How Have Private Markets Evolved Over the Years?

“What happens behind closed doors stays behind closed doors.” Well, not if you’re investing in the private markets in India.

Not that you can blame the system, of course.

There are clear reasons why investment activity in the private markets in India have been growing steadily in the past decade, both in terms of the number of deals and their value. As per latest estimates, the net inflows to this section amounted to ₹1,172 billion, across 1,218 deals in FY2023.

In the previous chapter, we explored the evolution of the regulations in the private markets in the US. In this last chapter, we’re going to explore the Indian landscape and trace the development in regulations over the years.

For a long time, private equity was considered a domain for the wealthy and institutional investors, attracting less regulatory attention than commercial banks and brokerages. It was automatically assumed that if you can find and negotiate your own investment opportunity, you don’t need to be supervised.

But times have changed. And with them, so have the regulatory requirements in the alternative investment space.

While market developments are a more gradual process, regulatory changes generally happen in spades. Every time there has been a significant financial crisis in history, we have come out of it bolstered with stronger regulations. It is the equivalent of vaccinating yourself against preventable illnesses that you know about.

After India opened its economy in 1991, private equity investment, especially in early-stage tech firms, began to flourish. SEBI’s 1996 Venture Capital Funds Regulations and the 2000 Foreign Venture Capital Investor Regulations catalysed this growth. The former encouraged the flow of funds, and the latter safeguarded the interests of the participating funds.

An Early Example of Market Regulation

To trace one of the earliest instances of market regulation, we travel back in time to the early 14th century, where Alauddin Khalji was challenging the norms of market transactions.

He fixed prices for essential goods like grains, cloth, slaves, and animals to ensure they were affordable for everyone. His actions weren’t just about controlling prices; they were aimed at transforming society​.

Alauddin established different types of markets in Delhi: Mandi for grains, Sera-i Adl for manufactured goods, and specific markets for slaves, animals, and other commodities.
To enforce these reforms, Alauddin appointed market controllers, established government-run granaries, and implemented anti-hoarding measures. He even set up a network of spies and officers to ensure compliance and punished violators severely.

Alauddin was meticulous. He sought daily reports from multiple sources to keep a pulse on the market. During droughts, he implemented rationing and ensured that grain prices remained stable.

The Securities Exchange Board of India (SEBI) governs public and private markets in India. For private market investments, SEBI has set up the Alternative Investment Funds Regulations (AIF), 2012. These rules cover every aspect of private investments, defining the type of assets, participants, accredited investors, accreditation agencies, and many other relevant specifications.

The ‘alternative investment funds’ that the act refers to have been defined, too. These rules govern all private investment vehicles, including venture capital, equity, real estate, etc. They administer asset allocation, financial reporting, and compliance requirements for every entity operating in the private markets in one form or another.

According to the AIF Regulations, there are three different categories of AIFs:

• Category I AIFs: These focus on investing in start-ups, early-stage ventures, SMEs, and other sectors that are considered socially or economically beneficial by the government or regulators. This category includes venture capital funds, SME funds and social impact funds.
• Category II AIFs: This category focusses on a broad spectrum of investments without employing leverage. It includes funds without specific incentives or concessions from the government.
• Category III AIFs: Funds in this category use complex trading strategies and may use leverage, including investment in listed or unlisted derivatives. Hedge funds are an example of Category III AIFs.

As of March 2023, SEBI’s roster boasts an impressive 1,096 AIFs, with about 36% of these launched in just the last two years. A remarkable two-thirds of AIFs sprung up in the preceding five years, with Category II AIFs claiming 58% of the space. The financial commitment to AIFs rocketed from ₹14 billion in 2013 to a staggering ₹8,338 billion in 2023, evidencing a fivefold surge in just half a decade. Category II AIFs particularly flourished, their commitments ballooning nearly 6.5 times within five years.

Benchmarking in the Private Markets

The only way you can tell how a particular initiative is performing is if you compare it with other similar initiatives. In the private markets, this has always been quite easy — all you have to do is compare the performance of the fund or the stock with the market index.

As there is no such index in the private markets, this simple process is a lot more challenging here.

CRISIL has developed two distinct benchmarks for evaluating AIFs in India — one for Category I venture capital funds and Category II equity funds that predominantly invest in early-stage ventures (seed and Series A rounds), and another for those focusing on Series B and later stages.

As of March 2023, the collective IRR for early-stage investment funds stood at 39%, while for later-stage funds, it was 26%. Notably, the performance variance is broader among early-stage investment funds compared to their later-stage counterparts.

To go deeper, in Criteria 1, Peer Benchmark 1 showcased a pooled IRR of 39.02%, and Peer Benchmark 2 showed a pooled IRR of 25.98%. Also, the variation between the top and bottom quartiles was more pronounced for Peer Benchmark 1 compared to Peer Benchmark 2.

As for Criteria 2, Peer Benchmark 1 reported a pooled IRR of 39.81%, and Peer Benchmark 2 reported 27.02%, with the latter not having sufficient funds across most vintage years to effectively compare quartile variations.

Disclosure Requirements Per AIF Regulations

The AIF regulations state that AIFs must publish reports relevant to their operations and risk management strategies. They must be able to validate their actions and practices as those taken to protect the interests of the rightful parties, particularly investors.

SEBI checks for market manipulation and fraud in these markets via financial and risk reporting. Hence, it is safe to assume that the governance standards that apply to AIFs are stringent.

While regulation will continue to make a significant difference in how private markets function, other factors like investor awareness and corporate ethics will steer these markets in terms of making them more reliable.

A Goldman Sachs study published in September 2023 shows that general partners and limited partners who were surveyed believed that private markets are set for growth in the coming years despite the current gloom. Hence, if anyone has doubts about the role of regulatory bodies or whether they plan to focus on these markets can rest assured that private market regulation is only going to increase and strengthen in the future.