Industry
Co-investor conundrum: Investors urge Sebi to rethink exit rules
Summary
Sebi brought in new rules under the PMS (portfolio management services) regime for co-investments in 2022. A key reason to regulate co-investors was to ensure that all AIF investors had identical terms—meaning a co-investor cannot have more favourable terms than other investors of an AIF.
India-based venture capital and private equity firms have petitioned Securities Exchange Board of India (Sebi) to reconsider rules that mandate their co-investors exit alongside the fund, three people familiar with the development said.
Co-investors are those who typically want to take additional exposure to a particular investment made by an alternative investment fund (AIF)—vehicles used by private equity and venture capital firms to invest in India .
Sebi brought in new rules under the PMS (portfolio management services) regime for co-investments in 2022. A key reason to regulate co-investors was to ensure that all AIF investors had identical terms—meaning a co-investor cannot have more favourable terms than other investors of an AIF. This included synchronising co-investor exits alongside funds.
While this has been a thorny issue for two years, it has especially come up over the last year as VC/ PE exits have soared on the back of multiple initial public offerings (IPOs).
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Many fund managers have booked exits via block deals after the listing of their portfolio firms, but their co-investors have wanted to stay on for a longer period of time, the people cited above said on the condition of anonymity.
Industry concerns
“Instead of facilitating co-investments in the true sense, the existing regulatory framework almost seems suspicious of such arrangements (by prescribing simultaneous exits on identical terms)," said Swapneil B. Akut, partner, S&R Associates. Akut leads the firm’s funds practice.
“Most funds are deliberately designed to function as limited-life vehicles, with initial public offerings providing the exits they need at the end of their life cycles. However, the large-ticket investors offered co-investment opportunities often have higher risk appetites and may not be inclined to exit high-quality investee companies at the time of an initial public offering. With Indian listed equities continuing to perform well and attracting global interest, it comes as no surprise that such co-investors are seeking practical regulatory reforms. Insofar as the interests of other fund investors are not adversely impacted, it is a fair ask not to be compelled to exit along with the fund," Akut said.
"Co-investments to limited partners (LPs), historically has been a function of their overall relevance to the portfolio company, contribution to the fund, availability of the cap table to absorb capital and finally founders' comfort on adding more investors to the cap table of the company. Having a pari passu democratic right across the LP base of a fund may defeat the purpose and make it an execution challenge. We believe that SFA will factor it in whilst making the operational guidance to the industry and the regulators so that these can be made easier to implement," said Ankush Bhutra, financial controller, Blume Ventures, an early-stage venture capital firm.
SFA stands for Standard Setting Forum constituted with industry representatives from IVCA and PE and VC firms.
On 14 January, a Business Standard report said that the International Financial Services Centres Authority (IFSCA) in the Gift city has proposed that funds be allowed to set up a special purpose vehicle for co-investments.
Global investors adopt a special purpose vehicle for co-investments in other geographies.
However, in India, a special purpose vehicle for co-investments would meet the description of an NBFC, flouting existing laws.
Sebi's perspective
Instead, some investors had proposed that co-investment units be issued within an AIF, the people cited earlier said. However, Sebi felt that this would contravene the principles of a blind-pool AIF which requires that all investors within an AIF vehicle are offered the same terms, a fourth person with knowledge of the discussions said. Sebi was clear that a co-investor—who pays an additional fee to the fund manager for the opportunity to invest more—should not be given more favourable terms than an existing AIF investor.
Further, Sebi felt that synchorising exits alongside fund managers would best protect co-investor interests, as they may not get the necessary guidance after the manager exits, the fourth person added.
Read more: Alternate investment funds: An industry at risk of death by a thousand circulars
Fund managers, however, feel that a more elegant solution needs to be found as limited partners or investors in AIFs have a greater incentive to stay invested in a company well after a fund exits. This is especially true of fund managers in early-stage investments, the fund-managers cited above said.
"Lot of investors have a longer investment horizon than the fund which has a defined life of 10 years. Sebi is treating them as mutual fund investors. Maybe Sebi is worried about transparency in which case they should focus on educating these investors rather than coming up with such rules," Anand Lunia, founding partner at homegrown venture capital firm India Quotient, said, noting that AIF investors were far more sophisticated. "Sebi is protecting them like they are retail investors vulnerable to malpractice by funds and as a result removing all the flexibility that this investor class deserves."
