Key Players in the Private Market Ecosystem

You know how when we’re in kindergarten and another kid is mean to you, you can just go running to the class teacher to complain?

Having someone in a regulatory position helps ensure that there is fair play. Of course, when it comes to the capital markets, there’s more to it than just conflict resolution. The market regulator ensures that there are established fair practices and looks after the interests of investors.

In this module, we have covered all the main participants in the private investment space. This chapter is dedicated to the role of the regulator, in this case, SEBI.

Let’s consider how much the alternative investment space has grown in the past few years.
According to data from SEBI, AIFs in India had raised fund commitments worth about INR 8.45 lakh crores by the end of June 2023. A decade ago, the amount of fund commitments raised by AIFs was INR 2357 crores.

Of course, if you compare this with the size of the mutual fund industry, it is still only a fraction. But that just means the potential for growth is all the more!

Now, with increased market participation and growth, there is also an increased chance of foul play. After all, the last thing any investor wants is to wake up one morning and realise that the exciting new fund they had invested in, has all but vanished into thin air!

The Scandal That Shook the Far Corners of the World

One of the most infamous financial frauds in history was the Bernie Madoff Ponzi scheme. Madoff’s fraudulent investment operation spanned decades and duped thousands of investors, including individuals, charities, and institutions.

It was the mother of all dupes, if you will. And one of the main reasons it managed to last for as long as it did is because of the absence of adequate regulatory scrutiny.

As per the latest estimates, the scandal caused cash losses of about US$20 billion and paper losses worth US$65 billion!

The creation of SEBI marked quite a pivotal moment in the Indian capital markets. It was established on April 12, 1988, as an autonomous statutory regulatory body under the Securities and Exchange Board of India Act, 1992.

The need was obvious — we needed a centralised and expert regulatory authority to oversee the capital markets and look out for the investors.

Over the years, SEBI has grown into a cornerstone of the Indian capital markets. It has undergone several transformations and has grown in both scope and authority. It has also played a vital role in spreading awareness and educating potential investors about the different asset classes and investment fair practices.

The alternative investment market in India is relatively more recent as compared to conventional equity. It represents a range of different asset classes and it opens up a whole spectrum of new opportunities. To any investor, it can seem like this market is teeming with potential and just waiting for someone to come in and scoop it all up.

Having said that, however, the private markets also pose quite a high risk to an investor’s portfolio. There is a lack of transparency about how the investments are performing. There is also a lack of liquidity — once invested, the funds are locked away for at least a few years. This means things can go wrong and investors can be left with the short end of the stick.

Let’s take a look at how SEBI has regulated this space.

SEBI introduced a comprehensive regulatory framework for AIFs in 2012, with Regulation 2 (1) (b) of the Regulation Act. Since then, it has been updated to address the evolving needs of the industry.

The framework recognises that AIFs can be set up as companies, LLPs, corporates or trusts. It segregates these funds into the following three categories:

1. Category I AIFs

   These are funds that invest in start-ups, small and medium-sized enterprises (SMEs), infrastructure and other similar sectors. These investment activities directly impact the development of these sectors, and SEBI’s role ensures that the objective is realised.

2. Category II AIFs

   This is the largest category and it includes private equity, debt, or other alternative investments. As of June 2023, it accounts for about 82% of the total AUM of alternative investment funds.

   SEBI regulates the activities, including any restrictions on leverage, investment strategies, and all the necessary disclosure requirements.

3. Category III AIFs

   Category III AIFs are hedge funds or other funds with diverse trading strategies. This category requires specific regulations on leverage, portfolio management and disclosures to maintain market integrity and protect investors.

Differences between the three categories of AIFs:

1. Registration and Compliance

   First things first. When starting off in unchartered territory, we begin by taking stock of the resources we have with us. In the private markets, we start with a record of all the participants in the alternative investment space.

   SEBI is responsible for registering and regulating AIFs, including their managers and custodians. Any fund that is looking to operate in the Indian private markets must meet the eligibility criteria.

   It isn’t enough to just have a headcount, however. SEBI conducts quite an intensive due diligence and compliance check to make sure that all the AIFs and their managers meet the required standards.

   Investors, too, have to meet certain eligibility criteria before they are even allowed to participate in the alternative investment space. They also have to go through a mandatory KYC disclosure process before they start investing.

2. Ongoing Supervision and Reporting

   Once all the participants have been accounted for and SEBI has taken stock of the resources, they’re free to operate!

   But, SEBI’s role does not end. If anything, this is where the real involvement begins.

   AIFs are required to report various disclosures and financial information periodically. SEBI closely examines this information to ensure everyone is playing by the rules and to detect any unusual activities.

   Category I and Category II AIFs don’t use leverage. Because of this, they only need to spill the beans on their financial status every three months. But, for Category III AIFs, SEBI expects more frequent updates, with monthly reports.

3. Investor Protection

   SEBI takes on a crucial mission in the alternative investment arena: being the guardian of investors’ interests. They are the ones who make sure that private market funds focus on safeguarding investor wealth. After all – we need the participation of both investors and AIFs for a functional and flourishing private market.

   Given the nature of these investments, SEBI places great importance on transparency. They demand thorough and stringent disclosures. It’s all about making sure investors have all the facts. They need to be in the know about the fund’s investment strategies, risks, and fees so that they can make an informed decision.

4. Regulatory Updates and Guidance

   These regulations are not set in stone. Based on the newer developments in the private markets, SEBI updates the regulations and provides new guidelines to AIFs.

   What’s on the menu of updates?

   Well, it could be anything from tweaking the list of investment options you’re allowed to play with, adjusting those leverage limits, or fine-tuning any other nitty-gritty operational details.

5. Misuse of AIF Structure

   In October 2023, SEBI uncovered several cases valued at about ₹200 billion, where the AIF structure has been used to sidestep the regulations. They have been used to sell stressed loans to unsuspecting investors and then use the funds to pay off the original loans.

   “We have found various cases of AIF structures are being used to circumvent other regulations. These cases do bother us even when we want the industry to grow.” — SEBI

6. Enforcement and Penal Action

   When an investor senses they’ve been dealt an unfair hand, they don’t have to fold their cards and give up. They can ask SEBI to step in and recover the funds, if possible.

   SEBI uses a variety of measures to enforce its decree. Think penalties that can sting, suspending operations to put the brakes on, and if necessary, cancelling the registration altogether!

7. Promoting Industry Growth

   For a market to grow, it has to have a strong foundation. This is created by clear rules and regulations that outline the expectations and the responsibilities of each of the involved parties.

   The alternative investment space, in particular, plays an important role in fostering economic growth and innovation. It encourages startups to raise funding and provides alternative sources apart from the heavily regulated public markets.

   It is SEBI’s objective to create a conducive environment so that the alternative investment space can flourish.