Sebi codifies 'excuse-exclude' norms used by AIFs for managing portfolios

Move to help curb cherry-picking of deals by LPs, manage conflict of interest

The Securities and Exchange Board of India (Sebi) has codified the ‘excuse-exclude’ norms used by alternative investment funds (AIFs), such as private equity and venture capital (PE/VC), for managing portfolio companies.

The move is expected to sidestep conflict, rein in investment breaches, and introduce transparency in the dealings.

While the excuse-exclude provisions are widely being followed by the PE/VC industry, the recent guidelines by Sebi will formalise the process and bring in uniformity, observe industry players.

Sebi has mandated the submission of legal opinion, reviewing disclosures in the contribution agreement, and offering rationale and documents before granting such flexibility.

At present, such exclusions were being used in some cases to benefit particular investors, owing to varying interpretations from PE/VC funds.

Limited partners (LPs) or investors in the fund will now be able to excuse themselves from certain deals based on the opinion of a legal advisor confirming that their participation would be a violation of a law or regulation.

For instance, certain LPs don’t allow investments in liquor-associated companies, gaming firms, and occasionally non-banking financial companies due to internal restrictions.

AIFs are pooled investment vehicles: some are structured on a blind-pool basis, others deal-by-deal, and still others hybrids.

Sebi has laid the groundwork for exercising the excuse-exclude clause.

An investor will be able to opt out of a deal by an AIF if it is disclosed in the contribution agreement that such an investment is in contravention of its internal policy.

Any change to the terms of this agreement will have to be informed to the AIF manager within 15 days.

“The new guidelines bring more transparency with a requirement of recording the reasons for each segment, along with limiting the terms for being excused from a deal or excluding an investor. This has rightfully been extended to even fund of funds and other investment vehicles investing in AIFs, on a pro-rata basis,” says Sahil Shah, counsel, Khaitan & Co.

“With the excuse provisions having crystallised, they prevent LPs from cherry-picking deals under the guise of excuse rights. LPs may have religious reasons, such as not investing in alcohol, gambling, etc — industries that may be well defined as internal policies upfront,” added Shah.

Further, if AIF managers believe there may be a violation — regulatory or taxation — or a material adverse effect on the fund, they will be able to exclude an investor from the deal.

However, managers will be required to record the rationale behind such exclusion, along with the documents relied upon.

Industry players say that an AIF manager may decide to exclude an overseas investor if it is in grey geographies in regulatory terms or lead to a breach in the investment threshold by an FPI.

“Besides providing flexibility to AIFs in their investment decisions, this circular will provide regulatory support and the much-needed clarity on several current practices. Foreign investors cannot breach the 10 per cent holding limit in a company. If by virtue of holding AIF units they are breaching the limit, there will be an opportunity to address it. However, the onus will still be on the AIF to offer a rationale. A lacuna, however, on the regulatory support of identifying FPIs that have reached this limit remains,” says Neha Malviya Kulkarni, chief growth officer, SuperNAV.

Legal experts say that in cases where an investor may be subject to insider trading regulations or investments indicative of conflict of interest, they may request to be excused from such deals. It could be something similar to the negative list of securities provided to portfolio managers.

“In certain cases, if there was a loss in a certain investment, some managers excluded particular LPs to give them benefit — which was a wrong practice. The new guidelines curb this with additional disclosures,” says another legal expert.