The Paperwork That Holds an AIF Together

The Paperwork That Holds an AIF Together

9.1 What "legal documentation" means

An AIF is not a building or a bank account. It is a set of promises written down. The workbook defines legal documentation as the set of legal contracts and documents that define the AIF architecture and set out the binding roles and performance obligations of the connected parties, so that the outcome of the fund activity protects the interests of the investors and other stakeholders.

There are five principal documents:

Why do these documents matter so much? Two reasons, both from the workbook.

• To attract high quality investors, the fund documents — including marketing literature such as "pitch documents" and the PPM — should articulate the fund's governance standards. Fund documents are an important aspect of the fundraising exercise.
• They make the whole structure "bankable" from a regulatory, commercial and contractual perspective, so investors are reassured that their interests are protected.

9.2 The constitutional document — trust, LLP or company

The AIF can take three legal forms. Each is born through a different document.

The trust in a little more detail. The settlor is the author of the trust. He settles the trust and conveys the initial sum of money to the trustee to set it up and create its assets. The trust document is also the instrument of trusteeship, vested in the trustees. It must be drafted carefully to show the "determinate" status of its corpus — this is needed to establish the trust's status and tax treatment under the Income Tax Act, 1961.

Who sees it? The constitution document is the charter document, so it is shared with all investors alike, and also shared with SEBI for registering the AIF.

9.3 The Investment Management Agreement (IMA)

The IMA is signed between the trustee (on behalf of the AIF) and the investment manager. It does two things:

1. It sets out the terms on which the manager manages the fund.
2. Through it, the trustee delegates all its investment management powers to the manager — except certain retained powers identified in the Indenture of Trust.

It is signed once for the trust as a whole — not at the launch of each scheme.

Why most Indian AIFs are trusts. In a trust, the manager is only a counterparty service provider to the AIF. That ring-fences the manager's liability — including fiduciary and breach-of-fund-document liability — from the AIF's. Compare a company AIF, where the manager may sit on the board, or an LLP, where it may be a designated partner. The workbook says this is why the majority of AIFs in India are constituted as trusts and not as LLPs.

Investors have become more cautious. After the financial crisis of 2008 and several frauds in fund management, investors do not want to give managers excessive room. So agreements may include a termination clause allowing the manager to be removed, or the investor to withdraw, if the interests of investors and manager are grossly misaligned and there is considerable moral hazard in continuing.

"For cause" removal means the investors prematurely terminate the manager because of events of default — mainly fraud, wilful misconduct and gross negligence. These facts are subject to interpretation by courts, so litigation can be long drawn and vexatious. Arbitration clauses can mitigate this risk to some extent.

9.4 The contribution (subscription) agreement

This is signed between each contributor (investor), the trustee and the investment manager — three parties. It sets the conditions for an investor to participate in the AIF and can be amended as needed.

Most fund investing is blind pool investing — the investor commits money before knowing exactly which companies it will buy. So the agreement covers everything: computation of beneficial interest, drawdowns, the distribution waterfall, fees and expenses, the governance structure and the powers of the investment committee.

Is it shared with other investors? Generally not. It contains representations and warranties that may be specific to each contributor.

Units must be in demat form. Units held by an investor have to be issued in dematerialised mode only. Investors then get periodic statements from the depository showing their balance and transactions. This requirement is written into the subscription agreement, and it protects investor interests.

Why not a company? In a company, share allotment and application money are regulated concepts under the Companies Act, 2013. AIFs need flexibility in the terms between investors, the AIF and the manager, so a company structure poses difficulties. Hence the trust has become the most popular structure for an AIF.

9.4.1 Side letters

Some investors — usually a few institutional or large investors — want special terms. These are recorded separately in side letters, signed by the specific investor, the AIF and the investment manager.

Typical subjects of side letters:

• Differential management fee
• How the distribution waterfall works for them
• Participation rights in investment committees
• Investor giveback
• A protection right so no other investor is placed in a better position — the Most Favoured Nation (MFN) clause

The MFN clause lets an investor receive side letter entitlements to protect itself from less favourable terms than those offered to other current or future investors.

Three cautions the workbook raises:

1. Side letter enforceability has not been tested adequately in Indian courts, so they carry legal risk.
2. The manager owes a fiduciary duty to all the other investors. To avoid breaching it, most managers create a separate class of units with differential rights for large investors.
3. Side letters are bilateral and not disclosed to other investors. That makes it hard for an advisor to assess risk for his client, because he cannot see what preferential rights have already been granted.

In global practice, the key terms sit in the charter documents signed by all investors, and side letters contain only terms that give an individual right of action and do not affect the general operation of the fund for others.

9.5 The Private Placement Memorandum (PPM)

The PPM is akin to an offer document. For an AIF raising commitments, it is the most important and informative document, giving sophisticated investors information not generally available to the public.

To make disclosures uniform, SEBI issued a circular with PPM templates for different categories of AIFs (dated 5 February 2020, per the workbook's footnote). The PPM has Section A (minimum prescribed disclosures, in fifteen parts) and Section B (any additional disclosures the AIF chooses to make).

Warehousing has a precise meaning here: investment transactions made to park securities for a period so they can be transferred later, where the investor acts for an ultimate beneficiary or purely as a service provider. It is not the same as warehousing of deals, which means building a pipeline of deals before the first close.

9.5.1 Filing the PPM and launching a scheme

To speed up launches, SEBI introduced GARUDA — Green Channel: AIF Rollout Upon Document Acknowledgement. The workbook describes two tracks.

Working days exclude Saturdays, Sundays and public holidays on which the SEBI office is closed.

Documents for a regular scheme, filed on the SEBI Intermediary Portal with the PPM and scheme fee: the merchant banker due diligence certificate, fit and proper declarations for the AIF, sponsor and manager, sponsor/manager declarations on continuing interest, and PAN copies of the AIF, sponsor, manager, trustee, their directors/partners and key investment team. The application fee does not apply to the launch of an AIF's first scheme.

SEBI does not approve the PPM. It only gives observations. The mandatory disclaimer says submission to SEBI should not be deemed to mean SEBI has approved it, and SEBI takes no responsibility for the accuracy of disclosures or the performance of the manager.

Changes to the PPM are intimated to SEBI on a consolidated basis within 1 month of the end of each financial year. AI-only Funds and LVFs can file these changes directly, with an undertaking from the CEO and Compliance Officer.

9.5.1 (additional) Investor Charter and complaints

Every registered AIF must publish an Investor Charter — services to investors, grievance redressal, and investors' responsibilities, in one place. For new schemes it goes in the PPM; for existing schemes it was sent to investors' registered e-mail IDs as a one-time measure.

Complaint data must also be disclosed. New schemes include a separate chapter on Investor Grievance Redressal in the PPM. Existing schemes update the PPM within 1 month from the end of each financial year. Data is kept for every quarter (March, June, September, December) and for the last three financial years, and must be compiled within 7 days from the end of the quarter.

9.5.2 PPM audit

Every AIF must carry out an annual audit of compliance with the terms of the PPM at the end of each financial year, by an internal or external auditor or legal professional. Findings go to the trustee / board / designated partners of the AIF, the board of the manager, and SEBI within 6 months from the end of the financial year.

9.5.3 Material changes

A material change to the PPM triggers a compulsory exit option for investors. Examples: change in sponsor or manager (not internal group restructuring), change in control of sponsor or manager, and change in fee structure or hurdle rate that may adversely affect investors. (Chapter 13 covers this in detail.)

9.6 The wrapper

A wrapper is a supplement attached to the PPM of the domestic fund, distributed at offshore locations in a unified structure. It helps meet private placement rules in jurisdictions outside India.

9.7 Support services agreements