Tuesday, August 23, 2011

Securities and Exchange Board of India Proposes Regulation of Hedge Funds and Other Alternative Investment Funds

The Securities and Exchange Board of India has issued a concept paper proposing the regulation of hedge funds and other alternative investment funds. SEBI proposes to create a regulatory framework embracing all shades of private pools of capital or investment vehicles so that such funds are channeled into the desired space in a regulated manner without posing systemic risk. For example, private pools of capital of institutions or sophisticated investors who entrust pooled funds to managers who themselves need to have their own funds forming part of the corpus could potentially employ leverage. Also, at that end of the spectrum, the regulations would not try to regulate the business risks but would provide minimum ground rules for disclosures and governance practices to minimize conflict. Up the middle of the regulatory spectrum would be various specialized funds where risks are graded and investment portfolios designed to suit specific regulatory incentives.

SEBI intends to regulate private pools of capital where institutions or high
net worth investors invest in alternative investment funds. While institutions and high net worth investors are expected to be savvy investors and need not be protected
from market and credit risk, noted SEBI, there is a need for a regulatory framework to deter from fraud and unfair trade practices and minimize conflicts of interest. Mitigation of potential conflicts and the deterrence to fraud will be addressed through disclosure,incentive structures, and reporting requirements.

Making clear distinctions among the various types of private pooled investment
vehicles of institutional or sophisticated investors will allow the regulator to tailor concessions that may be desirable for individual kinds of funds, like venture capital funds. These concessions will be tied to investment restrictions for special kinds of funds, said SEBI, and may not be available to private equity, PIPE or hedge funds.

Under the proposal, it would be mandatory for all types of private pools of capital or investment funds to register with SEBI. The regulations would require that the fund manager or asset management company or trustees of the fund be specified, and that a change of such entities be reported to the regulator. At the time of application, the fund would specify the category under which it is seeking registration, the targeted size of the proposed fund, and its life cycle and target investors.

The investment restrictions on different types of alternative investment funds would be specified separately for each category of fund, as these would be the main differentiating criteria between the different types of funds.

For strategy funds, the fund would be guided by the strategy it specifies at the time of registration with no other restrictions. Any fund operating as a hedge fund will be required to be registered as a strategy fund under the alternative investment fund regulations.

Any alteration to the fund strategy must be made with the consent of at least 75 percent of unit holders. Compensation arrangement must be on the basis of performance related remuneration, plus a cost of fund management. The responsibilities of the fund manager or asset management company must be clearly defined. There must also be identification of conflicts of interest and the establishment of a mechanism for managing these conflicts of interest.

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