Foundation — The AIF ecosystem: investors, sponsors, trustees and the investment manager

A theatre production needs four groups of people, and none of them can be dispensed with.

The audience buys the tickets — that is the INVESTORS, looking out for alternative investment opportunity.

The director stages the play — that is the ALTERNATIVE INVESTMENT MANAGERS, having the expertise to IDENTIFY, INVEST, MANAGE AND HARVEST RETURNS for investors. Four verbs, and they map precisely onto the five aspects of role play set out later in the chapter.

The producer decides there will be a play at all, chooses the script and raises the money — that is the SPONSORS, who INITIATE AND FLOAT the AIFs, and the workbook adds a parenthesis worth noting: MORE OFTEN THE MANAGERS THEMSELVES.

And then the crew nobody in the audience ever sees — lighting, sound, box office, accounts — which is EXTERNAL SERVICE PROVIDERS who FACILITATE AND MAKE UP THE ECOSYSTEM. The chapter devotes eleven sub-sections to them, from merchant bankers to independent valuers.

The point worth carrying forward is that sponsor and manager are frequently the same people wearing different hats, which is why the regulations impose sponsor commitment — a cash investment that puts the sponsor's own capital at risk alongside the investors'. When the producer and the director are the same person, the audience needs the producer to have bought a ticket too.

A cricket match needs an umpire, and the one rule that makes the umpire useful is that he is not on either team.

The AIF Regulations apply exactly that principle. The trustee CANNOT be the MANAGER, DIRECTOR (INCLUDING INDEPENDENT DIRECTOR), OFFICER, OR EMPLOYEE of an investment management company.

Note how far that prohibition reaches — even an INDEPENDENT DIRECTOR of the management company is disqualified. Independence from the company is not enough; the trustee must be independent of the company itself.

And three things about trustees surprise candidates. First, there is NO REQUIREMENT for appointment of a REGISTERED SEBI TRUSTEE under the AIF Regulations — unlike mutual funds. Second, the Regulations do NOT specifically provide for the QUALIFICATION REQUIREMENTS OR CERTIFICATION OR LEGAL FORM for trustees. Third, and despite both of those, they DO have laid down the CODE OF CONDUCT for trustees.

So the regulation constrains behaviour rather than credentials. What it requires instead is character: the trustee should be a person of ABILITY, INTEGRITY and NOT be guilty of MORAL TURPITUDE, ANY ECONOMIC OFFENCE OR VIOLATION OF ANY SECURITIES LAW.

And the duty is broad. The trustee shall ensure that ALL TRANSACTIONS entered into by the managers are IN COMPLIANCE WITH THE REGULATIONS AND THE SCHEME'S OBJECTIVES AND INTENT, and shall ensure the interests of the investors are not compromised in any dealings with DISTRIBUTORS, OTHER SERVICE PROVIDERS AND EVEN UNIT HOLDERS OF OTHER SCHEMES IN THE AIF.

That final clause is the one to notice. The trustee protects this scheme's investors even against other investors in the same house — because a manager running several schemes has obvious temptations about which scheme gets which opportunity.

A bank sanctions a business an overdraft of Rs 2 crore. The money does not move. The business draws it as needed, and the sanction is what allows the business to plan.

An AIF capital commitment works the same way, with the direction reversed — the investor is the one who has promised.

Capital commitment refers to THE TOTAL FUNDS TO BE CONTRIBUTED BY INVESTORS for subscription to AIF, DURING THE LIFE OF THE FUND. And crucially: capital commitment is ONLY THE LEGALLY BINDING COMMITMENT for a certain amount against future opportunities a fund manager selects. INVESTORS DO NOT DEPOSIT THE CASH WITH THE FUND MANAGER.

Drawdown is the process by which a fund manager will CALL the capital commitment from the investors AS AND WHEN THE FUNDS ARE REQUIRED for investment activity. These are capital calls, made by a drawdown notice indicating a date by which the payments have to be made, the method of payment, applicable interest fee and penalties in case of failure to honour the capital calls.

The arithmetic in the workbook's own example is worth holding. A scheme closes with committed capital of INR 1,000 crore. At a given time drawdowns total INR 650 crore — that is the INVESTED CAPITAL. The undrawn INR 350 crore is known as DRY POWDER or PENDING DRAWDOWNS.

The burden this places on the investor is real and the workbook says so: because drawdowns depend on the manager finding deals, it makes it PARTICULARLY DIFFICULT TO FORECAST FROM A CASH PERSPECTIVE, and investors have to KEEP AVAILABLE CASH RESOURCES during the agreed drawdown period. A commitment is not a payment, but it is not freedom either.

Eight families commit to share the cost of a community function. On the day the bills fall due, one family cannot pay. The caterer does not care whose share is missing; the food has been ordered.

AIF documents anticipate this, and the mechanism is worth understanding because it explains why commitments are taken so seriously.

Investment managers protect themselves from the risk of an investor being unable to fund their commitments by putting in place a mechanism whereby IF A PARTICULAR INVESTOR CANNOT FUND A DRAWDOWN, OTHER INVESTORS TAKE UP THE DRAWDOWN CALL.

And the consequence for the defaulter is severe: they SUBSTANTIALLY LOSE THEIR RIGHTS AND RETURNS under the investment agreement. The workbook names the event: this is called DEFAULT IN DRAWDOWN under the agreement.

The three options the agreement may provide: reduce the capital commitment, charge interest for delayed payment, or in extreme cases, TERMINATE THE AGREEMENT AND RETURN THE CAPITAL INVESTED SO FAR.

Note the asymmetry that makes this fair rather than harsh. The manager has committed the fund to a transaction on the strength of the total commitments. A defaulting investor does not merely fail to profit; they put the fund's obligation to an investee company at risk — and the other investors must fill the gap.

The workbook also notes a limit on how flexible a manager may be: as per existing regulations, a fund CAN'T OFFER DIFFERENTIAL DRAWDOWN TERMS TO INVESTORS IN THE SAME CLASS. Accommodation must be equal within a class, or not given at all.

Water released at the top of a terraced hillside fills the first terrace completely before any of it reaches the second. The order is the whole design.

AIF distributions work identically, and the workbook calls the sequence the WATERFALL.

Under the EUROPEAN WATERFALL, 100% of all investment cash flow (the invested corpus) is paid out to investors ON A PRO RATA BASIS, and thereafter the PREFERRED RETURN is paid out in full, as the first and second priority payments respectively. PRO-RATA means that all capital is treated equally and distributions are paid out in proportion to the amount of capital invested — an individual who contributed 10% of the invested capital would be entitled to 10% of the distributions until he has received back 100% of his contribution plus the preferred return.

Only then does the manager get paid. If there is a CATCH UP clause, the manager receives the third priority distribution IN FULL until the additional return CATCHES UP to the agreed percentage of total return.

The drawback is a human one, and the workbook is candid: the manager's profit sharing MAY NOT GET REALISED FOR SIX TO EIGHT YEARS after the initial investment, and AN UNDERPAID MANAGER MAY BE INCENTIVISED TO SEEK QUICKER EXITS AND LIQUIDATION RATHER THAN MAXIMISING THE RETURN POTENTIAL OF THE FUND.

The AMERICAN WATERFALL addresses the waiting. It allows managers to get paid PRIOR to investors receiving 100% of their invested capital with preferred return thereon — an incentive fee on EACH DEAL, regardless of whether the investor's preferred return and capital have been paid back in full. It can help a smaller manager SMOOTH OUT THEIR INCOME over the life of the fund, and the workbook notes it is suitable for PURE DEBT FUNDS wherein the fund's investment theme could primarily be to HOLD ASSETS TO MATURITY.

And because paying early creates a new risk, a protection is built in — the CLAWBACK, considered in the next analogy.

A salesman is paid commission on each sale as it is made. In November, four of his March customers return the goods. The company wants its commission back, and his contract says it may have it.

That is clawback, and in the AIF context it exists because the American waterfall pays the manager before the outcome is known.

In order to ensure that there is NO MORAL HAZARD in the American Waterfall, there is usually a CLAWBACK PROVISION built in for investors.

The problem it solves is stated precisely: clawback addresses the problem of BOTH PROFITS AND LOSSES OCCURRING THROUGH TIME WITHIN A PORTFOLIO. Some private equity funds have clawback clauses in which performance fees based on EARLY SUCCESSFUL EXITS can be CLAWED BACK or RECOVERED BY THE INVESTORS FROM THE MANAGER TO OFFSET THE LOSSES ON SUBSEQUENT FAILED INVESTMENTS.

The definition to memorise: clawback right entitles investors to REVERSE ANY INCENTIVE FEES taken by the manager during the life of the investment, to ensure that fees based on the FUND-AS-A-WHOLE approach are adjusted to reflect A FULL NETTING OF PROFITS AND LOSSES OVER ITS LIFE.

And the workbook adds the practical warning that makes the clause real rather than decorative: this clause is ONLY AS GOOD AS THE MANAGER'S ABILITY TO REFUND THE EXCESS RETURN, so it's important that the manager has HIGH CREDIBILITY AND A BALANCE SHEET TO SUPPORT. A clawback against a manager with nothing to claw back is a sentence in a document.

Two Indian variations are worth knowing. It is customary to include a RESERVE CREATION in the waterfall to provide for unforeseen tax liability or other charges, especially in funds involving offshore investors. Alternatively there may be a GIVEBACK clause whereby some amounts are adjusted against givebacks by the investors from distributions — and the workbook notes giveback may work better for the manager than creation of reserves, as PREFERRED RETURNS NEED NOT BE PROVIDED ON THE GIVEBACK AMOUNTS.

And the simplest solution of all is the commonest: a lot of AIFs typically charge the performance fees AT THE END OF THE LIFE OF THE FUND to avoid any clawback on performance.

A high jumper must clear a bar before scoring at all. And once she has cleared 1.80 metres, the bar is never lowered back for her — every later attempt is measured from her best.

Those are the two devices that govern a manager's performance fee, and they do different jobs.

The HURDLE RATE is the bar. Hurdle Rate of Return, or PREFERRED RETURN, is the THRESHOLD RETURN THAT THE INVESTORS IN THE AIF MUST RECEIVE, BEFORE THE MANAGER RECEIVES ADDITIONAL RETURNS, IF ANY.

And the workbook is careful about what it is not: the purpose of having a hurdle rate is TO BENCHMARK THE EXPECTATIONS OF THE INVESTORS, RATHER THAN TO PROVIDE A GUARANTEED RETURN TO INVESTORS, WHICH IS NEITHER ETHICAL NOR PRACTICALLY POSSIBLE.

Why the bar is set where it is: AIFs should COMPENSATE INVESTORS FOR TAKING HIGHER RISK OF ILLIQUIDITY AND LONGER TERM OF HOLDING. Hence, HURDLE RATES HAVE TO BE BETTER THAN COMPARABLE MARKET RETURNS IN TRADITIONAL INVESTMENTS. It can be correlated with THE OPPORTUNITY COST FOR AN INVESTOR, and may be a fixed return per annum or based on a REFERENCE ASSET OR INDEX.

The HIGH-WATER MARK is the ratchet. It is the HIGHER of (i) the SUBSCRIPTION PRICE of units issued to a particular class of investors, or (ii) the HIGHEST NAV ACHIEVED AT THE END OF ANY PREVIOUS FINANCIAL YEARS. It is important for the purpose of COMPUTING THE INCREMENTAL RETURNS earned by the Manager.

Why both are needed. Without a hurdle, a manager earns a fee for a return the investor could have had anywhere. Without a high-water mark, a manager who loses 20 per cent and then gains 20 per cent would charge a performance fee on the recovery — being paid twice for the same ground.

And the Additional Return is computed against whichever is higher: the difference between the AUM of the fund and THE HIGHER AMOUNT OF REFERENCE HURDLE OR THE HIGH-WATER MARK, as at the end of the financial year.

A caterer prepares for one hundred guests. One guest, delighted by a particular dish, asks for a larger portion than the standard serving. He cannot simply take from everyone else's plate — so a separate portion is arranged for him.

That is co-investment, and the workbook's own illustration makes the arithmetic clear.

A scheme of an AIF is making an investment in a company for say INR 100 crore as part of the scheme's portfolio, on behalf of investors in the pool. If the NEED OF THE COMPANY IS INR 300 CRORE, the manager of the AIF may OFFER THIS ADDITIONAL INVESTMENT OPPORTUNITY TO ANY INVESTOR OF THE SCHEME who may want to invest IN ADDITION TO THEIR INVESTMENT THROUGH THE AIF.

The regulatory definition: co-investment means investment made by a MANAGER OR SPONSOR OR INVESTOR of CATEGORY I AIFs AND CATEGORY II AIFs in UNLISTED SECURITIES of investee companies WHERE SUCH CATEGORY I AND II AIFs MAKE INVESTMENT.

Two routes are permitted, and both are examinable. Through a CO-INVESTMENT PORTFOLIO MANAGER as specified under SEBI (Portfolio Managers) Regulations, 2020 — under which an investor gets the right to DIRECTLY INVEST in an investee company IN PARALLEL to the investment being made by the AIF. Or by launching a separate CO-INVESTMENT SCHEME (CIV scheme) under SEBI (AIF) Regulations — a scheme of a Category I or II AIF which facilitates co-investment to the investors of a particular scheme, in unlisted securities of a company where the scheme of the AIF is making investment or has invested.

Why an investor wants it: to be in a position to BENEFIT FROM A LARGER DIRECT EXPOSURE to an attractive investment opportunity that may bring OVERALL IMPROVEMENT IN THE RETURN ON THE PORTFOLIO. WITHOUT THE CO-INVESTMENT RIGHT, THE INVESTOR'S RETURN DEPENDS UPON THE PERFORMANCE OF THE SCHEME ALONE.

And who gets offered it: co-investment rights are NOT A STANDARD FEATURE and these are GENERALLY OFFERED TO ACCREDITED INVESTORS by the fund managers. Which is precisely why the conflict-of-interest list requires that conflicts within co-investments by the Manager shall be disclosed to potential and existing investors BEFORE ANY ALLOCATION IS MADE.