SEBI is looking into matters related to side letters or contribution agreements, that govern preferential terms for some LPs in a venture fund
LPs are said to have raised concerns about whether VC funds are being fair and equal in courting the interest of HNIs, family offices, corporate funds and institutional investors alike
If SEBI bars side letters, large funding rounds for startups might fall through the cracks, and it might make it challenging for Indian VC funds to raise large corpuses
India’s private equity (PE) and venture capital (VC) landscape is already bracing itself for a slew of changes — from skill-based certification for key personnel at AIFs to more transparency in how their funds are being liquidated. Many of these, of course, don’t affect Indian VC firms run by professional fund managers, but the latest demand by SEBI is likely to change that.
According to an ET report, SEBI recently asked AIFs or Indian VC firms to reveal which of their investors or limited partners (LPs) have entered into deals with preferential terms or a bigger say in the deal making process. Of course, this has opened up concerns about whether VC funds are being fair and equal in courting the interest of HNIs, family offices, corporate funds and institutional investors alike.
As per SEBI data, India is home to over 1,200 AIFs and many of these have launched multiple schemes or funds over the years, and much of the investment in Indian startups happens through these AIFs, which raise capital through LPs across classes as mentioned above.
Sources in the industry tell us that SEBI has received complaints from some influential LPs about preferential treatment to other limited partners. The practice in question is called a side letter or a contribution agreement, and in many cases, it governs terms for preferential returns timelines as well as exposure of the LP to certain kinds of assets.
In some cases, limited partners want to pay lower fees, which could be the case for corporate LPs or institutional funds, whereas HNIs and family offices might be asked to pay more. Fund managers claim this is typical practice because the former class of LPs contributes more to a corpus, whereas the latter are more in number.
So consider the example of some Indian VC firms which have existed for well over a decade. In these cases, the corpus size typically grows significantly from one fund to another. In these cases, the increase in the corpus is more likely to come from institutional or corporate LPs rather than several dozens of HNIs.
“It’s not surprising that SEBI is asking now about LPs and the private placement memorandum (PPM). PPM should be standard for everyone, but we all know that’s not the case. In fact, even those LPs that may be complaining now knew about it,“ says a Bengaluru-based early stage fund manager.
The Question Of Side Letters
It’s very possible that such side letters were allowed by SEBI when startup investments and AIFs were not everywhere. But that’s not the case anymore. The biggest example is Shark Tank India, which will soon go into production for its fourth season.
The show was well-timed, coming at the tail end of 2021, when the pandemic had turned many Indian startups such as into household brands. And it garnered plenty of attention due to bombastic angel investors or sharks.
And this is just my opinion — since then Shark Tank India has matured and it’s no longer a shouty reality show. Its third season actually merited some praise for how it dealt with critical aspects of building a brand or startup. But that’s just one example.
We have also seen a proliferation of micro VC firms — a trend we covered a couple of weeks ago — and family offices looking to diversify. It’s only right that some of these family offices backed by traditional and legacy businesses might have some concerns about how AIFs and VC funds invest their money.
One multi-family office fund manager told Inc42 that typically large institutional LPs get a 25% discount on management fees, 1.5% vs the 2% that other LPs pay. To compensate for those LPs that backed a fund during its first close, investors in subsequent round closes are charged an equalisation premium.
Larger conglomerates such as Reliance and Tata are also LPs in funds, and such large corporate venture funds tend to get favourable terms in the market from funds, especially those run by pedigreed fund managers.
“Having a large CVC as a corporate LP means your portfolio gets direct exposure to the LP’s network, which then allows them to scale up and grow faster. It’s a win-win for the fund manager and the other LPs. But it’s a problem when large corporate giants become acquisitive and acquire companies in the fund’s portfolio in distress situations.”
This leaves other LPs holding the bag of losses. Such a case gained prominence in 2021 when Reliance invested in Kalaari Capital on the heels of acquiring four companies in Kalaari’s portfolio, with Urban Ladder acquired at a 75% discount to its last valuation.
How SEBI’s Ask Impacts Indian VCs
“Asking for more transparency from the entities it regulates is SEBI’s prerogative. But as an investor I also want to have the right kind of diversification in my portfolio, so now it will become tricky for me to invest in pooled funds if SEBI bars side letters,” according to a principal at a Mumbai-based private equity firm.
This is where side letters are used as leverage by fund managers to bring on large LPs. These LPs may have investment policies that forbid investments in certain business sectors, so fund managers have to accommodate their requests if they want their capital.
All the capital raised ends up in a blind pool, but with side letters in play, the pool is not so blind. It means fund managers have enough visibility of the pool to know which LPs to draw down or basically call in the commitment.
So when the fund is investing in an EV startup but the large automobile OEM that is a major LP does not want that exposure, the fund is forced to ask for a bigger drawdown from its other LPs to fulfil the round. The argument can be extended to any disruptive startup that is seeking capital from funds that have incumbents as LPs.
If SEBI bars side letters, many of these rounds might indeed fall through the cracks as the fund will be unable to meet the commitment.
The Push For Standards
In recent times it has become clear that SEBI has looked to standardise AIFs and startup investments. Side letters and special deals run contrary to this direction.
Since side letters govern terms related to management fees at times, many LPs feel short changed when there is disparity in these terms. It can lead to friction between LPs and this could lead to reputational damage to the VC firm and the fund manager.
More importantly SEBI’s rules are likely to be harder on existing large funds since they have a longer track record and have the potential to have the same LPs over multiple funds and therefore a higher likelihood of side letters.
While AIFs might find it easier to manage all LPs with one agreement, it does make it harder to raise large corpuses.
Will SEBI bar side letters? That’s unlikely to happen, according to some of the fund managers that we spoke to, because that will severely impact fundraising. “SEBI will probably want more transparency. It has asked for performance reporting to some degree so now next it wants LP reports. Some clauses may be targetted but it’s not likely that the practice will be disallowed,” the PE investor quoted above added.
But SEBI has a track record of doing that with public markets, even though these were not really side letters. Before July this year, stock exchanges offered brokers discounts on fees based on their trading volume. Simply put, higher trade volumes for a broker meant lower fee costs and more profits. But SEBI introduced uniform charges in July, to effectively end volume-based discounts.
That is quite different from standardising the PE and VC world, since their structures are so different and they cater to investors with longer horizons.
A crackdown on side letters means large institutional investors — particularly those that want to avoid exposure to particular sectors — might park their money elsewhere. And that doesn’t help Indian VC funds or startups.
