Navigating the Conclusion of Fund Life: Deciding Between Secondaries Fund, Continuation Fund, or Liquidation Scheme

Evolving Strategies for Navigating the Conclusion of Fund Life in India’s Alternative Investment Landscape

In the dynamic realm of investment, the landscape is continually evolving, guided by emerging trends, shifting regulations, and the quest for optimal returns. Alternative Investment Funds (AIFs) have gained prominence as a crucial asset class in India, driven by a regulatory framework that accommodates the preferences of sophisticated investors seeking exposure to the unlisted sector. This surge is further fueled by burgeoning investment opportunities, propelled by sustained economic growth. AIFs are emerging as vital contributors to sustaining and expanding the country’s economic trajectory.

A central objective of AIF investments typically revolves around maximizing portfolio value within the AIF’s tenure. This necessitates an “orderly exit” strategy to realize the anticipated exit value of the asset class. Historically, exit routes often centered around Initial Public Offerings (IPOs), mergers and acquisitions (M&A), or trade sales. However, a distinct trend has emerged in India over the past few years: the ascension of secondary deals. This entails transactions primarily between AIFs and Private Equity Funds, where one fund sells its assets to another. A multitude of global capital pools are dedicated to funds focused on such secondary deals.

In this context, investment vehicles designed to acquire portfolio investments from AIFs approaching the end of their tenure have taken shape, often referred to as secondary funds, continuation funds, or liquidation schemes. The Securities and Exchange Board of India (SEBI) highlights that the tenure of 24 AIF schemes valued at INR 3,037 crores will conclude in the Financial Year (FY) 2023-24. An additional 43 schemes valued at Rs 13,450 crores will conclude in FY 2024-25.

The common thread among these strategies—secondary funds, continuation funds, and liquidation schemes—is the transfer of assets from an existing AIF to a new investment vehicle. This maneuver enables fund managers to extend the lifespan of unliquidated investments beyond the original fund’s tenure, potentially yielding enhanced returns for investors. Simultaneously, existing investors retain the choice to transition their interest to the new investment vehicle. This approach mitigates their exposure to a limited blind pool risk and extends the investment duration, while still ensuring a faster return of capital and related returns.

In practice, secondary funds and continuation funds differ, particularly in terms of risk profiles. Secondary funds offer diversified exposure through new investments, whereas continuation funds often possess a more concentrated portfolio, encompassing a subset of existing investments from the original fund, with or without follow-on rounds. The latter comes into play when an AIF reaches the end of its initial term but still holds valuable assets that require additional time to mature or reach its full potential. Instead of prematurely liquidating these assets, fund managers establish continuation funds, permitting existing investors to roll over their investments and continue benefiting from portfolio growth. While new capital infusion isn’t obligatory, existing investors can either transition their investments or cash out. This underscores the fund manager’s confidence in achieving better returns through the continuation fund, while secondary funds offer new investors potentially discounted access to the portfolio. Secondary funds may accept fresh capital commitments from investors for follow-on or new portfolio investments in certain cases.

Recently, SEBI introduced regulatory recognition for continuation funds through a liquidation scheme amendment to the SEBI (Alternative Investment Funds) Amendment Regulations, 2023. This adjustment enables closed-ended funds to launch a liquidation scheme during the liquidation period to transfer unliquidated investments from the original scheme to the liquidation scheme. The process involves obtaining consent from 75% of investors based on their investment value, arranging bids for at least 25% of the consolidated value of unliquidated investments, disclosing bid values and valuations to all investors, accommodating dissenting investors through proceeds from the bid, distributing the unsubscribed portion pro-rata, and finally, transferring the unliquidated investments to the liquidation scheme. Units of the liquidation scheme are then allocated to the original scheme’s investors.

The crux of the matter lies in the differentiation between liquidation schemes, continuation funds, and secondary funds. The former is precluded from accepting new investor commitments or making new investments. If assets within the liquidation scheme remain unsold due to liquidity constraints at the term’s end, they must be distributed as directed by SEBI. However, challenges persist in launching a liquidation scheme, including unclear taxation on portfolio transfers, restrictions on transferability due to pending litigations, and transfer limitations outlined in investment documents.

A pivotal concern revolves around managing inherent conflicts of interest when investment managers simultaneously act as sellers and buyers in continuation funds and secondary funds. The Institutional Limited Partners Association (ILPA) provides guidance on continuation funds, emphasizing the need for LP Advisory Committee (LPAC) approval for any conflicts where benefits received by investment managers are not shared with investors. This underscores the significance of investor-fund manager collaboration in navigating such scenarios. Clear delineation of risk and governance terms agreed upon in the existing fund’s side letter is also crucial for continuation funds and secondary funds.

In conclusion, as India’s secondary market evolves and exit cycles elongate, the prevalence of secondary funds, continuation funds, and liquidation schemes as end-of-term strategies is likely to grow. These strategies are integral to the alternative investment space’s capital structure, deepening the market’s scope. Simultaneously, transparency and consistency in executing such deals are imperative for their effectiveness. While SEBI has yet to mandate distinct modalities for launching secondary funds and continuation funds, a robust partnership between investors and fund managers is vital to implementing a suitable strategy successfully.

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