Tuesday, August 16, 2011

Comments on SEBI's concept paper on Alternative Investment Funds

This is my first ever blog. My apologies in advance for mistakes made as I learn to use this tool

AUGUST 11, 2011
SEBI recently released their “Concept paper on proposed alternative investment funds regulation for public comments” (http://www.sebi.gov.in/commreport/alternativeinvestment.pdf).
Directionally SEBI appears to be proposing some very positive steps. Even though costs may increase as a result of increased regulation, proper regulation and properly regulated market mechanisms are valuable. That said, I have some comments and suggestions that I feel: could be considered by SEBI and; are in line with SEBI’s original purpose of fostering the funding of entrepreneurs’ early stage investments.
Disclaimer:  these are my views and not necessarily the views of the institution I work for; and my inputs are biased given my interest in making more funds available to a broader range of entrepreneurs.
The comments/suggestions below also assume, for reasons of brevity that the reader is familiar with the contents of the “Concept Paper”.  Finally, the comments and suggestions are not based on any intricate knowledge of all the regulations pertaining to funds investment in the country and are meant not as a criticism of SEBI. They are meant only as food for thought and while it is accepted that the “devil is in the details” it is also recognized that “where there is a will, there is a way”.
1)      While the concept paper is directly related to funds, perhaps there should be a section on what’s being done in the area of Alternative Investment Activity. For example, there may be entities outside India that do not want to create funds in India – but solely to invest in India. In such cases it is more their activities, rather than their fund-raising that becomes relevant. In such cases too, there ought to be regulations that will protect both investors and investees without hampering growth. In this aspect, I am excluding Private Equity Funds as I suspect that those would be covered more by FDI regulations. I am referring more to funds created abroad for the express purpose of say, SME investing or social investing.

2)      The concept paper suggests that the minimum floor for an investor in a given fund should be INR one crore ostensibly to prevent the subject funds from becoming retail based.  In the case of AIF’s constituted as Company or LLP the units would not exceed INR ten lakhs and the number of partners not exceed fifty.
Given the inherent risks in early stage investing, and SEBI’s goal is to encourage early stage investing, it may well be worthwhile developing ring fencing mechanisms that prevent the “retail-ization” of funds while allowing for smaller size investments.
3)      Directly tied with the idea above is the notion that the concept paper’s definition of Social Venture Funds be amended to also include very-early-stage SME funds. Doing so will encourage the aggregation of investment capital that is more concerned with social returns than absolute economic returns and which does not mind that their funds are being used to create entrepreneurs rather than to fund entrepreneurs who have already achieved a modicum of success.  If SEBI was also to require that the funds could only invest in registered entrepreneurs (i.e. registered firms) it would also help make a dent in the very large component of total funding for entrepreneurs – that of informal financing of entrepreneurs. For all of this to happen, it must be possible to invest smaller amounts as doing so allows the investor to lower his/her perceived risk or spread that risk by investing the same 25 crores in 2 or 3 funds as opposed to a single fund.

4)      It may also be useful for the concept paper to address the issue of governance of the fund managers more substantially. I believe that in the case of SME funds and SVF’s the funds must limit the number of investments that any one fund (or within a fund, a portfolio manager) manager can oversee. The managers must also be reasonably qualified and this qualification ought to be reviewed and all managers of portfolios approved by a regulatory body. After all, the stated advantage of having formal investors in early-stage funds is the industry focus and hand-holding that they bring to their investments.

5)      Similarly, to encourage a broad based investment approach and encourage more early stage funding, it may be worthwhile to limit the maximum investment in any one firm to 10% rather than 25%. It may be possible to have different limits for different kinds of funds.

6)      The concept paper notes that MFI (Micro Finance Institutions) could be funded by SVF’s (Social Venture Funds). In my view, the MFI’s are often an aggregator and distributor of funds and therefore present an additional layer or link – and therefore often additional cost – in the chain that flows from the source of the funds to the user of the funds. MFI’s should be judged by their ability to lower funding costs to entrepreneurs. So if SVF’s that expect lower returns are used to fund MFI’s, it should logically flow that the MFI’s must demonstrate that they are not costlier for consumers than at best, bank price of funds (assuming the unbanked got prices similar to the lower end of the banked segment – that is high spreads to cover risk) or at worst not costlier than prices arrived at after MFI’s are funded by alternate sources of equity.

7)      Equity funding appears to be the thrust of the paper despite the references to the possibility of investing in convertible debt. Based on the concept paper, my view is that Debt funding of early stage companies is largely ignored. For example the “Conditions for Debt Funds” are unlikely to ever cause the debt funding of early stage firms.  The creation of securitized debt assumes a revenue stream to allow the repayment of the debt (or in the case of collateralized debt the presence of assets that would cover the default). Early stage companies may not have that luxury as they could well be in a pre-revenue stage. On the other hand they may prefer to have debt rather than equity based on the nature of their business. In both cases, early debt and early equity, the investor could insist on close monitoring of the firm and involvement in the management of the firm and if needed convertible debt.
I would welcome feedback on these comments and suggestions and furthermore, on any ideas, suggestions and solutions related to how funds can be made more easily available to entrepreneurs.