India continues to witness the rise of Alternative Investment Funds (AIF) as an asset class – a growth facilitated by an evolving regulatory landscape that caters to the needs of sophisticated investors wanting to take exposure in the unlisted space and increasing investment opportunities fuelled by sustained economic growth. AIFs have presented themselves as one of the important levers to sustain and expand the economic growth in the country.
One of the key objectives of an investment by an AIF is typically to maximize the value from the portfolio, ideally within the tenure of the AIF. The AIF should be able to make an ‘orderly exit’ from the portfolio so that it is able to realise the expected exit value of the asset class. While the traditional exit modes relied upon by the AIFs were Initial Public Offerings (IPO) or mergers and acquisitions (M&A) or trade sale, what has emerged more strongly in India over the last couple of years is the rise of secondaries where the trades are largely between AIFs and Private Equity Funds, with one fund selling to other. There are large pools of capital globally that have been committed to funds focusing primarily or exclusively on such secondary deals.
With this backdrop, investment vehicles focusing on acquiring portfolio investments from existing AIFs, which are near the end of their tenure and termed differently, have evolved either as secondaries fund, continuation fund or liquidation scheme. As per the Securities and Exchange Board of India (SEBI), a two-year extension period for 24 schemes of AIFs with a valuation of INR 3,037 crores will expire in Financial Year (FY) 2023-24 and the tenure of another 43 schemes with a valuation of Rs 13,450 crores will expire in FY 2024-25.
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The unifying factor, among secondaries fund, continuation fund and the liquidation scheme, is the transfer of assets from an existing AIF to a new investment vehicle. This allows fund managers to hold unliquidated investments beyond the original tenure of the existing fund, thus paving the way for potentially enhanced returns for the investors. Concurrently, the existing investors can opt out from rolling over their interest to the new investment vehicle. Consequently, they are presented with a limited blind pool risk and extended but shorter investment duration with a faster return of capital and return thereon.
In practice, traditional secondaries funds differ from continuation funds, particularly in terms of risk profile. A secondaries fund would offer a more diversified exposure with new investments, whereas the portfolio of a continuation fund would be more concentrated in nature with fewer existing investments from the original fund, both with or without follow-on rounds. Continuation fund offers a solution when an AIF reaches the end of its initial term but still holds trophy assets that require more time to mature or realize their full potential. Instead of selling these investments prematurely, the fund manager sets up a continuation fund, allowing existing investors to roll over their investments and continue participating in the growth of the portfolio. Although new capital infusion is not a requirement, the existing investors have a choice of either rolling their investment into the continuation fund or cashing out. Thus, a continuation fund showcases fund manager’s conviction to achieve better returns while, in a secondaries fund, the new investors may look for a potentially discounted access to the portfolio. The secondaries fund may accept fresh capital commitments from the investors to either make follow-on investments or even fresh portfolio investments in some instances.
Recently, a continuation fund received regulatory recognition from SEBI through a liquidation scheme, introduced via an amendment to the SEBI (Alternative Investment Funds) Amendment Regulations, 2023. With this change, close ended funds can, during the liquidation period, launch a liquidation scheme for the purpose of transferring the unliquidated investments from the original scheme to the liquidation scheme. The modalities for launching a liquidation scheme require,
- Consent of 75% of the investors by value of their investment for launching liquidation scheme
- Arrangement of bid for a minimum of 25% of the consolidated value of the unliquidated investments
- Disclosure of the bid value to all the investors along with the valuation of unliquidated investments carried out by two independent valuers
- Exit to dissenting investors (if any) from the proceeds of the bid
- Distribution of the unsubscribed portion to non-dissenting investors for a pro-rata exit
- Sale of unliquidated investments to the liquidation scheme
- Allotment of the units of the liquidation scheme to the original scheme
- Distribution of units of liquidation scheme to the investors of the original scheme in lieu of units of the original scheme.
The key difference among the continuation funds, the secondaries fund and the liquidation scheme are that liquidation scheme is prohibited from accepting new commitments from any investor or making new investments. If the assets of the liquidation scheme are not sold due to a lack of liquidity at the tenure’s end, they will have to be distributed in-specie as directed by SEBI. However, there are several challenges in launching a liquidation scheme. Some of these include lack of clarity on taxation on transfer of portfolio, restriction on transferability of investments due to pending litigations, and transfer restrictions under the investment documents.
The fundamental issue is to manage the inherent conflict of interest in cases where the investment managers act as both sellers and buyers of continuation funds and secondaries funds. Here, a reference can be drawn from the Institutional Limited Partners Association (ILPA) guidance note on continuation funds. It provides that any conflicts where the investment manager might receive benefits that are not shared with the investors should be approved by the LP Advisory Committee (LPAC). Potential conflicts to review can include, but are not limited to, the crystallization of carried interest, the method of soliciting bids on the selected assets and changes to the existing commercial terms of offering etc. Further, investors should be afforded a reasonable number of days to make decisions on whether to roll or sell. All relevant risk and governance terms agreed to in the existing fund side letter should be applicable for the secondaries and continuation fund as well.
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As the world of secondaries evolves in India and exit cycles keep getting extended, we expect the prevalence of various forms of secondaries viz. secondaries funds, continuation funds and liquidation schemes to only increase as an end of fund’s term strategy. They are all a very important part of the capital stack in the alternative space and their presence will only further deepen the markets. At the same time with their rise, the need for transparency and consistency in such deals becomes crucial for their effectiveness and successful execution. Although the regulator has not mandated distinct modalities for launching a secondaries fund and a continuation fund, a strong collaboration between investors and fund managers is essential to successfully implement a suitable strategy.
This article has been written by Siddharth Shah, Sahil Shah and Shambhavi Sinha. Siddharth Shah is Partner, Sahil Shah is Counsel and Shambhavi Sinha is Associate at Khaitan &Co. Views expressed are personal.
