SEBI freezes AIFs with 'priority distribution model'

SEBI has taken cognizance of irregularities in some AIFs and froze their fund raising and investing activities.

AIF is an Investment Vehicle wherein the AIF raises money from HNIs and Institutional Investors to further invest in Startups/ Private Equities/ Hedging transactions. AIFs have a very clear 'Pass Through Status' wherein Investors (including Sponsors/Fund Managers) share the Profits or Losses. Profits or Losses are distributed in the proportion to their investment in the AIF.

Now, some AIFs have adopted a 'Waterfall distribution', wherein certain Investors have a preference in receiving the proceeds out of the distribution by the AIFs, meaning they also have a lesser share in the losses of AIF than other Investors. SEBI, in an earlier Circular had already clarified on the matter:

"c. With respect to investment by the sponsor/manager in the AIF, the sharing of loss by the sponsor/manager shall not be less than pro rata to their holding in the AIF vis-à-vis other unit holders."

SEBI has now taken into cognizance that, despite clear Regulations and Circulars, certain schemes of AIFs are following this Waterfall Distribution Model. This causes injustice to Investors who are not prioritized. SEBI has stepped in to protect such Investors. SEBI is examining this matter in consultation with Alternate Investment Policy Committee, AIF Industry association and other stakeholders.

In the meantime, SEBI has now issued a Circular mandating all such schemes of AIFs not to raise any fresh commitment or make investment in a new investee company. This has effectively frozen such AIFs. The AIF industry is now awaiting a swift decision from the Regulator to protect the interests of Investors.

AIFs in the recent years have risen as a very critical way of fund raising for investors wanting to invest in Startups and Hedge Funds. They are a major force in the startup ecosystem with almost ₹ 7 Trillion funds raised by AIFs, as per data available for June 2022. Having a strong investors protection measures is necessary for the growth of this sector.