Sebi to soon propose norms for funds, key personnel to stop misuse of AIF structures

The regulator has proposed that AIFs no longer sell schemes that allow this practice through their preferential distribution (PD) model.

After a crackdown on alternative investment funds (AIFs) that helped regulated lenders to hide stressed assets, market watchdog Sebi is working on a code of conduct for the funds and key management personnel (KMP) so that they could not get around any regulations.

At a conference organised by the Association of Investment Bankers of India (AIBI), Securities and Exchange Board of India (Sebi) whole-time member Anant Narayan spoke about the most rampant frauds in the AIF industry.

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"The biggest case of Type 1 error in AIFs, we have seen funds being structured to circumvent existing regulations," he said. "We have seen cases of circumvention of FEMA guidelines, SARFAESI guidelines, around QIBs, investments into IPOs... We could come up with a set of regulations for each of these, but this will result in Type 2 error... We propose to come up with a code of conduct for funds and the KMPs, which will enjoin them to do due diligence to ensure that the funds are not being used to circumvent existing financial sector regulations."

Narayan added that the regulator intends to make it very specific and that it will be a three-step process - general obligation in regulation, second to what is it that we are trying to address, the specific do's and don'ts that the regulator wants done in consultation with the industry. The consultation paper should be out in a few days, he said.

Sebi released a consultation paper on May 2023 on stopping AIF structures that allowed schemes to hide stressed loan books. These schemes were doing it through evergreening of loans and tranching of securities that leads to a lack of transparency for investors, much like the tranching of collateralised debt obligations (CDOs) did during the 2008 financial crisis.

Therefore, the regulator proposed that AIFs no longer sell schemes that allow this practice through their preferential distribution (PD) model.
Under the PD model, the profits or losses are not distributed pro rata — proportional to investment — but are distributed based on the ‘waterfall’ method. That is, one set of unitholders (junior class/tranche) other than the sponsor/manager absorbs a loss that is more than the proportion of their holding in the AIF versus another class of unitholders (senior class/tranche).