Warehousing of investments

Somebody buys a stake today, holds it, and sells it on to the fund tomorrow. That is warehousing, and the workbook gives it a precise definition in the PPM disclosure template.

Warehousing means investment transactions that are made with an intention to park the securities for a period of time so as to be able to transfer or dispose them off at an appropriate later date. In such a transaction, the investor is acting either on behalf of an ultimate beneficiary or purely as a service provider.

The reason it appears in the conflicts section rather than the strategy section is obvious once stated: the party doing the parking usually decides the price at which the fund buys, and when.

The disclosure obligation sits in Section IX of the PPM, Conflicts of Interest, which requires the manager to set out all potential sources of conflict it envisages — at the level of the employee, the service providers, the manager, the sponsor, the investor, members of the governance bodies and group entities of the sponsor or manager across schemes — together with the steps taken for effective resolution. Details on conflict of interest on account of warehousing of investments or making co-investments are disclosed there specifically.

The regulation behind it is general and strict. The sponsor and manager act in a fiduciary capacity and must disclose all conflicts as and when they arise or seem likely to arise, with written policies and procedures to identify, monitor and appropriately mitigate them.

The Code of Conduct then closes the obvious abuse. A manager and its key management personnel shall not enter into arrangements for sale or purchase of securities where there is no effective change in beneficial interest, or where the transfer of beneficial interest is only between parties acting in concert or collusion, other than for bona fide and legally valid reasons.

And the workbook takes care to separate a term that sounds identical. Warehousing of deals means building a pipeline of investment deals before the first close of a fund is achieved. That is ordinary fund-raising practice, and it is not what Section IX is about.

Chandra Capital is raising Chandra India Fund III, a Rs 750 crore Category II AIF. First close is expected in September.

In March, an entity in the sponsor group buys 18% of a logistics company for Rs 60 crore — a deal the manager fully intends the fund to own once it has money.

In October, the fund buys that 18% from the sponsor entity for Rs 72 crore.

What the Rs 12 crore did:

Assume the stake is worth Rs 150 crore at exit. On a Rs 60 crore base the fund would have shown a gain of Rs 90 crore; on a Rs 72 crore base it shows Rs 78 crore. At a 20% additional return that is Rs 2.4 crore less carry for the manager — and Rs 12 crore less for the investors, who paid the uplift to an entity in the manager's own group.

Nothing here is automatically prohibited. What is required is that the manager disclosed the warehousing conflict in Section IX, that the transfer price was arrived at bona fide, and that the arrangement is not simply a transfer of beneficial interest between parties acting in concert. An investor conducting fund due diligence asks for exactly that trail.

Chapter 13 (Legal Documentation and Negotiations) carries the PPM disclosure template, and footnote 134 to Section IX is where the definition and the deals-versus-investments distinction live. Chapter 11 section 11.10 supplies the Code of Conduct clause on transfers with no effective change in beneficial interest. Expect a 'which of these must be disclosed under conflicts of interest' question and, more often, a trap on the two meanings of warehousing.

• Two meanings, one word. Warehousing of investments is a conflict of interest; warehousing of deals — building a pipeline before first close — is normal practice.
• The test in the definition is the role: the party is acting on behalf of an ultimate beneficiary, or purely as a service provider.
• It is disclosed in Section IX of the PPM, alongside co-investment conflicts — not in the investment strategy section.
• Disclosure is not a cure. The manager still needs written policies to identify, monitor and mitigate, and conflicts must be disclosed as and when they arise or seem likely to arise.
• The Code of Conduct bars transfers with no effective change in beneficial interest, or between parties acting in concert or collusion, unless bona fide and legally valid.
• The harm to investors is in the cost base, which is invisible in a headline IRR until you ask what the fund paid and who it paid.