5 Flexibility and Risk: Operational and Prudential Norms for Category III AIFs

Key Takeaways:

- Category III AIFs can choose to calculate investment concentration norms based on either investable funds or net asset value (NAV).

- Detailed guidelines are provided for leveraging strategies, including the calculation of leverage ratios and the maximum permissible leverage limit.

- Robust risk management frameworks and independent compliance functions are mandated for AIFs employing leverage.

- Specific norms govern the redemption process for open-ended Category III AIFs, including provisions for suspension of redemptions under exceptional circumstances.

- Breach of corpus guidelines and the subsequent actions required are outlined for open-ended schemes.

Detailed Narrative:

The Alternative Investment Fund (AIF) landscape in India is diverse, with Category III AIFs occupying a unique position. These funds are permitted to invest in a wide array of securities, including listed and unlisted equities, derivatives, and complex structured products. Additionally, they have the flexibility to employ leverage, subject to certain conditions.

To ensure prudent operations and effective risk management, the Securities and Exchange Board of India (SEBI) has established a comprehensive set of norms specifically tailored for Category III AIFs. These norms aim to strike a delicate balance between providing operational flexibility and safeguarding the interests of investors.

One of the key aspects addressed in this chapter is the calculation of investment concentration norms. Category III AIFs have the option to calculate these norms based on either the investable funds or the net asset value (NAV) of the scheme. This flexibility allows AIFs to align their investment strategies with their risk appetites and portfolio objectives. However, it is crucial that the chosen method for calculating concentration norms is disclosed in the Private Placement Memorandum (PPM) and remains consistent throughout the scheme's tenure.

Leveraging strategies are a hallmark of Category III AIFs, and this chapter provides detailed guidelines on this front. AIFs employing leverage, whether through derivatives or borrowing, must adhere to specific prudential requirements. The leverage ratio is calculated as the ratio of the fund's exposure to its NAV, and the maximum permissible leverage limit is set at two times the NAV. This means that if an AIF's NAV is ₹100 crore, its exposure (longs + shorts) after offsetting positions cannot exceed ₹200 crore.

To mitigate the risks associated with leveraging, Category III AIFs are mandated to have robust risk management frameworks and independent compliance functions in place. These functions should be commensurate with the size, complexity, and risk profile of the fund. Additionally, AIFs must maintain appropriate records of trades and transactions, ensuring transparency and accountability.

The chapter also addresses the redemption norms for open-ended Category III AIFs. Managers of these AIFs are required to ensure adequate liquidity to meet redemption obligations and other liabilities. They must establish and implement a comprehensive liquidity management policy and disclose the possibility of suspension of redemptions under exceptional circumstances in the PPM.

Suspension of redemptions is permitted only in exceptional circumstances or when required by SEBI, and the decision must be appropriately documented and communicated to both SEBI and investors. Managers must regularly review the suspension and take necessary steps to resume normal operations as soon as possible, keeping SEBI and investors informed throughout the process.

Furthermore, the chapter outlines the actions to be taken in case of a breach in the corpus of an open-ended scheme. If the corpus falls below ₹20 crore, the AIF must intimate SEBI within two days and take necessary steps to restore the corpus within three months. Failure to do so may result in the winding up of the scheme and potential regulatory action against the AIF.

Throughout the chapter, specific references are made to various SEBI circulars and notifications, ensuring compliance with the regulatory framework. These include:

- SEBI Circular No. SEBI/HO/IMD/IMD-I/DOF6/P/CIR/2022/0000000037 dated March 28, 2022, which outlines the guidelines for calculating investment concentration norms based on NAV.

- SEBI Circular No. SEBI/HO/IMD/IMD-I/DOF6/P/CIR/2021/663 dated November 22, 2021, which provides further clarification on the calculation of investment concentration norms based on NAV.

- SEBI Circular No. CIR/IMD/DF/10/2013 dated July 29, 2013, which establishes the prudential requirements for leverage, risk management, and compliance functions.

By adhering to these operational and prudential norms, Category III AIFs can navigate the complex investment landscape while maintaining robust risk management practices and ensuring investor protection.

FAQs:

Q1: What is the significance of the investment concentration norms for Category III AIFs?

A1: The investment concentration norms are crucial for managing risk exposure and ensuring diversification within the portfolio. By allowing AIFs to choose between calculating these norms based on investable funds or NAV, SEBI provides flexibility to align with the fund's investment strategy and risk appetite.

Q2: Why is it important for Category III AIFs employing leverage to have robust risk management frameworks?

A2: Leveraging strategies can amplify both potential gains and losses. Robust risk management frameworks and independent compliance functions are essential to identify, monitor, and mitigate the risks associated with leverage. These measures help protect the interests of investors and ensure the long-term sustainability of the fund.

Q3: Under what circumstances can open-ended Category III AIFs suspend redemptions?

A3: Open-ended Category III AIFs can suspend redemptions only in exceptional circumstances or when required by SEBI, provided that such suspension is exclusively in the best interest of investors. The decision must be appropriately documented, communicated to SEBI and investors, and regularly reviewed to resume normal operations as soon as possible.

Q4: What actions must an AIF take if the corpus of an open-ended scheme falls below ₹20 crore?

A4: If the corpus of an open-ended scheme falls below ₹20 crore, the AIF must intimate SEBI within two days and take necessary steps to restore the corpus to ₹20 crore within three months. Failure to do so may result in the winding up of the scheme and potential regulatory action against the AIF.

Key Precedents:

1. SEBI Circular No. SEBI/HO/IMD/IMD-I/DOF6/P/CIR/2022/0000000037 dated March 28, 2022:

This circular outlines the guidelines for Category III AIFs to calculate investment concentration norms based on NAV. It specifies the conditions and procedures to be followed, including the treatment of passive breaches and the timeframe for rectification.

Q2. SEBI Circular No. CIR/IMD/DF/10/2013 dated July 29, 2013:

This circular establishes the prudential requirements for Category III AIFs employing leverage. It defines the calculation of leverage ratios, sets the maximum permissible leverage limit, and mandates robust risk management and compliance functions.

Q3. SEBI Circular No. CIR/IMD/DF/14/2014 dated June 19, 2014:

This circular outlines the actions to be taken in case of a breach in the corpus of an open-ended scheme. It specifies the timelines for intimating SEBI, restoring the corpus, and the potential consequences of failure to comply.

These precedents have played a crucial role in shaping the operational and prudential norms for Category III AIFs, ensuring a balanced approach that fosters innovation while maintaining investor protection and systemic stability.

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Here's AIF Master Circular's verbatim Chapter 5

Chapter 5 - Operational and prudential norms for Category III AIFs

5.1. Calculation of investment concentration norm for Category III AIFs{16}

Regulation 15(1 )(d) of AIF Regulations provides flexibility to Category III AIFs, including large value funds for accredited investors of Category III AIFs, to calculate investment concentration norm based either on investable funds or net asset value (‘NAV’) of the scheme while investing in listed equity of an investee company, subject to the conditions specified by SEBI from time to time. In this regard, the following is specified:

5.1.1. All Category III AIFs shall disclose the basis for calculation of investment concentration norm in the PPM of their schemes.

5.1.2. The basis for calculating investment concentration norm shall not be changed during the term of the scheme.

5.1.3. Category III AIFs which choose to calculate investment concentration norm based on NAV, shall comply with the following{17}:

(i) The limit for investment in listed equity shall be calculated based on the NAV of the fund on the business day immediately preceding the date on which the Category III AIF makes such investment.

(ii) NAV of the AIF shall be the sum of value of all securities adjusted for mark to market gains/losses (including cash and cash equivalents). The NAV shall exclude any funds borrowed by the AIF.

(iii) Passive breach of concentration norm, i.e. when the market value of the investment of Category III AIF in listed equity of an investee company exceeds the investment limit as specified under Regulation 15(1 )(d) of AIF Regulations, shall be rectified within 30 days from the date of the breach.

5.2. Prudential requirements with respect to leverage{18}

All Category III AIFs which undertake leverage, whether through investment in derivatives or by borrowing or by any other means shall comply with the following prudential requirements:

5.2.1. For the purpose of arriving at leverage undertaken by an AIF, leverage shall be calculated as the ratio of the exposure to the NAV of the AIF.

5.2.2. Leverage shall be calculated as under:

Leverage=Total exposure {Longs+Shorts (after offsetting as permitted')}

Leverage Net Asset Value (NAV)

5.2.3. The leverage of a Category III AIF shall not exceed 2 times of the NAV of the fund. i.e. If an AIF’s NAV is 100 crore rupees, its exposure (Longs + shorts) after offsetting positions as permitted shall not exceed 200 crore rupees.

5.2.4. Category III AIFs investing in units of other AIFs may undertake leverage not exceeding two times of the value of portfolio (NAV) after excluding the value of investment in units of other AIFs19.

Calculation of exposure and NAV

5.2.5. The total exposure of the fund for the purpose of computing leverage shall be the sum of the market value of all the securities/ contracts held by the fund. The total exposure at any point of time will be a sum of exposure through instruments in both the spot market and the derivative market.

5.2.6. Exposure shall be calculated as below:

(i) Futures (long and short) = Futures Price * Lot Size * Number of Contracts

(ii) Options bought = Option Premium Paid * Lot Size * Number of Contracts

(iii) Options sold = Market price of underlying * Lot size * Number of contracts

(iv) In case of any other derivative exposure, the exposure is proposed to be calculated as the notional market value of the contract.

5.2.7. Idle cash and cash equivalents shall not be included in the calculation of total exposure. Long put positions shall be considered as short exposure and short put positions shall be considered as long exposure. Short selling of a stock through Securities Lending and Borrowing Mechanism (‘SLBM’) shall be treated as short exposure. Temporary borrowing arrangements which relate to and are fully covered by capital commitments from investors need not be included in calculation of leverage.

5.2.8. Offsetting of positions shall be allowed for calculation of leverage for transactions entered into for hedging and portfolio rebalancing as provided in para 12.25 of Master Circular No. SEBI/HO/IMD/IMD-PoD- 1/P/CIR/2023/74 for Mutual Funds dated May 19, 2023.

5.2.9. Sum of all exposures without offsetting transactions for hedging and portfolio rebalancing shall be termed as 'gross exposure' and the ratio of such gross exposure and NAV shall be termed as 'gross leverage'.

5.2.10. NAV of the AIF shall be the sum of value of all securities adjusted for mark to market gains/losses (including cash and cash equivalents). The NAV shall exclude any funds borrowed by the AIF.

5.2.11. All the above restrictions/limits shall apply at the scheme-level.

Breach of leverage limits

5.2.12. All Category III AIFs shall have adequate systems in place to monitor their exposures. It shall be responsibility of the AIFs to ensure that the leverage shall not exceed the specified limit at all times.

5.2.13. All Category III AIFs shall report to the custodian the amount of leverage at the end of the day (based on closing prices), by the end of next working day{20}.

5.2.14. In case of a breach in limit:

a. Obligation of AIF:

(i) The AIF shall send a report to the custodian in case there has been any breach of limit during the day, by the end of the same day.

(ii) The AIF shall send a report to all its clients before 10 a.m. on the next working day stating that there is a breach in the limit along with reasons for the same.

(iii) The AIF shall square off the excess exposure and bring back the leverage within the specified limit by end of next working day. This shall however not prejudice any action that may be taken by SEBI against the AIF under AIF Regulations or the SEBI Act.

(iv) A confirmation of squaring off of the excess exposure shall be sent to all the clients by the AIF by end of the day on which the exposure was squared off.

b. Obligation of custodian:

(i) The custodian shall report to SEBI providing name of the fund, the extent of breach and reasons for the same before 10 a.m. on the next working day.

(ii) A confirmation of squaring off of the excess exposure shall be sent to SEBI by the custodian by end of the day on which the exposure was squared off.

5.3. Risk Management and Compliance{21}

All Category III AIFs which employ leverage shall:

5.3.1. have a comprehensive risk management framework supported by an independent risk management function, appropriate to the size, complexity and risk profile of the fund.

5.3.2. have a strong and independent compliance function appropriate to the size, complexity and risk profile of the fund supported by sound and controlled operations and infrastructure, adequate resources and checks and balances in operations.

5.3.3. maintain appropriate records of the trades/transactions performed and such information should be available to SEBI, whenever sought.

5.3.4. provide full disclosure and transparency about conflicts of interest and how they manage them from time to time, to investors, in accordance with Regulation 21 of the AIF Regulations and any other guidelines as may be specified by SEBI from time to time. Such conflicts shall be disclosed to the investors in the placement memorandum and by separate correspondences as and when such conflicts may arise. Such information shall also be disclosed to SEBI as and when required by SEBI.

5.4. Redemption norms{22}

5.4.1. These norms shall apply to open ended schemes of Category III AIFs.

5.4.2. The Manager of such AIFs shall ensure adequate and sufficient degree of liquidity of the scheme/ fund in order to allow it, in general, to meet redemption obligations and other liabilities.

5.4.3. The Manager shall establish, implement and maintain an appropriate liquidity management policy and process to ensure that the liquidity of the various underlying assets is consistent with the overall liquidity profile of the fund/scheme while making any investment.

5.4.4. The Manager of such AIFs shall clearly disclose the possibility of suspension of redemptions in exceptional circumstances to investors, in the PPM.

5.4.5. Suspension of redemptions by the Manager shall be justified only:

(i) in exceptional circumstances provided that such suspension is exclusively in the best interest of investors of the AIF, or

(ii) if the suspension is required under the AIF regulations or required by SEBI.

5.4.6. The Manager of such AIFs shall build the operational capability to suspend redemptions in an orderly and efficient manner. During the suspension of the redemptions, the Manager shall not accept new subscriptions.

5.4.7. The decision by the Manager to suspend redemptions, in particular the reasons for the suspension and the planned actions shall be appropriately documented and communicated to SEBI and to the investors.

5.4.8. The suspension shall be regularly reviewed by the Manager. The Manager shall take all necessary steps in order to resume normal operations as soon as possible having regard to the best interest of investors.

5.4.9. The Manager of such AIFs shall keep SEBI and investors informed about the actions undertaken by the manager throughout the period of suspension. The decision to resume normal operations shall also be communicated to SEBI and the investors as soon as possible.

5.5. Breach in corpus of open ended scheme{23}

For the purpose of Regulation 10(b) of AIF Regulations, in case the corpus of an open-ended scheme falls below twenty crore rupees:

5.5.1. The AIF shall intimate to SEBI within 2 days of receiving request for redemption from the client.

5.5.2. The AIF shall take necessary action to bring back the scheme size to twenty crore rupees within 3 months from the date of such breach.

5.5.3.In case the AIF fails to bring back the corpus within the specified period, it shall redeem entire units of all investors and wind up the scheme in terms of Regulation 29 of AIF Regulations.

5.5.4. In case of repeated violations by the AIF, SEBI may take action against the AIF, as may be appropriate.

Notes:-

{16}SEBI Circular No. SEBI/HO/IMD/IMD-I/DOF6/P/CIR/2022/0000000037 dated March 28, 2022

{17}SEBI Circular No. SEBI/HO/IMD/IMD-I/DOF6/P/CIR/2021/663 dated Nov 22, 2021

{18}SEBI Circular No. CIR/IMD/DF/10/2013 dated July 29, 2013.

{19}SEBI Circular No. SEBI/HO/IMD-I/DF6/P/CIR/2021/584 dated June 25, 2021.

{20}SEBI circular No. CIR/IMD/DF/14/2014 dated June 19, 2014.

{21}SEBI Circular No. CIR/IMD/DF/10/2013 dated July 29, 2013

{22}SEBI Circular No. CIR/IMD/DF/10/2013 dated July 29, 2013.

{23}SEBI circular No. CIR/IMD/DF/14/2014 dated June 19, 2014.