Aman Jha, Anurag Shah
Apr 5, 20216 min
[Aman and Anurag are students at National Law University, Delhi, and School of Law, Christ (Deemed to be University), respectively.]
The Ministry of Finance vide its gazette notification dated 15 March 2021 (Notification) has amended the investment pattern of private pension funds (PFs). Through this amendment, the government has now allowed PFs to invest 5% of their surplus in units issued by Category I and Category II Alternate Investment Funds (AIFs) that are regulated by the Securities and Exchange Board of India (SEBI). This amended investment pattern would now allow PFs to tap into the avenues of infrastructure entities, small and medium enterprises (SMEs), and venture capital. This post seeks to analyze the investment pattern vis-à-vis the risk aptitude of PFs, and how the same would be a win-win for both the PFs and the specified sectors in the Notification.
This Notification amends an earlier notification dated 2 March 2015 wherein the government had provided for a detailed investment pattern that was allowed for PFs. As per the 2015 notification, PFs could only invest in specific categories, which included government securities, debt securities issued by banks and corporates, rupee bonds, and other similar debt instruments. This was followed by an amendment in the pattern, which allowed PFs to invest in units of debt-exchange traded funds and later equities. The present Notification, through an amendment to Column 2 of the 2015 notification, allows PFs to invest in units issued by Category I and Category II AIFs. However, the investment would only be allowed subject to certain conditions being satisfied.
In totality, there are seven conditions that must be fulfilled for investment by PFs into the aforementioned AIFs. First, investments can only be made in permitted funds under Category I AIFs, which include infrastructure funds, SME funds, venture capital funds, and social venture capital funds. Second, in case the investment is being made to a Category II AIF, the AIF shall have at least 51% of its investments in the aforementioned sectors. Third, PFs can only make investments in the AIFs with a corpus equal to INR 100 crores or more.
The fourth condition is that the PF’s exposure to a single AIF should not exceed a total of 10% of the concerned AIF’s size. However, government-sponsored AIFs would be exempt from this condition. The fifth condition entails that the PFs should not make any investments directly or indirectly into the securities of a company or any fund which is incorporated and/or operated outside India. The sixth condition requires that the sponsors of the AIF which receives investments from PFs should not be promoters or belong to the promoter group of the PF. Finally, the AIFs should not, in any way, be managed by an investment manager who is directly or indirectly under the control or management of the PF itself or the promoter group of the PF.
The new investment pattern has received a positive response from the industry. The most crucial effect of this new pattern would be its ability to allow private PFs and gratuity funds managed by large conglomerates to invest in venture capital and infrastructure funds. The government has time and again faced issues with providing stable sources of capital to infrastructure projects owning to their peculiarly long project-term and uncertainty. This would help in providing a new avenue of raising capital for such projects. Similarly, the new pattern would help raise domestic capital for AIFs, which continue to be excessively reliant upon foreign investments. While venturing into such investment options is a high-risk investment, the same would allow PFs to enhance their yields, which have generally been prone to low-interest rates.
The new pattern also reflects the present government’s resolve to provide a boost to the start-up economy in India. Indian PFs have a huge corpus for investment, owing to the mandatory regulatory requirements. Diverting such corpus to the start-up ecosystem would allow Indian start-ups to raise capital domestically, making it a win-win situation for both PFs and the start-ups in India. An overview of the new pattern reflects that the motive of the government was not to only provide for a new investment avenue for PFs but to also provide a capital boost to the identified sectors such as SMEs and infrastructure, which are not so liquid in nature. These sectors form the backbone of a developing economy, and having an option to raise capital domestically through PFs would give them the boost which is necessary against the backdrop of the pandemic.
Even though there are multiple positive aspects of the new investment pattern, if seen against the backdrop of an important fact related to PFs, the same would seem a road that should be treaded upon carefully. PFs are comprised of the hard-earned contributions of employees who do not necessarily look for excessive returns, but rather desire future security on their investment. It is a well-researched fact that PFs should have a robust investment process, coupled with independent decision-making to ensure that the hard-earned money of the employees is invested judiciously with minimal risk for the ultimate stakeholder – employees.
One of the reasons why PFs have generally been limited from investing in high-risk avenues is that the value for the ultimate stakeholders does not lie in higher returns but rather in safer returns. An investment in a highly liquid market would allow the PFs to have the necessary corpus to provide liquidity to contributors, whereas investments in sectors like infrastructure and SMEs would have an impact on the liquidity of the PFs themselves. Therefore, it has always been a stance to make sure PFs invest in risk-free and liquid assets where the pension obligations of the employees can be met without any issues.
Moreover, the issue of risky investments by PFs can also lead to the economical problem of moral hazard. This problem arises when an investor deems it lucrative to increase risk exposure, owing to the fact that the cost of the risk would not be borne by them directly. In the case of PFs, since the employees are not directly involved in the managing of the fund, the same might lead to the issue of moral hazard where they might be exposed to higher risk without consenting to the same.
The new pattern introduced in India is not new for the jurisdictions of the US and Canada. In the US, pension funds have been a major source of capital generation for private equity funds from way back in 2001. Similarly, in Canada, pension funds have been functioning as the most important institutional source of capital investments to venture capital and private equity funds. However, before this was made possible, there was an issue of corpus allocation faced by both these jurisdictions.
While the pension funds did invest in private equity, the corpus allocation to this asset class was really low. The allocation was slightly higher in the U.S. as compared to Canada. However, pension funds in both these jurisdictions were reluctant in increasing their fund allocation to private equity. The rationale behind their reluctance was the complexity in executing private equity and venture capital investments, their cost, and extensive specific monitoring requirements. Along with the aforementioned, these investments were highly illiquid and had complicated exit options. As mentioned already, the allocation was higher in the US as compared to Canada. The reason for the same can be traced to the issue of exit opportunity. For instance, IPOs are generally a very common exit mode for private equity investments. However, the IPO market in Canada is not as active as its American counterpart, and the same would lead to lower corpus allocation for private equity in Canada.
However, the government found a solution to the issue by encouraging investments in pooled investment vehicles, such as funds of funds. This allowed pension funds to increase their corpus allocation since they were not directly investing in the private equity or capital markets industry, and therefore, a number of issues such as extensive monitoring and exit problems were resolved. The same also solved the issue of liquidity for the pension funds, as they were not relying upon private equity for liquidity anymore and relied on the pooled investment vehicle instead.
As seen in the jurisdictions of the US and Canada, investing through pooled investment vehicles into complex sectors such as venture capital and infrastructure can potentially be a very shrewd move to boost capital raising in these sectors. However, while doing so, it is imperative that the exposure to risk is kept in check by a robust investment mechanism and independent management. The Notification by the government has tried to cover these aspects as well. The requirements of ensuring that the investment manager of the AIF is not controlled directly or indirectly by the PF or the promoter group of the PF would ensure the independence of the investment decisions.
Therefore, by implementing these checks and ensuring that the risk exposure of the PFs does not harm the ultimate stakeholders in any way, the government would be able to create a win-win situation for both the PFs and the sectors specified in the Notification.