A sponsor plays a vital role in the establishment of mutual fund. It can be either in its individual capacity or in collaboration with another legal entity. The sponsor oversees all aspects of establishing a mutual fund, including getting relevant approvals, fundraising, incorporation, and forming an Asset Management Company (AMC).

In the recent past, private equity funds have been indirectly holding stakes in sponsors of mutual funds.

What are Private Equity (PE) Funds?

A private equity fund, like a mutual fund or hedge fund, is a pooled investment vehicle in which the manager combines the money placed in the fund by all of the investors and utilises that money to make investments on behalf of the fund. When you invest in a private equity fund, you are putting your money into a fund that is managed by a private equity firm.

On January 13, 2023, i.e., Friday, the capital markets regulator, the Securities Exchange Board of India (SEBI), proposed allowing Private Equity (PE) Funds to become the sponsor for a mutual fund house and boost their investment in schemes. This move is expected to bring in strategic guidance and talent to propel the mutual fund industry’s growth.

Regulation 7 of the ‘SEBI (Mutual Funds) Regulations, 1996’

This regulation establishes the eligibility criteria for mutual fund sponsors. Amongst the various stringent parameters, the regulations specify the following:

• The sponsor should have a sound track record and a general reputation for fairness and integrity while simultaneously carrying on business for the last five years with a positive net worth throughout those years.

A new provision was added to the Mutual Fund Regulations in 2021 to reflect the changing landscape of the mutual fund sector. It cleared the way for an interested applicant to sponsor a mutual fund even if the profitability track-record requirement of eligibility was not met, provided that the applicant had a positive net worth of not less than Rs 100 crore.

Having said that, SEBI has now issued a consultation document with the proposal. The paper states that a SEBI-constituted working group has projected an alternative set of eligibility criteria. This allows private equity funds that do not qualify under the current requirements to act as sponsors of mutual funds. Moreover, strengthen the existing eligibility requirements to ensure that only high-quality entities qualify.

Currently, any entity that owns 40% or more of a mutual fund is deemed a sponsor and must meet the qualifying conditions.

The alternate eligibility criteria for sponsor of Mutual Funds include:

• Sponsors should capitalise the mutual fund house such that the positive liquid net worth of AMC should be at least Rs 150 crore
• The capital contributed to the AMC should be locked in for a period of 5 years
• The minimum sponsor stake of 40% should also be locked in within the same period of 5 years

In light of these developments, apart from meeting the alternate eligibility criteria, the regulator has suggested additional safeguards:

• Private Equity Fund or its manager should have a minimum of five years of experience in the capacity of the investment manager in the financial sector and should have managed committed and drawn-drown capital of at least Rs 5,000 crore as of the date of the application.
• Off-market transactions should not be permitted between the schemes of MF and Sponsor PE.
• The mutual fund sponsored by the PE should not participate as an anchor investor in the public issue of an investee company where any of the schemes/funds managed by the sponsor PE have an investment of 10% or more or has a board representation.

Besides the recommendations of the working group, with regard to the role of the sponsor when the AMC matures, it has been suggested that the reduction of the sponsor’s stake in the AMC should be voluntary and left to market dynamics; thus, no suggestion for phased stake reduction was made.

Given that, the AMC proposing to become a self-sponsored AMC will have to fulfil certain conditions, which include:

• AMCs should be carrying on business in financial services for at least five years
• Have a net profit of Rs 10 crore in each of the immediately preceding five years
• AMCs should not launch any new guaranteed returns scheme

Among other things, sponsors seeking to disassociate must have been a sponsor of the relevant mutual fund for at least 5 years prior to the planned date of disassociation; such sponsors must reduce shares below a certain threshold within a set time frame.

The Securities and Exchange Board of India (SEBI) will be seeking feedback/comments from the public/market participants till January 29, 2023, on the proposals of allowing private equity funds to act as mutual fund sponsors.

How will this proposal benefit the Mutual Fund Industry?

The Indian Mutual Funds industry is not nascent as it was in the years following the setting up of the SEBI MF regulations in 1996. It now stands at Rs 39.89 Trillion as on December 31, 2022.

In the early stages, a strong sponsor was required to lend a brand name to the newly set up mutual fund house. However, the SEBI consultation paper comes at a time when there has been considerable interest from PE firms to acquire mutual fund houses in India. Prior to this proposal, there were reports that the major PE giants Blackstone and KKR Investment management company evinced interest in L&T Mutual Fund and IDFC AMC. Eventually, the acquisition of IDFC Mutual Fund was made by a consortium consisting of Bandhan Financial Holdings Ltd., Sovereign Wealth Fund GIC, and private equity fund ChrysCapital.

Many existing sponsors and trustees are suffering a financial crisis as a result of their primary businesses’ failure to generate sufficient funds. Private Equity Funds with significant capital can invest in technology, stimulate growth and innovation, and expand the influence of mutual funds, bringing in more players from various backgrounds to make the industry more diverse. PE as sponsors of mutual funds may potentially give healthy competition to the industry’s incumbent companies and boost value for investors.

Although PE has the capital the mutual fund industry needs for growth, do note that the money managed by PE funds has a limited life cycle, and they are obliged to pay returns to their investors, which may pose a risk to mutual funds investors.

This article first appeared on PersonalFN here