The growth of alternative investment fund (AIF) in India has been significant in the last few years. In order to bring greater checks and balances in the AIF ecosystem, Securities Exchange Board of India (SEBI) has in the last 12 months introduced several changes in the regulatory regime governing AIFs.
One of the recent reforms introduced by SEBI is with respect to ‘Excuse and Exclusion’ right of an investor from its obligation to make an investment. On 5 February 2020, SEBI had introduced certain disclosure standards in relation to the private placement memorandum (PPM). The PPM template also provided for disclosures under the term “Excuse and Exclusion”. However, as SEBI observed certain disclosure-related inconsistencies in PPMs and lack of transparency, new guidelines have been introduced by SEBI in relation to excuse rights of investors pursuant to circular dated 10 April 2023.
EXCUSE OR EXCLUSION: MEANING
A typical investment structure involves investors (LPs) who participate in an AIF by committing their capital and relying on the skill and acumen of the investment manager (GP), to identify favourable investment opportunities. Excuse or exclusion rights provide LPs with the ability to opt-out from participating in a deal / investment identified by the GP in certain scenarios.
An AIF may excuse its investors from participating in a particular investment in the following instances:
- If based on the opinion of a legal professional or legal advisor, the investor confirms that its participation in the investment opportunity would result in violation of an applicable law or regulation.
- If the investor, pursuant to a contribution agreement or any other agreement signed with the AIF, had disclosed to the fund manager that, participating in such investment opportunity would be in contravention to the internal policy of the investor. The Guidelines also require the fund manager to ensure that the terms of such agreement require disclosure of any change in the disclosed internal policy to the AIF within 15 days of change.
Excuse rights based on internal policy of the investor should be as explicit as possible to avoid the GP having to second guess the LP on each investment. GPs should try to limit the amount of investor discretion in determining what an excused investment is as the emphasis should be on using the investor’s full commitment rather than allowing it to cherry pick deals. Ideally, excuse rights should be documented in the contribution agreement and informed to other investors as well. The terms of these rights should be objective, to avoid future disputes over their application.
An AIF may exclude an investor from participating in a particular investment if the manager of the AIF is satisfied that the participation of such investor would lead to the scheme of the AIF being in violation of applicable law or regulation or would result in material adverse effect on the scheme of the AIF.
The manager of the AIF is required to record the rationale for any aforementioned exclusion, along with the documents relied upon, if any.
In terms of the exclude rights, GPs have a broad discretion under the term ‘material adverse effect’ to exclude investor. This decision of the GP to exclude an investor is not required to be supported by a legal opinion. In light of the same, LPs should insist that the fund documents should clearly set out the parameters for exclusion on the basis of ‘material adverse effect’ and the decision of the GP on exclude rights to be supported by a legal opinion.
PARTIAL EXCUSE/EXCLUDE RIGHTS
In case an investor is also an AIF or any other investment vehicle, then such investor may be partially excused or excluded from participation in an investment opportunity, to the extent of the contribution of the said investment vehicle’s underlying investors, who are excused or excluded from the same opportunity. The manager of the AIF must record the rationale for such exclusion, along with the documents relied upon, if any.
Excuse / exclude rights are a useful mechanism, but can be complicated to execute. Set out below are some key considerations:
Capital commitment of LPs: Capital calls are made by GPs by issuing drawdown notices to the LPs and pursuant thereto the LPs are often required to contribute. Usually, the capital contributions are made in proportion to their unfunded capital commitments and not their total capital commitments. However, in the event, an LP decides to exercise its excuse rights or is excluded from a particular investment, other investors should be put on notice as to the reason that a particular LP has received an excuse right for the particular investment or has been excluded. Moreover, the fund documents must clearly explain the impact that an excuse / exclude right would have if ever exercised—for instance, in terms of the present investment – (i) whether the other investors have an option to fund more than their pro rata share of an investment to cover the shortfall, (ii) whether in terms of future investment, the capital contribution will be based on the unfunded capital commitments or total capital commitments, and (iii) whether the unfunded capital commitment of an LP pursuant to the excuse / exclude right is reduced thereby impacting the corpus of the fund. Further the excused / excluded LP should not benefit from any distributions related to such investment.
Fund expenses and management fees: Ideally the excused / excluded LP should continue to bear its share of fund expenses and management fee other than all direct expenditure in relation to such specific portfolio investment.
Carried interest: As the distribution waterfall of the LP, would not include the excused / excluded investment, carried interest for such investments to the GP should not be required to be paid.
The Guidelines can be seen as a move by SEBI to enhance transparency and simplifying the disclosure process by identifying specific criterions for exercise of excuse or exclusion rights. Having said that, since the Guidelines do not legislate or prescribe the manner in which post exercise of such excuse / exclusion rights, future drawdowns, expenses, distributions or inter-se voting rights will work, SEBI has left some flexibilities to parties to negotiate on these contractually. Therefore the provisions in relation to impact of the excuse / exclude rights if ever exercised should be carefully incorporated in fund documentation in order to define the framework for such rights between LPs and GPs.