The Securities and Exchange Board of India (Sebi) has offered significant relief to Alternative Investment Funds (AIFs) regarding the implementation of new pro-rata rights rules introduced in December 2024. In a consultation paper released recently, the market regulator addressed industry concerns about operational challenges in maintaining proportional rights for investors during investment and distribution processes.
Clarification on Commitment Calculation
Sebi's latest proposal provides AIFs with crucial flexibility in interpreting investor commitments. Funds can now choose between two approaches when applying pro-rata requirements: they can consider either the total committed capital promised by investors or focus specifically on the undrawn commitment—the portion not yet called by the fund. This distinction is particularly important during capital drawdowns and investment proceeds distribution.
The regulatory flexibility is expected to help AIFs better align their investment cycles with investor commitments without violating pro-rata requirements. This addresses one of the major concerns raised by the industry following the December 2024 circular, which mandated that all investors in an AIF scheme must receive returns in proportion to their commitment levels.
Transition Relief for Existing Schemes
In a move that brings operational comfort to fund managers, Sebi has clarified that existing AIF schemes with established drawdown structures can continue their current approach until the end of their tenure. However, funds using other methodologies must align with one of the approved methods for new capital calls or future investments.
The regulator also provided grandfathering provisions for investments made before December 13, 2024. AIFs that had deployed capital before this date can continue distributing proceeds according to terms already specified in their Private Placement Memorandum (PPM) and other fund documents. This prevents funds from being forced to retroactively modify distribution waterfalls, which could have created significant legal and operational complications.
Special Provisions for Category III AIFs
Open-ended Category III AIFs, which allow investors to enter or exit schemes at any time, received specific relief from the pro-rata drawdown rule. Sebi recognized that these funds operate differently since they issue and redeem units based on the fund's Net Asset Value (NAV). Instead, such funds must ensure that any distribution of proceeds is made pro-rata to the units held by each investor at the time of payout.
However, open-ended schemes primarily investing in unlisted securities must still comply with broader pro-rata investment and distribution conditions. This maintains regulatory oversight while acknowledging the unique structure of Category III AIFs, which include hedge funds and other high-risk investment vehicles using aggressive strategies like algorithmic high-frequency trading.
Unresolved Industry Concerns
Despite the clarifications bringing relief to AIF industry officials, some challenges remain unaddressed. Investors with differential fee arrangements are particularly concerned that the new pro-rata income distribution rule might undermine their fee advantages. While such differential fees remain legally permitted, the pro-rata requirement effectively neutralizes them in practice.
Another significant issue involves AIFs with previously compliant but varied structures and distribution models now finding themselves in regulatory limbo. These funds await further guidance on unwinding existing agreements, leading to difficult negotiations between AIFs and their investors. Many industry participants hope that implementation standards from the Standard Setting Forum for AIFs (SFA) will provide additional clarity.
The consultation paper remains open for public comments until November 28, 2025, giving stakeholders additional time to provide feedback on the proposed clarifications. The AIF industry, which collects funds from investors to deploy in non-traditional assets beyond stocks, bonds, and mutual funds, continues to navigate these regulatory changes while maintaining operational efficiency.
