Foundation — Profiling the investor and the three fund selection criteria

Why this chapter carries 15 marks

Chapter 8 is the heaviest chapter in the workbook — 15 marks out of 100, more than the enormous regulatory Chapter 4. That tells you something about what NISM thinks this certification is for.

You are being examined as a distributor. And a distributor's central duty is not to know the AIF Regulations by heart — it is to put the right product in front of the right investor, and then to help that investor examine the fund properly before committing money. Mis-selling is the industry's biggest risk, and this chapter is SEBI's answer to it.

Read every section of this chapter asking: what would a careless distributor get wrong here?

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8.1 The investor perspective

This Chapter discusses the aspects relating to fund selection process and due diligence to be done before an investor decides to become contributory to a particular AIF. Since the distributor plays an important role in the marketing of AIF schemes and the consequent fund selection by an investor, it is important for distributors to understand the importance of investor perspective.

The distributor's understanding of its investor is based on three important criteria – (1) risk profile and investment requirements of the investor, (2) the fund structure and governance aspects and (3) profile and performance track record of investment manager.

Learn those three. They are the skeleton of the whole chapter: the investor, the fund, the manager.

Step 1 — build the risk profile

As a first step, the distributor should have detailed discussions with the prospective investor to formulate a unique customer-specific risk profile. This would be based on seeking specific information on investor's investment objectives, intended tenure of investment, risk appetite, return expectations, liquidity requirements, if any, during the investment period and other relevant information. A distributor may do well to create a questionnaire for this purpose.

Six inputs: investment objectives, intended tenure, risk appetite, return expectations, liquidity requirements, and other relevant information. And a practical suggestion — create a questionnaire.

Note the word unique customer-specific. This is repeated at the end of the section in a sentence you should memorise:

One investor's requirements cannot be universally applied to market AIF products to other investors.

Through this process, the distributor gets to understand the investor profile better and establish product compatibility before marketing specific AIF schemes.

The pension fund example

The workbook gives one worked illustration, and it is worth studying closely because Case 8.1 later in the chapter repeats it in exam form:

For e.g. a particular investor such as a pension fund may be less risk-oriented focussing mainly on steady long term income. For such an investor, recommending equity growth-oriented AIF may be incompatible with its fundamental risk-profile. Instead, a debt fund that seeks to invest in rated debt instruments, operational special purpose vehicles, infrastructure investment trusts or real estate investment trusts that offer steady long term cash flow may be a better fit.

Notice the reasoning. A pension fund is not looking for the highest return available. It has long-dated liabilities — pensions to pay every month — so it wants steady long term income. That single fact rules out an early-stage equity fund, however brilliant the manager, and points to rated debt, operational SPVs, InvITs and REITs.

Step 2 — the wish list and the shortlist

Based on the investment strategy of the investor and the resulting portfolio design, a wish list of scheme characteristics needs to be established. The wish list defines the types of AIF schemes / products that are consistent with the investment strategy of the investor. Based on this finding, a shortlist of AIF schemes / products may be formulated by the distributor that fit a particular investor.

Wish list = the characteristics. Shortlist = the actual schemes. In that order.

Distributors need to map the investment objectives of each investor with the fund's investment objectives and other aspects such as tenure of the fund, is it Category I or II AIF, is it a pure debt fund or equity fund, is it a sectoral fund or a sector agnostic fund and so on to assess the fitment of the fund / scheme to the investor.

Four mapping questions in that sentence: tenure, Category I or II, debt or equity, sectoral or sector agnostic.

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8.2 Fund selection criteria — the three fundamental factors

At the highest level, three factors are fundamental in the fund selection process by an investor – (a) ownership structure and continuing interest, (b) alignment of interests and (c) competing or outside interests.

Commit those three to memory. Sample question 6 asks directly for one of them.

8.2.1 Ownership structure and continuing interest

Under the AIF Regulations, it is mandatory for the sponsor/manager to have minimum capital commitment and continuing interest in the AIF. Therefore, one of the primary concerns for an investor is to verify the level of commitment.

The fund structure is more relevant to examine whether the sponsor, investment manager and the fund (trust or LLP) are structured at arm's length with each other, whether there are related parties in the fund structure or are in the third parties engaged as experts/ service providers etc.

The verification of the ownership structure and the commitment/continued interest would provide preliminary comfort to the potential investor before a fund due diligence is conducted. This is due to the fact that continuing interest provides the 'skin-in-the-game' for the manager and removes one of the main sources of mis-alignment of interests and moral hazard for the investors.

And a sentence with real commercial meaning:

Many first time managers would invest more than the mandatory minimum continuing interest to provide greater comfort to investors.

Think about why. A first-time manager has no track record. He cannot point to a previous fund that returned 3x. What he can do is put in more of his own money than the law demands — which is a costly, credible signal that he believes his own pitch. A distributor should notice when a manager does this, and equally should notice when a manager with a thin record puts in only the bare 2.5 per cent.

8.2.2 Alignment of interests — the eight areas

The main areas where alignment of interest between investors and the sponsors/managers is required are:

1. Sponsor/manager commitment
2. Management Fee and Additional Return / Carry terms including super-carry or higher carry after a higher preferred return
3. Distribution Waterfall
4. Catch-up and Clawback
5. Competing or outside interests for the manager
6. transparency and governance in fund structure and reporting
7. related party transactions by fund / manager
8. Co-investment opportunities

All these areas are important for potential investors to verify and negotiate firmly during due diligence or discussions for execution of subscription agreement with the fund.

Super carry is defined in a footnote and is examinable: higher additional returns charged by highly sought after funds that have a very high return track record in fund performance. Since these funds are in high demand from investors, they tend to negotiate higher additional return than industry norm. In some instances, super carry may be in the interests of investors if they negotiate a super carry in lieu of higher management fee to the fund manager.

That last line is counter-intuitive and therefore examinable. Super carry can be good for investors — if it is traded in lieu of a higher management fee. Management fee is paid whether or not the fund performs; carry is paid only if it does. An investor who accepts 25 per cent carry in exchange for a 1.5 per cent fee instead of 2.5 per cent has moved the manager's pay from certain to contingent, which is exactly what alignment means.

And where the market is heading: Hard negotiations by investors are driving down management fee and expense structures and making it difficult for managers to aspire for higher carry/super carry and catch-up clauses in the investment management agreements.

8.2.3 Competing or outside interests

While investors would seek to ensure that the manager's time and efforts are used in the best interests of the Fund/Scheme/Firm they invest in, it is possible sometimes that due to the structure of the fund or otherwise, there could be competing or outside interests that may conflict with their interest.

Four specific problems the workbook names:

(i) Deal allocation. For e.g. referral of investment deals to a particular scheme or fund may be affected if the fund manager is managing several funds or schemes or is involved with other business interests outside the AIF.

This is the classic conflict of multi-fund managers. When a good deal arrives and the manager runs three funds, which one gets it? The one that most needs a win before its next fundraise? The one where his own commitment is largest?

(ii) Time and attention. It is also necessary to verify if the investment manager has other outside interests in business ventures, other AIF interests or other business obligations that may compromise the time devoted to the fund management.

(iii) Service providers who benefit the manager but are paid by the fund. there could be outside engagement of service providers, professionals who may be benefiting the manager but their service fee may be charged to the fund. These kind of arrangements and conflicts need to be looked into by the investors at the time of fund due diligence and suitable negotiations are required to protect against their downside.

(iv) Nominee directorships. Conflict due to outside interests may also arise when financing deals or board positions held by manager in investee companies can compromise the interests of the AIF. This can arise when the portfolio company is distressed or is in negotiations with other investors or funding sources. Further, such director may have some disclosure issues when certain portfolio company information is under a non-disclosure agreement but his/her duties to the AIF would require disclosure of this information.

That is a genuine legal bind, not a hypothetical one. A fund's nominee sits on a portfolio company board. He learns, in confidence, that the company is about to lose its biggest customer. His duty to the company says keep it confidential; his duty to the fund says report it. The workbook's answer: Suitable framing of nominee directorship policies by the fund and incorporation of some of these provisions in the investee company documentation would address this issue.

And a disclosure rule to remember: Investment managers should also disclose fees and equities received by its employees from portfolio companies for services rendered. Investors may verify the policy with regard to such practices at the time of fund due diligence and on-going reporting by the manager.

Note fees AND equities — a manager's employee taking shares in a portfolio company personally is a conflict as sharp as taking cash.

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8.3 Evaluating the fund manager

From an investor perspective, selection of the right type of AIF to associate with depends largely on the selection of the investment manager. This is not a simple process and if not executed properly can lead to the risk of adverse selection. Manager selection is not mechanical process but requires industry experience and resources to conduct both research and due diligence.

Not a mechanical process — an important phrase, because it explains why fund due diligence cannot be reduced to a scorecard.

How the eco-system actually works:

Generally, the AIF eco-system relies on relationships between investors and fund managers based on their track record of past performance, credentials of work experience and prior association. Therefore, existing well-performing managers and their funds are in high demand. Frequently, when a fund manager with a proven track-record of fund performance raises a new fund, investors in previous funds quickly commit, often leading to oversubscription.

The six evaluation criteria

The key criteria in evaluating managers would be the following:

1. Fund management experience in earlier assignments
2. Performance track record in delivering returns
3. Specific expertise in the proposed fund / scheme's investment strategy
4. Expertise in exit management and successful exits in the past
5. Litigations, write-downs, write-offs and liquidations or such other adverse events faced in past fund management
6. Instances of conflict of interest, strained relations with investors, non-compliance issues with regulators, litigation proceedings with investee companies or with investors etc. that reflect on the conduct of the managers.

These factors weigh very heavily on investor's investment decision as they would determine the assessment of the fund manager.

Look at the shape of that list. Criteria 1 to 4 are about ability — experience, returns, strategy fit, and exits. Criteria 5 and 6 are about conduct — what went wrong, and how the manager behaved when it did. A distributor who reports only the first four has given half the picture.

Criterion 3 deserves a moment. Specific expertise in the proposed fund/scheme's investment strategy — a manager with a magnificent record in consumer businesses is not thereby qualified to run an infrastructure debt fund. Track record is strategy-specific.

Criterion 4 echoes Chapter 3: harvesting returns by managing exit risks is probably the most important skill attribute of an investment manager. A manager who has entered brilliantly and never exited has not yet proved anything.

The problem this creates — and the distributor's opportunity

Investors also tend to rely more on existing manager relationships which may have delivered good results in the past. Finding new managers is also a difficult and expensive exercise for investors as the due diligence process has to be conducted much more exhaustively for commencing a new relationship. Sometimes, investors may perceive additional risk of uncertainty in fund closures in the case of new AIF managers.

Nevertheless, distributors may provide a value add in this area by bringing newer AIF schemes/products launched by lesser known managers to the attention of investors that may fit their criteria and risk profile and thereby enable them to broad-base their AIF portfolio. In the long run, it would be a significant contribution by distributors/Advisors in the development of a deeper AIF industry.

This is one of the few places in the workbook where the distributor is given a genuinely constructive role rather than a compliance duty. Established managers sell themselves; investors queue up and oversubscription follows. The good new manager with no relationships is the one who cannot get a meeting — and introducing him to investors for whom he genuinely fits is a significant contribution... in the development of a deeper AIF industry.