IP and Asset Management- India Specific - Additions to Chapter-1 - 7

A review-based trigger is one that comes out in the course of the discussion on a portfolio review between the investor and the financial planner. There may be a change in the objectives of the investor, in the fundamentals of the investment, sustained under-performance, or there may be a better or more suitable investment which can be availed of by switching out from an existing investment. Ad-hoc or event-based triggers reflect the uncertainties or volatilities of the market. While some volatility or noise keeps on happening every day, when there is a significant event, either positive or negative, it may require an exit if that serves the portfolio better Exit Parameters The exit parameters can be time-based, value-based or event-based. Time based triggers Many a time, an investment is made for a particular financial objective, which is defined in terms of amount and time. For example, down payment for purchase of house, 5 years from date, Rs 20 lakh; daughter’s education, 10 years from date, Rs 10 lakh; purchase of a car, 2 years from now, Rs 5 lakh. These earmarked investments, as part of the financial plan, are put into appropriate avenues and liquidated once the purpose of the investment is reached. There is a concept of “laddering” in debt investments, where the investment, in a defined-maturity product, matures on its own. The advantage of this is that the market fluctuations at that point of time do not impact the value of the investment. However, there is no laddering possible in equity investments as there is no concept of “maturity” in equities. Value based triggers Where the timing of the investment objective is flexible, it can be defined in terms of value. If the financial need is non-essential in nature e.g. a luxury or comfort, a certain amount is invested and as and when it grows to the desired quantum, it is utilized. For examples, foreign travel 5 years or more from now, Rs 3 lakh; purchase of sedan car 3 years or more from now, Rs 10 lakh; purchase of a bigger house 7 years or more from now, Rs 1 crore. For growth over long term, equity is proven over debt or gold. However, equity being relatively more volatile than debt or gold, while one may do the calculations assuming growth at a certain percentage, it may take a longer time. For luxury or consumption objectives, it is better to set the financial goal not only in terms of time, but value as well. As and when the value is reached, that is the trigger point and the investment is cashed out. IP and Asset Management – India Specific Page 101

Event based triggers An event that would trigger an exit from an investment may be either in the context of the investment or about the investor. Some changes keep on happening every day, either in the market where the portfolio is invested or in the situation or circumstances of the investor. The parameter is that the event should be significant enough to trigger an exit or switch to another investment. Example: Ratan, aged 55, believes in India’s growth potential and has an allocation of 80% to Indian equity in his portfolio. Of late, border tensions between India and a neighbouring country has escalated and threatening to become a full-fledged war. Equity market is tanking, apprehending war with the neighbouring country. In this case, it is advisable to reduce Ratan’s exposure to equity from 80%. At this age, which is time for consolidation of the portfolio, equity allocation is on the higher side. This event may be taken as a trigger to de-risk the portfolio to a certain extent. Equity may be brought down to say 50% of the portfolio. Review based portfolio shuffling The instances discussed above are either pre-decided e.g. time based or value based, or ad-hoc due to an event. When a portfolio review is conducted between the investor and financial planner, some shuffling of the portfolio may be the outcome. A shuffling involves exit from some investments and entry into others. Market level / profit booking trigger Though financial planning maintains that the market level should not be the basis of allocation decisions, sometimes the client may prefer it that way. It does not hurt to book profits. The financial planner should suggest that if the investment is for a long term, then it should not be disturbed. Having said that, if the client is not comfortable with a particular market level, it also means his/her risk appetite has altered. While the asset class may have a bright long term future, allocation should be as per the comfort level of the client. Entry triggers Time or value-based entry triggers are usually not discussed, because entry based on attempts to time the market goes against the grain of financial planning. Allocation in portfolio should be as per the objectives of the investor, the risk profile of the investor, and the time horizon. As discussed earlier, when there is a significant correction in an asset class e.g. equity, allocation may be increased on a relative basis, with a long term view as long as it is in line with the portfolio objectives. IP and Asset Management – India Specific Page 102

SIP and SWP The systematic investment plan (SIP) and systematic withdrawal plan (SWP) are time-based entry and exit triggers. In SIP, the underlying theme is that we cannot time the market, hence distributing the investments over a period of time to average out the cost. Historically it has been seen that through SIP, the average cost of investments are lower than lump sum investments. SWP is timebased exit trigger; though it is more about cash flow requirements, it also averages out the exit level from the market. There are certain trigger-based funds, where it is pre-set that on a particular level of the market, say at a particular level of Nifty or Sensex, “X” per cent of the fund would be booked out and transferred to say a liquid fund. This is an example of value-based exit trigger. Direct and Regular Plans - Investment Advisor’s Role Concept of Direct and Regular Plans Earlier, a few do-it-yourself investors would go to the office of Mutual Funds and put in the application directly, without the services of an intermediary. Over a period of time, it occurred to SEBI, the recurring expenses charged to MF schemes include the component of distribution commission. For DIY investors, who are coming directly to the MF, there is no logic for charging this component of the expenses. In a Circular dated 13 September 2012, SEBI stated that mutual funds/AMCs shall provide a separate plan for direct investments, i.e., investments not routed through a distributor, in existing as well as new schemes. Such separate plan shall have a lower expense ratio excluding distribution expenses, commission, etc., and no commission shall be paid from such plans. The plan shall also have a separate NAV. Thus, applicable since 1 January 2013, every MF Scheme has two sets of NAVs, one for direct plan and one for regular plan. The expenses of the direct plan are lower, to the extent of distribution commission paid in that scheme. Distribution mode for Investment Advisers In this context, it is important to bifurcate between advisors and distributors. An “adviser” is a SEBI registered investment adviser (RIA) and a “distributor” is an AMFI registered mutual fund distributor (MFD). An RIA can only advise his/her client and not offer execution of the investments. In exchange for the advice, the adviser is supposed to charge fees to the client, and not receive any commission from the product manufacturer. A distributor is not supposed to offer “advice” to the client, apart from some “incidental advice” and not supposed to charge fees to the client. The MFD gets commission IP and Asset Management – India Specific Page 103

from the Mutual Fund products distributed. As on 13 April 2021, there are 1,342 RIAs (source: SEBI website) and 1,77,669 MFDs (source: AMFI website). Relevance of direct and regular plans • Investors taking advice from an RIA should invest in direct plans of mutual funds to benefit from lower expense ratio. In other words, the benefit of lower expense ratio is shared, in part or full, with the RIA as fees. • However, nothing stops the investor from investing in regular plans of MFs, at the cost of higher expense ratio, if s/he wants to avail of the execution from an MFD, and tracking services. • DIY investors invest straight into direct plans, without availing of RIA’s services, and save on both. Investors going through an MFD invest in regular plans of  MFs share the distribution commission with the MFD, which is part of the expense ratio. The client is not supposed to pay any advisory fees over and above this to the MFD. Regulatory backdrop The amendment dated 3 July 2020 to the SEBI Investment Adviser Regulations allows “client level segregation of advisory and distribution activities”. It states that • An individual investment adviser shall not provide distribution services • The family of an individual investment adviser shall not provide distribution services to the client advised by the individual investment adviser and no individual investment adviser shall provide advice to a client who is receiving distribution services from other family members • A non-individual investment adviser shall have client level segregation at group level for investment advisory and distribution services. • The same client cannot be offered both advisory and distribution services within the group of the non-individual entity We have seen the regulations and the cost differentials between direct and regular plans. Going by the numbers, the investor would be tempted to save the costs, more so if it is seen from the perspective of compounded effects over a period of time. However, to be borne in mind, there is a service being offered and by opting for direct plan, the investor is giving up on those services. Investing in mutual funds through stock exchange platforms SEBI (Securities Exchange Board of India) has decided to allow the purchase of mutual funds directly from the stock exchanges instead of having to go through the distributors. Now mutual funds units can be bought and redeemed through the stock exchanges. This would save some money for the investors since any Regular Plan mutual fund will include a small expense ratio which the fund managers will pay the distributors for facilitating the buying and redemption of the units invested in their funds. These IP and Asset Management – India Specific Page 104

very same platforms can now be directly accessed by the investors to make their investments. BSE, for example, had launched the STAR MF platform for IFAs (MFD Model) in 2014. Similarly, NSE has an online platform NMF II. Registration process Step 1: Investors need to fill in up necessary details to get IIN. (Investor Identification Number) Step 2: Send a soft copy of the PAN card, address proof, and a copy of the cheque for verification. Step 3: After verification of filled Investors Information form and submitted documents, IIN form will be generated. Step 4: Investor will get pre-filled IIN Form on the registered email address and Login ID & Password through SMS. Step 5: To activate your online mutual fund transaction investment account investor needs to submit IIN Form along with a cancelled cheque to the NSE service centre i.e., CAMS any branches. Cost and Benefit in investing in mutual funds through a stock exchange: The cost involved here is the fund manager's expenses and distribution expenses, where the fund manager would have to pay a distributor for buying and selling of mutual fund units. The key benefit is investors can save countless hours of time, energy and frustration involved with the research and analysis required to find quality investments to hold in a portfolio. Direct Mutual Fund Platforms: • CAMS My Cams &Karvy KFIN Kart CAMS Online/My Cams is one of the best direct mutual fund’s investment platforms. My Cams is a 100% free platform. It supports 14 mutual fund service providers. One will get a dashboard view for mutual fund holding and asset allocations while logging into this platform. Karvy KFIN KART can invest, track, and manage across multiple mutual funds using this platform. It will provide a web-based version as well as an app version. The total mutual fund AMC supported by Karvy is 19. It is a 100% free platform like My Cams • Mutual Fund Companies portals It is easy and no headache of relying on anyone if you are already KYC complied. However, the only hurdle is to remember the login details of each company portals. This is completely free. Generating a report is not an issue as you will get the consolidated account statements from NSDL. IP and Asset Management – India Specific Page 105

• Robo Advisory Robo advisor is nothing but a financial adviser who provides automated investment solutions online. So, you no longer must appoint a financial planner in person to draw your investment plan. These platforms are digital advisors who provide portfolio management and financial planning services online, without little or no human intervention. They are likely to deliver plans, faster as they are based on mathematical algorithms. If you have a high-speed internet connection and a mid-range computer/laptop, you are halfway there. Everything is now possible just by one click. Use of platform by Investment Adviser and transaction feeds The RIAs (Registered Investment Advisors) have been able to handle practically all relevant transactions, like subscription, redemption, Systematic Investment Plan (SIP), Systematic Withdrawal Plan (SWP), Systematic Transfer Plan (STP), Switch and other transactions of mutual fund units on these platforms. An RIA has under the relevant regulations advises clients in the best interest. They are further constrained to segregate advisory and execution at the client level, or rather are barred to execute transactions unless they are devoid of any commission to the RIA, family/group. High net worth clients have large transactions. It is advisable to save the commission paid to third p[arty (distributors) even if the same is permitted as per regulations. In order to achieve this, the digital platforms and the use of tools and technology are necessary to provide the best advice possible, and at the same time to consistently demonstrate their value. These platforms feed insights tailored to client portfolios, aided by portfolio analytics. It improves client engagement, their participation and transparency in the whole process. By using direct plans on the exchange-based platform, an RIA can transact on behalf of the client in direct plans by using feeds from the asset management companies. The system takes away the rigour and complexity of sharing such feeds and is highly time-efficient, or rather in real time. It also removes the need for an RIA to be registered with the MF Utility platform, or in transacting in the schemes of those AMCs which are not part of the Utility. Taxation Aspects and Basis of Redemption The return from a mutual fund scheme can arise on two counts: dividend distributed in the scheme on invested units while remaining invested, and capital gains arising at the time of redemption of units. The first taxation aspect is on income distribution which is alike in all types of schemes, viz. equity, IP and Asset Management – India Specific Page 106

debt and liquid schemes, in so far as taxation is concerned in the hands of unit holder. However, the mutual fund schemes pay a dividend distribution tax (DDT) before disbursing dividend, it is 11.648% (including surcharge and tax) for equity-oriented schemes and 29.12% (including surcharge and tax) for all schemes other than equity-oriented ones. Thus, in effect the dividends which are stated tax-free in the hands of investors actually get taxed at source. This aspect changes with effect from 1st April, 2020. The DDT shall be gone at source, whether companies or mutual fund schemes, and is now taxable in the hands of investors/unit holders at their respective slab rate. However, a Mutual Fund house will deduct 10% tax at source before distributing the dividend over Rs. 5,000 in a year. This change is likely to benefit those unit holders in the debt mutual fund schemes who are in the lower tax brackets. This, however, will most adversely impact investors/unit holders in the higher tax slabs and high net worth investors. The changed dividend taxation regime from 1st April, 2020 will overall likely change a long-standing anomaly of dividends from mutual funds, which are a part of investment going back to unit holders, unlike companies where it is out of the profits generated from operation. It will put an end to dividend arbitrage, and will induce unit holders towards growth option. The second aspect of return from mutual fund investing is capital gains on redemption. For equity oriented funds, the holding basis to qualify for long-term capital gains, at effective rate of 10.4%, is 12 months, while an amount of Rs. 1 lakh (inclusive of such long-term capital gains from direct equity shares) is exempt for an individual in a financial year. For holding period less than 12 months, the gains are taxed at short-term capital gain tax rate of 15.6% (effective rate including cess). The tax regime for capital gains arising from all schemes other than equity-oriented ones, e.g. debt and liquid funds, is subject to a holding period of 36 months to qualify for long-term capital gains. Such gains are taxed at an effective rate of 20.8% after benefits of cost indexation. For holding period less than 36 months for such schemes, the short-term capital gains are added to income and taxed at slab rate applicable to a unit holder. Investor’s rights to various disclosures under Mutual Fund schemes Apart from the disclosures in the offer document of a scheme and in the KIM on an on-going basis, SEBI mandates that the trustees shall be bound to make such disclosures to the unit holders, as are essential in order to keep them informed about any information which may have an adverse bearing on their investment. There are other periodic and continual disclosures, such as: apprising duly audited annual statements of accounts including the balance sheet and the profit and loss account for the scheme; hosting unaudited financial results on their website along with publishing an advertisement disclosing such hosting of financial results. A mutual fund shall, before the expiry of ten days from the close of each half year, send to all unit holders a complete statement of its scheme portfolio IP and Asset Management – India Specific Page 107

Portfolio Management Schemes Registration requirement of Portfolio Manager SEBI in their Portfolio Manager Regulations, 2020 defines a portfolio manager as being a body corporate, whether as a discretionary portfolio manager or otherwise, advises or directs or undertakes on behalf of the client the management or administration of a portfolio of securities or goods or funds of the client, as the case may be. This arrangement is strictly pursuant to a contract with a client. SEBI in the said regulations prescribe that a portfolio manager, a body corporate besides meeting a fit and proper person and other due diligence norms should have the necessary infrastructure and manpower to effectively conduct its activities as a portfolio manager. It must have the following officials with the necessary eligibility criteria: a) A Principal Officer appointed shall be responsible for the decisions made toward management or administration of the portfolio of securities or the funds of the client apart from other operations of the portfolio manager. The principal officer shall have a requisite professional qualification in finance, law, accountancy or business management or a CFA charter from the Chartered Financial Analyst Institute, USA. Experience of at least five years is also necessitated in related activities in the securities market, e.g. as a portfolio manager, a fund manager, an investment adviser, a research analyst, a stock broker, etc. At least two years out of these must be spent in funds management, portfolio management or investment advisory services. The principal officer must have, at all times, a valid relevant NISM certification as specified by SEBI in this regard. b) A Compliance Officer who shall be responsible for monitoring the compliance of the Act, rules and regulations, notifications, guidelines, instructions, etc., issued by SEBI or the Central Government and for redressal of investors' grievances. c) At least one another person with the qualifications of graduation from a recognized Indian or foreign institution and with an experience of at least two years in the securities market preferably with a fund manager, a portfolio manager, an investment adviser, or a stock broker. The net worth requirement for a portfolio manager is at least Rs 5 crore. The Net worth shall be maintained at all times. On the date of application for a portfolio manager, the certificate of such net worth obtained should not be more than three months prior to such date. Such net worth requirement under these regulations shall be fulfilled, separately and independently of the capital adequacy requirements, if any, for each activity undertaken by the portfolio manager under the relevant regulations. IP and Asset Management – India Specific Page 108

Responsibilities of Portfolio Manager The following responsibilities shall be fulfilled by a portfolio manager: a) Agreement: The portfolio manager shall enter into an agreement in writing with the client before taking up an assignment of management of funds and portfolio on her behalf. Such an agreement shall clearly define the relationship and set out their mutual rights, liabilities and obligations relating to the management of portfolio, and shall further include investment objectives, investment approach and restrictions, type of instruments and exposure norms, tenure of investments, terms for early withdrawal of funds and attendant risks in the type of portfolio management. The agreement will also specify the period of contract and the provisions of early termination, fee payable to the portfolio manager and its quantum and manner, and the liability of the client especially in case of a discretionary portfolio manager. b) Disclosure: A disclosure document shall clearly specify the quantum and manner of payment of fees by the client for each activity for which service is rendered by the portfolio manager directly or indirectly. The range of fees charged under various heads shall also be disclosed. The disclosure document shall include portfolio risks including risk specific to each investment approach offered by the portfolio manager. The document shall further include conflicts of interest related to services offered by associates and group companies along with the transactions with related parties. c) Discretionary and Non-discretionary portfolio manager: The discretionary portfolio manager shall individually and independently manage the funds of each client in accordance with the needs of the client in a manner which does not partake character of a Mutual Fund, whereas the non-discretionary portfolio manager shall manage the funds in accordance with the directions of the client. Portfolio manager cannot offer/ promise indicative or guaranteed returns to clients. d) Minimum amount: The portfolio manager shall not accept from the client, funds or securities worth less than Rs 50 lakh. e) Segregation of funds: The portfolio manager shall segregate each client’s holding in securities in separate accounts. f) Investment restrictions: The portfolio manager shall not borrow funds or securities on behalf of the client, nor lend the same to a third person. The discretionary portfolio manager shall invest funds of his clients in the listed tradeable securities, money market instruments, units of Mutual Funds and other specified securities in this regard. A non-discretionary portfolio manager or one offering advisory services, apart from the above investment norms, may invest (or advise for investment) up to 25% of the assets under management of such clients in unlisted securities. The investment restrictions apply on leveraging funds of the client, deployment in bills discounting, badla financing or other lending, commission-based MF distribution, IP and Asset Management – India Specific Page 109

speculative transactions and off-market transactions. Only direct plan of mutual fund schemes shall be opted by portfolio manager g) Other hygiene factors – A portfolio manager shall service the client in a fiduciary capacity, maintain the books of account, records and documents as prescribed, maintain separate client- wise accounts for investments and disinvestments, interest/dividends and other corporate actions Various costs - fixed, performance-based; High watermark, Hurdle rate, Catch-up The portfolio managers have an annual fixed charge of between 2% and 2.5% of the average assets under management as a recurring annual basis. This is more flexible as compared with mutual funds. For instance, a client with just the minimum required Rs 50 lakh may end up paying up to 2.5% of AUM, while another client of AUM of Rs 10 crore may negotiate to a level of well below 2% or even down to basis points, or even zero The above is possible as portfolio managers also have performance-based fee or variable fees, which gets triggered automatically on performance, or after a pre-set level of performance, called hurdle rate. It is definitely a win-win relationship as it is an incentive for the portfolio manager to exceed benchmark returns. In such arrangement, however, the downside is borne by the client. There are variants of trigger on variable fees. One of these is “full catch-up” where the variable fee is charged basis actual performance. For instance, on an investment of Rs 1 crore which at the end of the period rises to Rs 1.30 crore, the variable fees of, say 25% on “full catch-up” basis will be 25% of Rs 30 lakh, i.e. Rs 7.5 lakh. Most portfolio managers however have a “hurdle rate” concept, say a 10% hurdle rate over and above which the variable fees gets triggered and calculated. In the above case discussed, 10% hurdle rate would mean 10 lakh earned by the client on Rs 1 crore invested. The remaining 20 lakh would qualify for variable fees, which at 25% would amount to Rs 5 lakh. This is the condition of “no catch-up”. There is another variant of “partial catch-up”, where the hurdle rate is fixed along with two rates of variable fees, one for not hitting the hurdle rate, say 15%, and another for hitting the hurdle rate, say 25%. In the above discussed case, 15% variable fees will apply on Rs 10 lakh (up to the hurdle rate), i.e. a partial variable fees of Rs 1.5 lakh; and another 25% variable fees on Rs 20 lakh (exceeding the hurdle rate), i.e. another partial variable fees of Rs 5 lakh. Thus, cumulatively, a variable fee of Rs 6.5 lakh shall be payable in this “partial catch-up” agreement. We observe that in a “full catch-up”, the portfolio manager is rewarded for whatever performance; in a “no catch-up” only after the hurdle rate is hit and that too, over the hurdle rate of performance only; IP and Asset Management – India Specific Page 110

and in a “partial catch-up” less for the gains below the hurdle rate, but rewarded nonetheless. There is another concept of “high watermark” also when determining the variable fees payable. A “high watermark” is the higher of (i) corpus investment value at the start of the period (usually annual), or (ii) (ii) Highest Net Assets at which the fees has been paid during the period. For instance, considering annual periods basis for variable fees, if a client’s base investment of Rs 1 crore rises to Rs 1.30 crore at the end of 1 year, a pre-set percentage of variable fees is triggered for the Rs 30 lakh return. If the value of investments drops to Rs 1.20 crore at the end of second year, there is obviously no variable fees. However, if at the end of third year the portfolio value stands at Rs 1.50 crore, the variable fees get triggered for Rs 20 lakh (over the high watermark achieved earlier of Rs 1.30 core) The “high watermark” can also be combined with hurdle rate, and therefore with “no catch-up” variant. For instance, a portfolio manager may charge variable fees of 20% on all returns in excess of 10% hurdle rate on “no catch-up” basis subject to a high watermark annually. For example: A client enters into an agreement with a portfolio manager for a 0.5% fixed fees on the average daily assets, and a variable fees being 20% over and above a hurdle rate of 15% (no catch-up basis) subject to a high watermark. The client’s initial and only contribution remained Rs 5 crore. In the first year, the assets returned 20% performance, in the next year 15% negative return, and in the third year a 50% positive return. Considering the average daily assets of Rs 5.68 crore in the first year, Rs 5.34 crore in the second year and Rs 7.24 crore in the third year, what fixed and variable fees are payable to the portfolio manager? (All fees are paid to the portfolio manager from a separate account by the client) The fixed fees will be 0.5% of Rs (5.68 + 5.34 + 7.24) = Rs 9.13 lakh The Variable fees: First year, 20% of Rs 25 lakh = Rs 5 lakh Second year: Nil Third year: 20% of Rs 1.65 crore = Rs 33 lakh (At the end of first year, portfolio value is Rs 6 crore against the hurdle of 15% which gives Rs 5.75 crore. A decline of 15% in the second year sees the portfolio value at Rs 5.10 crore. The third year witnesses portfolio rising 50% over the previous year corpus of Rs 5.10 crore, which is Rs 7.65 crore. The high watermark achieved during these years is Rs 6 crore. Hence, only the incremental Rs 1.65 crore will count for payment of variable fees) PMS - Direct Access vs Regular plans, optimization by Investment Advisers through direct access The portfolio manager provides services across the following three areas: IP and Asset Management – India Specific Page 111

(i) Discretionary services – where the portfolio manager manages the portfolio and funds of each individual client independently according to the client’s needs; (ii) Non-discretionary services – where the portfolio manager manages the portfolio and funds of each individual in accordance with the directions of the client; and (iii) Advisory services – where the portfolio manager advises the client on investments as per the agreement. A portfolio manager can be an entity who is so registered to provide portfolio management services in accordance with the Regulations. The eligible fund managers may act as a portfolio manager to an eligible investment fund by fulfilling certain conditions and applying to SEBI under the Regulations. As the third category above suggests, SEBI Registered Investment Advisers (RIA) can also provide only advisory services on investments and portfolio of securities of a client. It has been respectively laid down in the SEBI (Portfolio Managers) Regulations, 2020 and SEBI (Investment Advisers) Regulations, 2013, as amended, that such entities will provide distribution services in mutual fund units by using “Direct Plans” instead of regular plans. They may also use other non-commission products while providing distribution services along with advisory services. The logic stands that portfolio manager provides services with a minimum ticket size of Rs 50 lakh. There is no limit at the higher end. Large transactions therefore would entail a substantial amount of commission, upfront and trail, on the portfolio assets. Therefore, adoption of direct plans by investment advisers would help their clients in the efficient execution services as well while saving large costs over a period of time on the commissions, anywhere between a few basis points up to 2 per cent. PMS - Performance disclosure requirement The following disclosures toward portfolio performance are required to be made by a portfolio manager to its client: a) Performance The performance of the portfolio manager shall be disclosed with segregated performance as per the different investment approach. The time weighted rate of return for the preceding three years shall be disclosed toward performance indicator in case of a discretionary portfolio manager. The audited financial statements for the preceding three years shall also be included along with the portfolio performance. The contents of the disclosure document shall be certified by an independent Chartered Accountant. b) Reports to be furnished to clients The portfolio manager shall furnish periodically (not exceeding 3 months) a report to the client consisting of details such as the composition and the value of the portfolio; description (with number and value) of each of the securities and goods IP and Asset Management – India Specific Page 112

held in the portfolio and cash balance; details of purchase and sales transactions undertaken and the beneficial interest (in the form of interest, dividend, bonus, rights, etc.) received during the period of report; expenses incurred in managing the portfolio including details of commission paid to distributor(s); and the risks foreseen by the portfolio manager and those relating to the securities recommended for investment or disinvestment. Alternative Investment Funds Role of Alternative Investment in Portfolio Management SEBI notified on 21st May 2012 their regulations related to the Alternative Investment Funds (AIF). This would include any fund established or incorporated in India in the form of a trust, or a company, or a limited liability partnership, or a body corporate, and which would be a privately pooled investment vehicle that collects funds from investors, whether Indian or foreign, for investing them in accordance with a defined investment policy for the benefit of its investors. AIFs would exclude mutual funds established under SEBI (Mutual Funds) Regulations, 1996. It would also exclude any scheme registered with SEBI under the Collective Investment Schemes Regulations, 1999, or for that matter under any other regulations of SEBI to regulate fund management activities. It also excludes family trusts set up for the benefit of relatives, employee welfare trusts or gratuity trusts, ESOP Trusts, securitization trusts, regulated under a specific regulatory framework, holding companies, other special purpose vehicles not established by fund managers, and any such pool of funds which is directly regulated by any other regulator in India. Eligibility Criteria for AIFs is minimum corpus of Rs 20 crore for each scheme and Rs10 crore for Angel Funds. Investors in AIFs can be Resident Indian, NRI or foreign nationals with minimum investment by each investor being Rs 1 crore. Alternative investments include private equity or venture capital, hedge funds, managed futures, art and antiques, commodities, and derivatives contracts. Real estate is also often classified as an alternative investment. These criteria single out AIFs as suitable to those having the requisite risk appetite. It opens huge vistas of investment for portfolio managers to realise the objective of their investors and give them a flavour of instruments which they may find difficult to subscribe individually and which have a potential of returns over long periods and tenors in sync with such investors’ objectives. Few risks and downsides would be unfathomable for retail investors. AIFs provide exposure to such vehicles which have the potentiality of super-normal returns. IP and Asset Management – India Specific Page 113

Categories of AIFs The AIF regulations categorize AIFs under three categories. Category-I AIFs are those that invest in start-up or early-stage ventures (venture capital funds investing primarily in unlisted securities of start-ups), social ventures, infrastructure, SMEs, or in areas which the government or regulators consider as socially or economically desirable. The ‘private equity funds’ that invest primarily in equity or equity linked instruments or partnership interests of investee companies are also in this category of AIF. It also includes ‘angel funds’ that are mainly involved in new products/services/ technology or intellectual property right based activities or a new business model. Category-III AIFs are those that employ diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives, such as hedge funds or funds which trade with a view to make short term returns or such other funds which are openended and for which no specific incentives or concessions are given by the government or any other regulators. Category-II AIFs are those that are not included in either Category-I or Category. As per SEBI (AIF) regulations, all Alternative Investment Funds shall state investment strategy, investment purpose and investment methodology in their placement memorandum to the investors. The AIFs may raise funds from any investor whether Indian, foreign or non-Resident Indians by way of issue of units. Each scheme of an AIF shall have corpus of at least Rs. 20 crore; subject to a ticket size of at least Rs. 1 crore from an investor. No scheme of an AIF shall have more than one thousand investors. The manager or sponsor shall have a continuing interest in the AIF of at least 2.5% of the corpus or Rs. 5 crore, whichever is lower, in the form of investment in the AIF. The schemes of Category-I and Category-II AIF shall be close-ended and the tenure of scheme shall be determined at the time of application, subject to a minimum tenure of three years. Category-III AIFs may be open- ended or close-ended. AIFs may invest in securities of companies incorporated outside India subject to such conditions or guidelines that may be stipulated by the RBI and SEBI in this regard from time to time. Category-I and Category-II AIFs shall invest not more than 25% of the investable funds in one Investee Company. They shall not invest in associates except with the approval of 75% of investors by value of their investment in the AIF. The un-invested portion of the investable funds (until its deployment as per the investment objective) may be invested in liquid mutual funds, bank deposits, Treasury bills, CBLOs, Commercial Papers, Certificates of Deposits, etc. IP and Asset Management – India Specific Page 114

There are well-defined investment conditions in the regulations for each category of Alternative investment Funds. Evolution and Growth of AIFs in India The number of AIFs in FY14 was relatively small at 6 and 13, respectively, for category I and II. Investments raised by AIFs reached around Rs 2 lakh crore by September 2020. As the industry matured, 11 and 49 such schemes were launched in FY18 The industry has grown at a compounded annual growth of over 74% between 2014 and 2020. During this period, however, the commitments for investments reached Rs 4 lakh crore, a CAGR of 65% during the same period. The following chart shows the growth over the years in AIFs in India. Suitability and Enablers for AIF Products in India The suitability of AIFs to the class of investors in India is in sync with the requirement of risk so as to enable generation of commensurate returns. The sophisticated investors who invest in AIFs are for a certain band of returns, which is indicated by the hurdle rate. The returns in 2020 have lagged behind Nifty-5o returns, when even the performance fees, “carry” in industry parlance was not levied by the fund managers. In 2021, however, the top performers even clocked between 132% to 164% 1-year returns, also improving the performance since inception of such funds. It is not in order to expect the returns from AIFs in synchrony as the investors take specific bets on investments as disclosed in private placements’ defined investment policy. It depends on the maturity cycle of underlying bets to exude a performance over time allocated. The enablers of such performance are discrete and specific to the type and class if AIFs. This amply demonstrates the suitability of AIFs to the class of investors who embrace such instruments India’s infrastructure development needs and the risks as well as the opportunity offered have presented the savvy investors a viable route in the form of AIF investments. The opportunity of gains brings the collective investments of Indian and foreign investors including foreign direct and portfolio investments, which also boosts the prospects of alternative resources for such development toward the overall economic growth IP and Asset Management – India Specific Page 115

Current AIF Market Status There has been a steady growth in the number of registered Alternative Investment Funds in India. From just 121 AIFs in 2014 to a figure of 758 as of June 2021, a healthy growth of 30% is registered in the number of AIFs in India. As of March 31, 2021 total commitments raised are to the extent of Rs 4.5 lakh crore of which the investment already made are Rs 2 lakh crore. SEBI Requirements on performance disclosure Chapter IV of the AIF Regulations provides for general obligations, responsibilities and transparency requirements that are required to be complied by all AIFs. Chapter IV provides for specific disclosure obligations on the AIF to the investors including conflict of interest, information on fund investments, fees, various risks, valuation, etc. Further, AIFs, in addition to what is required under the AIF Regulations, may also provide for additional disclosures to investors in the placement memorandum in respect of fee and charges. Every AIF shall, in its placement memorandum, add by way of an annexure, a detailed tabular example of how the fees and charges shall be applicable to the investor including the distribution waterfall. Additionally, they have to disclose information about litigations/pending disciplinary cases in respect of the AIF, sponsor, manager and their Directors/partners/promoters and associates, Trustees or Trustee Company and its directors. The disciplinary history shall include outstanding/pending and past cases of litigations, criminal or civil prosecution, disputes, non- payment of statutory dues, over dues to/defaults against banks or financial institutions, contingent liabilities not provided for, proceedings initiated for economic offences or civil offences, adverse findings with respect to compliance with securities laws, penalties levied, disputed tax liabilities, etc. Further, any disciplinary action taken by SEBI or any other regulatory authority must be disclosed. Distressed Securities Investment characteristics Distressed securities are the securities issued by a certain company which the company is finding difficult to services, viz. paying the due interest on the obligation and/or the return of capital borrowed. A market disruption or adverse macroeconomic conditions, locally or globally, may impact the credit profile of a distressed entity. It may happen as well that the situation has got nothing to with market conditions. Usually these are companies that are companies close to bankruptcy. These companies need a lifeline to revive. IP and Asset Management – India Specific Page 116

Distressed assets tend to show little correlation with either equity or debt markets or attendant risks including market risk. This asset class can be a good diversifier for the portfolio. In case of a company which files for bankruptcy, a number of resolution plans get submitted to NCLT involving big companies looking to strategically acquire large stressed assets at substantial discounts to their market prices Role in Investor Portfolios The distressed assets may present a market opportunity for the risk-seeking investors to make huge returns, especially if the subject company belongs to a certain sector that is currently facing headwinds, which may be temporary in nature but has already debilitated some companies’ financials beyond repair. Such market disruptions are real opportunities for investors who have the required risk appetite. Asset Reconstruction Companies specialize in evaluating such scenarios from a techno-legal angle as well as completing the financial due diligence for the stakes to change hands. The following modus operandi may be adopted to resolve a tricky non-performing asset, though there can be many variants depending on the actual stage a company nurses.  Acquiring a majority stake in debt; this will give a conclusive or at least a higher say in the reconstruction plan or in the enforcement,  Providing financial support in the operations (working capital) or infusing capital in the company’s capital expenditure plans,  Handholding the company through its revival phase by providing technical, legal and financial support Distressed assets are high stake games and require expertise on various facets. It requires a substantial time for the resolution process and a further revival period. Therefore, it requires patience and a long-term view. It requires professional expertise of fund managers or ARCs active in this field. Investors who aim at a very high risk to reward ratio may generally be interested, since these are distressed assets and if a revival does not take place or delays substantially, one may lose entire investment. The investment rationale in distressed assets can be adjudged on the yardstick of risk to reward. The risks are obviously the prolonged illiquidity, the expected turnaround blues, and a cynical price discovery. The levels at which such risks are to be evaluated are the pledged collateral present in the deal which would serve as a floor for expected returns, the strength of the underlying business, a cleaned-up balance sheet, and a reliability in the stage of resolution. IP and Asset Management – India Specific Page 117

There can be various approaches to valuating distressed companies. It is vital to understand the business of the company and its cyclicity, if any. The average multiples of the like business can be calculated to determine the likely value at stake. A fair market value approach is also necessary after accounting all assets and intangibles as well as all liabilities including contingent and off-balance sheet ones. It is a real financial engineering at its best. The upside can be tremendous for the investors who have the stomach for this kind of risk. Distressed investments are usually ‘standalone’ financial engineering opportunities, with low correlation with equity or debt markets. So, this asset class can be a great diversification strategy for evolved investors. Hedge funds have a flavour for distressed assets as do Category II Alternative Investment Funds. The approach is institutional as there are various facets to address during the phase of investment, negotiation, resolution and even staking in the turnaround of the underlying asset. IP and Asset Management – India Specific Page 118