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SEBI Mulls Revamping Ownership Structure of MFs

Finsec Law Advisors

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A “sponsor” is the nucleus of a Mutual Fund (MF) precisely because they are responsible for promoting, bringing in capital and setting up a MF. It is important to mention that the concept of a sponsor is a departure from the usual rule of a company being a separate legal entity. Third parties are never liable or responsible for either the financial or non-financials of a legal entity once incorporated. The reason for the departure from the stated policy is to introduce a promoting entity being responsible for the fund at a time the fund is somewhat new and systems are still not fully in place for accountability. Owing to this central role of a sponsor in a retail-oriented fund, the bar set up by the Securities and Exchange Board of India (SEBI)for an entity to qualify as the sponsor of a MF is quite high.  However, despite their important position,the general market trend suggests that once an MF has crossed a certain markfor assets under management (AUM), they earn a reputation and become established; and consequently, the role of a sponsor in such MF begins to diminish and indeed should be eliminated.

According to a recent statistic,the domestic MF industry in India has witnessed a two-fold growth in the past 5years in terms of AUM. This growth when quantified amounts to around Rs. 39.89 trillion as of December 31, 2022, from 21.27 trillion as of December 31, 2017. This demonstrates that the MF industry has the potential for a lot more growth for which new players may act as catalysts. Considering this, in April 2022, Working Group to review the role and eligibility of a sponsor of a MF. As part of consultation paper,the Working Group has proposed an alternate eligibility criteria for Private Equity players (PEs) to enable them to act as sponsors of MFs whilst also viewing the viability of having self-sponsored Asset Management Companies (AMCs).

Over the past few years, PEs have been allowed to act as sponsors of real estate investment trusts, asset reconstruction companies and entities in the insurance industry. In this light, it was observed that PEs have significant capital which can be invested to drive innovation and growth, consequently leading to constructive competition in the MF industry. With a view to enable the entry of PEs into the MF industry, SEBI has proposed an alternate eligibility criteria wherein a sponsor would have to capitalize the AMC in a manner, that the positive liquid net worth of the AMC is not less than Rs. 150 Crores. In addition to this, the minimum positive liquid net worth would have to be Rs.100 Crores and the AMC would have to maintain such net worth till it has profits for five consecutive years. Further, the minimum capital contributed and minimum sponsor stake of 40 per cent would have to be locked-in for a period of five years. While, on one hand, SEBI’s proposal to make the MF industry more inclusive is laudable, however, on the other hand, the net-worth-based eligibility criteria prescribed by SEBI defeats this purpose by invariably erecting high entry barriers for interested players. Adding net-worth for smart businesses ensures rich people rather than smart and ethical people enter. In any case, PE players do usually come with scale and thus the net-worth may not by itself be a barrier for them to enter. Further, it is far more likely that aPE enters as financial sponsor of a running AMC rather than setting a greenfield venture. The core strength of PEs is bringing large amounts of capital and ability to scale the business rapidly. Thus, once allowed, there will be mix-and-match between PE players and fund managers bringing in capital from the former and expertise with the latter in a jugalbandi of capitaland expertise.

SEBI has further observed that as MFs mature, AMCs acquire self-sufficiency and maturity in running its operations in the interest of theunitholders, thereby gradually reducing the sponsors’ obligations to insignificant activities. Considering this, the Working Group has proposed a reduction of ownership of the sponsor in the AMC over time from the current requirement of 40 per cent and has floated the idea of a self-sponsored AMC without any sponsor. The consultation paper highlights that a reduction of the sponsor’s stake in the AMC will pave way for other significant shareholders,bringing in strategic guidance, inclusivity, and good talent to fuel growth and innovation in the MF industry. Moreover, with the presence of other investors in the AMC, MFs will increasingly work in the interest of investors by engaging in fewer related party transactions and minimising investment in instruments connected to the sponsor, its associate or group companies. This would be an excellent move and would counter-intuitively bring greater accountability of the mutual fund and its manager, rather than relying on some third party, whoknows little of what is going on, to stand accountable.

The consultation paper recommends that such reduction in the stake of the sponsor may be achieved either voluntarily, where the AMC or the sponsor will have the liberty to apply for disassociation; or mandatorily, where the reduction in stake will be a regulatory requirement. In either case, the primary principle for permitting disassociation of existing sponsors will be that the AMC itself is able to meet the qualifying conditions for a self-sponsored AMC as prescribed by the regulator. It is possible that the disassociation of existing sponsors,as envisaged by SEBI, will result in some MFs continuing to have sponsors,while some operating without any sponsors, hence inviting two sets of compliance requirements catering to the specifications of each structure. A key distinction will be that in the case of a self-sponsored AMC, all obligations of a sponsor such as compensating for inappropriate valuation, maintenance of minimum liquid net worth of AMC on continuous basis, etc. will be performed by the AMC itself. The disassociated sponsor will be considered a ‘financial investor’, and no obligation of a sponsor will apply to the disassociated sponsor.

SEBI is proposing to put in place ownership norms akin to those stipulated by the Reserve Bank of India for banks, that requires promoters to mandatorily dilute their shareholding in banks within a specified period as per the prescribed guidelines. Given that the underlying intention is to usher in a new era of self-sufficient AMCs, it is suggested that a mandatory reduction in the stake of sponsors is the way to achieve this. At the same time, it is important to gauge if a model mandating disassociation of sponsors will be practically feasible for the AMCs presently operating in the Indian markets, who would then be required to adopt these norms retrospectively. A more practical and consistent model would be to allow sponsors to disassociate themselves voluntarily after a period of maturity of the MF/AMC, without mandating a divestment. The assumption that fragmented shareholding by itself is a good thing is questionable as we have seen in many banks. The regulator should let athousand flowers bloom from a control perspective so long as it is without diluting accountability standards.

Overall,SEBI’s proposals will go a long way in achieving fresh capital injection, encouraging and fostering competition and innovation, enabling new players to enter the MF space and providing an exit option to sponsors of AMCs. That being said, SEBI will have to put in place more balanced provisions to ensure that PEs can enter and sponsors can exit the MF industry comfortably while also protecting unitholders’ interests against any market imbalances and disruptions that maybe caused due to such actions. As the Indian MF industry continues to grow and evolve, it will be interesting to see how these proposals pan out in terms of implementation in a market space that might be set in its ways of operation.

This article was first published in Financial Express: Link