Chapter 7: Investment Process and Governance of Funds

The operational success of an Alternative Investment Fund is determined by the rigor of its deal origination and diligence architecture. Generating superior risk-adjusted alpha requires fund managers to originate high-quality deal flow and subject candidate investee companies to exhaustive investigative scrutiny before deploying investor capital.

+----------------------------------------------------------------------------------------------------+
|                                    AIF INVESTMENT DECISION WORKFLOW                                |
+----------------------------------------------------------------------------------------------------+
|                                                                                                    |
|    [ SOURCING & SCREENING ]                                                                        |
|    • Proprietary founder networks, investment banks, venture scouts.                               |
|    • Preliminary review against fund mandate; preparation of Preliminary Investment Memo (PIM).    |
|                                      |                                                             |
|                                      v                                                             |
|    [ TERM SHEET EXECUTION ]                                                                        |
|    • Non-binding valuation, indicative structure, governance terms, and exclusivity period.       |
|                                      |                                                             |
|                                      v                                                             |
|    [ MULTI-DISCIPLINARY DUE DILIGENCE REVIEW (DDR) ]                                               |
|    • Business & Commercial DD       • Financial & Tax Accounting DD                                |
|    • Legal & Regulatory Title DD    • ESG & Environmental Diligence                                |
|    • Forensic & Integrity DD        • Technology & IP Architecture DD                              |
|                                      |                                                             |
|                                      v                                                             |
|    [ FINAL INVESTMENT COMMITTEE (IC) APPROVAL ]                                                    |
|    • Comprehensive Final Investment Memo (FIM) presented to IC.                                    |
|    • Formal vote and binding approval recorded in minutes.                                         |
|                                      |                                                             |
|                                      v                                                             |
|    [ DEFINITIVE DOCUMENTATION & DISBURSEMENT ]                                                     |
|    • Execution of SSA, SHA, and Debenture Trust Deeds; fulfillment of Conditions Precedent (CPs).|
|                                                                                                    |
+----------------------------------------------------------------------------------------------------+

The Multi-Disciplinary Due Diligence Framework

1. Commercial and Business Due Diligence: Evaluates market size (TAM/SAM/SOM), competitive moats, pricing power, customer cohort retention metrics, unit economics (LTV to CAC ratio), and sustainable industry growth drivers.
2. Financial and Tax Diligence: Conducted by independent accounting firms to verify the quality of historical earnings (Quality of Earnings [QoE] report), normalize EBITDA for non-recurring expenses, detect hidden tax liabilities, and verify working capital cycles.
3. Legal and Regulatory Diligence: Conducted by specialized corporate law firms to verify clean share capital capitalization tables (cap tables), review intellectual property (IP) assignments, examine material litigation, inspect labor law compliance, and confirm regulatory operating permits.
4. Forensic and Integrity Diligence: Employs background intelligence investigations on promoters to uncover past bankruptcy proceedings, undisclosed related-party transactions, shell entity networks, or political affiliations.
5. ESG (Environmental, Social, and Governance) Diligence: Assesses workplace safety standards, carbon footprints, supply chain labor ethics, and data privacy compliance.

Once the Investment Committee approves an investment and diligence confirms operational integrity, the legal counsel drafts and negotiates the Definitive Transaction Agreements. In Indian private equity and debt, these primarily consist of the Share Subscription Agreement (SSA) and the Shareholders' Agreement (SHA).

Primary Transaction Agreements

Anatomy of Key Protective Covenants

• Conditions Precedent (CPs): Specific mandatory legal and operational milestones that the investee company must satisfy before the AIF transfers subscription funds (e.g., obtaining regulatory approvals, clearing tax liens, perfecting security charges).
• Representations and Warranties (R&Ws): Formal statements of fact made by the founders regarding the financial health, legal ownership of IP, tax compliance, and material contracts of the company. Breaches of R&Ws trigger indemnity claims.
• Indemnification and Liability Caps: Financial mechanisms requiring promoters to compensate the fund for losses resulting from misrepresentations, fraud, or undisclosed liabilities. Negotiated terms specify indemnity baskets, de minimis thresholds, and liability caps (typically 100% of deal value for fundamental warranties, 20%–50% for operational warranties).

To protect investor capital against promoter opportunism and ensure guaranteed avenues for capital realization, institutional AIFs negotiate powerful governance and exit covenants in the Shareholders' Agreement.

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|                                    HIERARCHY OF INVESTOR PROTECTION RIGHTS                         |
+--------------------------+-------------------------------------+-----------------------------------+
| GOVERNANCE RIGHTS        | TRANSFER RESTRICTIONS               | EXIT & LIQUIDATION RIGHTS         |
+--------------------------+-------------------------------------+-----------------------------------+
| • Board Nominee Rights   | • Lock-in on Founder Shares         | • Qualified IPO (QIPO) Mandate    |
| • Board Observer Rights  | • Right of First Refusal (ROFR)     | • Strategic Third-Party Sale      |
| • Affirmative Veto Rights| • Right of First Offer (ROFO)       | • Tag-Along Rights                |
| • Information & Audit    | • Pre-emptive / Anti-Dilution Right | • Drag-Along Rights               |
|   Inspection Rights      | • Permitted Transfer Carve-Outs     | • Liquidation Preference          |
+--------------------------+-------------------------------------+-----------------------------------+

Detailed Mechanics of Core Investor Rights

1. Affirmative Voting Rights (Reserved Matters): A defined list of critical corporate actions that cannot be approved or implemented by the investee company without the explicit written affirmative consent of the AIF's nominee director or authorized representative. Common reserved matters include:
   • Altering the Memorandum or Articles of Association.
   • Issuing new equity securities or taking on indebtedness above agreed thresholds.
   • Entering into related-party transactions with promoters or their relatives.
   • Changing the core line of business or executing strategic M&A.
2. Anti-Dilution Protection: Protects the fund against dilution in the event of a future "down-round" (a financing round at a lower valuation than the fund's entry price). The standard global and Indian mechanism is the Broad-Based Weighted Average Anti-Dilution Formula:

$$P_2 = P_1 \cdot \left[ \frac{A + B}{A + C} \right]$$

Where:

• $P_1$: Existing conversion price per share.
• $P_2$: Adjusted new conversion price per share.
• $A$: Total number of shares outstanding prior to the new issuance (on a fully diluted basis).
• $B$: Total number of shares that could be purchased at the existing price $P_1$ using the total proceeds raised in the down-round.
• $C$: Actual number of new shares issued in the down-round.

3. Tag-Along vs. Drag-Along Rights:
   • Tag-Along Right (Co-Sale Right): If the promoters receive an attractive acquisition offer from a third party to sell their equity stake, the AIF has the right to "tag along" and force the buyer to purchase the fund's shares on identical commercial terms, preventing the promoters from exiting alone.
   • Drag-Along Right: If the company fails to deliver an Initial Public Offering (IPO) within a defined contract window (e.g., 5 years), the AIF has the legal right to force the company and the promoters to sell 100% of the enterprise to a strategic acquirer, dragging the promoters along into the sale.
4. Liquidation Preference: Governs the distribution of proceeds upon a liquidity event (sale, merger, or winding-up). A 1x Non-Participating Liquidation Preference guarantees that the AIF recovers 100% of its invested capital before common equity holders receive any proceeds, or converts to common equity if doing so yields higher returns.

As the Indian AIF industry matured, institutional investors increasingly demanded opportunities to co-invest directly alongside main funds to deploy larger ticket sizes and reduce blended fee overhead. In response, SEBI established a specialized regulatory framework governing Co-Investment Portfolio Managers (CPM) and co-investment schemes.

SEBI Co-Investment Regulations

Under SEBI circulars and AIF amendment regulations:

1. Co-Investment Structure: Co-investments by investors in portfolio companies of an AIF must be routed either through a dedicated Co-Investment Scheme registered under the AIF Regulations or through a Portfolio Management Services (PMS) route managed by the AIF Manager holding a specialized PMS registration.
2. Pari Passu Terms: Co-investors must invest on terms that are no more favorable than the terms offered to the main AIF fund. The entry price, timing of investment, and exit terms must align strictly to avoid conflicts of interest or disadvantage to the general unitholders of the main AIF.
3. Proportional Exit Mandate: When an AIF decides to exit an investee company, co-investors participating alongside the fund must be provided an exit opportunity on a pro-rata basis and at identical valuation pricing.