation of functions, absence of conflicts of interest, and increased transparency and reporting.

• AIFs take unsystematic risk with investors' money, and investors are mostly institutions, family offices and HNIs taking concentrated risks.
• The governance framework includes service providers — custodians, prime brokers, administrators, investment advisors and distributors — and investors may even see the regulator of the fund's domicile as part of it.
• Written policies are not enough. Good governance needs a culture in which investors' interests are of primary importance, helped by an oversight board with sufficient independence, commitment and knowledge.
• It includes stewardship: SEBI has mandated stewardship responsibilities for all AIFs for investments in listed companies — monitoring and engaging on performance, strategy, corporate governance, ESG, capital structure — through discussions, board interaction and voting.
• Side letters and MFN: the sponsor and manager should regularise MFN provisions so that investors are not given special rights arbitrarily. An MFN provision entitles an investor to elect the benefit of rights in other investors' side letters, and potentially to view them.

11.3.2 The structure

In a trust-based fund, governance centres on the AIF trust, the investment management company (AMC) and the trustee.

The manager's obligations under the AIF Regulations:

1. Address all investor complaints
2. Provide SEBI any information it seeks
3. Maintain all records SEBI specifies
4. Take all steps to address conflicts of interest
5. Ensure transparency and disclosure

The manager files a Compliance Test Report (CTR) at the end of every financial year. The AMC's board supervises investment management; the trustee administers trust matters.

11.3.3 The Investment Committee (IC)

The manager is responsible for investment decisions. It may constitute an Investment Committee to approve them, subject to four conditions:

1. The manager may constitute an IC.
2. IC members are responsible for the decisions and for compliance with the AIF Regulations — except in a Large Value Fund, or an AIF where each investor (other than the manager, sponsor, and employees/directors) has committed at least ₹70 crore and has given a waiver.
3. IC members abide by the fund's Code of Conduct.
4. External members not named in the PPM or fund documents at on-boarding can be appointed only with consent of at least 75% of investors by value. No consent is needed to change ex-officio external members (such as the sponsor, sponsor group, manager group, or investors in their official capacity).

What a proposal to the IC contains: executive summary, company overview, market and industry overview, financial overview, risks and key areas of due diligence, valuation overview (comparables, precedent transactions, DCF, multiples), exit strategy, deal structure and term sheet conditions, recommendations and proposed size.

The IC tests each proposal on three things: (a) fit with the scheme's primary investment theme; (b) performance, risk profile and management of the portfolio; (c) fund-level risk concentration and compatibility with return potential. The IC has internal members and external independent members who are not in day-to-day management, to prevent conflicts.

Residency: to process registration and scheme launch, external IC members must be resident Indian citizens. Where they are non-resident Indian citizens, applications are processed only after clarifications from the Government and RBI.

11.3.4 Investor Advisory Committee

Not mandatory in India. Made up of a majority of investor representatives as a check and balance. It gives informed guidance to the manager or IC on conflict resolution, risk management, governance, investor-manager relations, reporting, statutory or tax issues, and even administrative issues in fund documents.

11.3.5 The AMC's board

The board (or designated partners) of the manager must:

• Ensure the PPM and periodic reports comply with law and all conflicts are addressed
• Ensure the team is not just compliant but acts as a fiduciary
• Approve reasonable, industry-standard terms for service providers chosen on competence and a competitive search, with no conflicts
• Review reports from the team and auditors independently
• Deliberate investment proposals and check fit with the scheme's objectives
• Set director remuneration commensurate with roles
• Adopt a policy to avoid related party transactions
• Monitor performance, portfolio, strategy, team contribution, HR, audit, reporting, compliance and investor engagement — on an ongoing basis, not only at board meetings

11.3.6 Conflicts of interest

The sponsor or manager must: identify potential conflicts; enforce high level principles; obtain investor consent, particularly for investments involving associates; disclose conflicts as and when they arise; and maintain written policies and a Conflict of Interest Register.

SEBI's stewardship circular lists ways to handle conflicts: blanket bans on some investments; a Conflict of Interest Committee; segregating voting from client relations and sales; a recusal policy; minutes of decisions; and periodic review and public disclosure.

11.3.7 Grievances and disputes

Under the SEBI (Facilitation of Grievance Redressal Mechanism) (Amendment) Regulations, 2023, AIF managers shall redress investor grievances within 21 calendar days from receipt.

A second-review complaint is closed only when SEBI disposes or closes it. AIFs must enrol on the ODR Portal and link to it on their website and app home page. And for a trust: no loss, damage or expense of the manager, including resolving investor disputes, can be met out of the trust property.

11.4 People and conflicts

The manager must avoid conflicts by: internal policies, Chinese walls for confidentiality, regular training, and due care in selecting outsourcing companies.

Examples of alignment of interest the workbook gives:

• List other fund management activities, beyond the minimum sponsor commitment, to show time dedicated to the fund
• Do not set up a new scheme with similar targets until the current scheme's investment period ends or its capital is substantially invested
• Achieve first close within a reasonable time after filing the PPM — do not wait for the 12 months permitted
• Equal treatment of investors; a side letter needs objective justification
• Disclose management fees and performance fees with the basis of calculation and clawback triggers
• Reinvestment of sale proceeds cannot exceed the capital invested in the asset that produced them
• Disclose any fees paid by portfolio companies to the manager or affiliates
• Refrain from co-investing in deals that may create conflicts with investors
• Annual and quarterly reports to investors

11.5 Co-investment

In a co-investment, an AIF's investors invest directly in an investee company alongside the fund. It suits large institutional and offshore investors who want control over selection and lower fees. Globally and in India, blind pools are making way for hybrid structures.

• Earlier route: a Co-investment Portfolio Manager under the SEBI (Portfolio Managers) Regulations, 2020 — which meant the manager needed an additional PMS registration.
• New alternative route: Category I and II AIFs can offer co-investment to accredited investors through a separate co-investment scheme (CIV scheme) within the AIF Regulations, in addition to the PMS route.
• Terms of co-investment shall not be more favourable than the AIF's terms, and exit terms, including timing, shall be identical to the AIF's.

11.6 Code of Conduct

It binds the manager and its key management personnel (KMP). KMP means: members of the key investment team named in the PPM; employees involved in decision making — such as MD, CEO, CIO, whole-time directors or equivalent; and anyone the AIF or manager declares as KMP. All KMP are named in the PPM; any change is intimated to investors and SEBI.

The code (items a to n) requires, among other things: abide by the law; integrity; due diligence and independent judgement; act as a fiduciary; follow conflict policies; no misleading statements about qualifications or achievements; record key decisions in writing with justification; give the valuer non-misleading inputs; no trades without a real change in beneficial interest (except for bona fide reasons); confidentiality; no inducements; document deal correspondence; deal fairly with investee companies; and keep their information confidential.

A separate code applies to IC members, trustees, trustee company directors and directors/designated partners of the AIF: integrity and due diligence; timely disclosure of conflicts and recusal; confidentiality; and no unethical practice, gross negligence or fraud.

The Investor Charter and the Code of Conduct are interconnected — the charter tells investors their rights; the code makes the manager behave in a way that upholds them.

11.7 Best practices

• A Supervisory Committee meeting at least once a year — for valuation of large assets, governance and conflicts. Its resolutions cannot replace mandatory investor consent.
• Identify key persons and take keyman insurance and indemnity insurance.
• A clearly defined investment strategy — jurisdictions, maximum per investment, concentration limits, excluded sectors.
• Not just one investment instrument — choose case by case.
• Assess the full value chain, including ESG risks, and design incentives for the target's management tied to exit returns.

Cyber Security and Cyber Resilience Framework (CSCRF)

AIFs need robust cyber security as part of operational risk management. CSCRF is graded, with five categories of regulated entities: MIIs, Qualified REs, Mid-size REs, Small-size REs and Self-certification REs.

• Categorised at manager level, not fund level — and VCF corpus is included if the same manager runs VCFs.
• Category is fixed at the start of the financial year on the previous year's data, and stays for the whole year.
• Self-certification REs with fewer than 100 clients are exempt from the mandatory Market-SOC (M-SOC).
• SEBI has formed a task force, cyber-suraksha.ai, to address AI-enabled cyber threats.