SEBI on 03-Feb-23 released a consultation paper on direct plans for schemes of Alternative Investment Funds (AIFs) and trail model for distribution commission in AIFs. The objective of the consultation paper was to seek feedback from all stake holders on (i) mandating direct plans for schemes of AIFs and (ii) introduction of trail model for distribution commission in AIFs.

Currently AIFs “may” offer a direct plan for investors at their option. This direct plan would not entail any distribution commission or placement fees for the investor. Currently there is also no restriction on how much commission and placement fees can be paid on an upfront basis. This is in stark contrast to mutual funds where mutual fund houses are not only mandated to provide direct plans but are also banned from paying out upfront commissions for distribution. Examining data on the SEBI website indicates that for mutual funds, on an asset base of about 26 lakh cr starting on 30-Jun-19, the net inflow into mutual funds has been about 4.30 lakh cr over a 3 year period. This amounts to an incremental net flow of about 16% of assets over a 3 year period. In comparison, AIFs on an asset base of 1.44 lakh cr on 30-Jun-19, have experienced net incremental inflows of about 1.94 lakh cr over the same 3 year period. This amounts to 134% of assets over a 3 year period.

It is gratifying to see AIFs playing a significant role in the financialization of savings of the Indian investor. While AIFs can have their rightful place in an investment portfolio, the massive difference in asset base growth of AIFs ~134% vs Mutual Funds ~16% begs a deeper question. Is this massive difference in asset base growth on account of the differing incentives vis a vis distribution commissions ? Are intermediaries preferring to get client monies invested in AIFs – which not only allow higher commissions but also permit the payment of massive upfront commissions. Is this promoting malpractices in the industry that will eventually result in poor outcomes for investors and will be akin to one step forward followed by two steps back due to erosion of investor trust in the system ? Can we address this regulatory arbitrage between mutual funds and AIFs? SEBIs consultation paper is thus a good step, though in our opinion it could have been undertaken earlier. In the paragraphs below we critique some of the proposals of the consultation paper.

4.4. AIFs to be mandated to offer the option of a Direct Plan for investors, entailing no distribution/ placement fee.
4.5. AIFs to ensure that any investor approaching an AIF through an intermediary, that is separately charging the investor a fee (such as advisory or portfolio management fee), invests in the AIF via the direct plan route only.
Our response:
These are excellent proposals. Moving from "may" provide to "must" provide a direct plan for AIF, will bring about the following changes in the market place:

a. Allow the market place for AIFs to be thoroughly vetted by fiduciaries such as RIAs who work only on an advisory fee model. The lack of a mandate to provide direct plans handicaps RIAs in their inability to charge fees over and above a regular plan AIF. As a result RIAs (such as us) simply stay away from AIFs - as double charging is clearly not aligned with a fiduciary role that an RIA is expected to play. The greater role of RIAs as intermediaries in the AIF market place will bring in more critical analysis and investor aligned schemes in the AIF market place.

b. Akin to direct plans in mutual funds, direct plans in AIFs will bring transparency in the amount of distribution costs (commissions) involved in regular plans and allow investors and fiduciaries to workout a market based mutually acceptable fee structure. Further there will be greater rationalization of commissions and over time intermediation costs in the AIF market place should reduce - clearly this is in investor interest.

We highly recommend these proposals and strongly support their final implementation.

4.6. Investors on-boarded via the direct plan to be provided for an adjusted higher number of units, taking into account the lower distribution charges applicable to them versus other investors, such that all investors would continue to see the same Net Asset value (NAV) on their unit holdings.
Our response:
Not providing for a separate NAV for the direct plan but instead awarding more units is NOT something we support. The reasons being as follows :

a. Why should an investor bear distribution costs after being onboarded into a direct plan AIF ? Without a separate NAV for direct and regular plans in an AIF, ongoing distribution costs cannot be segregated for direct plan investors. This is unfair to investors in the direct plan.

b. The lack of a separate NAV for direct plans is against the principle of market transparency and will not allow the market place to clearly slice and dice the costs of an AIF. On the other hand the presence of a separate NAV for direct and regular plans in mutual funds has brought in significant transparency to investors. AIFs too should go the mutual fund route and have separate NAVs for direct and regular plans.

c. Even if ongoing distribution costs are charged to regular plans only, through the ongoing reduction of units (similar to ULIPs) - the lack of separate NAVs for regular and direct plans is not in investor interest.

We do NOT support the proposal to keep the same NAV for direct and regular plans while providing for more units under the direct plan. Instead we strongly recommend that separate NAVs for regular and direct plans for AIFs be implemented.

5.3. To address the issue of probable mis-selling of AIFs, and to ensure parity across other SEBI products and offerings, a proposal on adopting trail model of distribution commission in AIFs was placed before AIPAC.
Our response:
Adopt a trail model of distribution commission in AIFs. We strongly support this measure. Clearly the huge upfront commissions in AIF schemes has encouraged mis-selling and churning in investor portfolios. Clearly investor and distributor interest are not aligned in a market place which allows huge upfront commissions. We strongly support this proposal to follow a trail only commission model for AIFs.

5.4 AIPAC deliberated on the proposal and recommended that in case of Category III AIFs, which are somewhat more directly comparable with Mutual Funds/Portfolio Manager Services, investors may be charged placement fee/ distribution fee on a trail basis.
5.5. In case of Category I AIFs and Category II AIFs, investors may also be charged on a trail basis, however, certain higher amount of distribution fee (viz: one-third of the present value of the total distribution fee) may be paid upfront in the first year. This is to acknowledge the need for some reasonable incentives to ensure the flow of savings into private capital markets.
Our response:
We do NOT support this proposal due to following rationale. SEBIs mandate is Investor Protection and is NOT to provide incentive to a particular segment of the market place. Why should private capital markets be encouraged at the expense of public markets ? Investor Protection is not served by allowing part upfront commission in specific segments. SEBI has plugged many leaks in the mutual fund system and has brought about significant transparency in the entire mutual fund market place over the last few years. The result has been unscrupulous players are now forced to move their game to higher upfront commission segments such as AIFs and Insurance Policies masqueraded as investments. The arbitrage provided through separate commission plans for CAT III vs CAT I and CAT II will once again create incentives for unscrupulous players to game the system with regulatory arbitrage.

Additional proposal :
Place an upper cap on expense ratios for AIFs akin to those placed on mutual funds and ULIPs.