Table of Contents
Chapter 10: Investment Process and Governance of Funds
The Institutional Deal Lifecycle
Category I and II AIF managers follow an institutional, multi-stage funnel to screen, evaluate, and execute private market transactions:
| Specification / Entity | Deal Sourcing (300 - 500 Opportunities) | Direct outreach, bankers, VC networks, founders |
|---|---|---|
| Preliminary Evaluation & PIM (50 Deals) | Initial financial model, preliminary IC memo | |
| Non-Binding Term Sheet (15 - 20 Deals) | Commercial valuation, exclusivity, board rights | |
| Multi-Disciplinary Due Diligence | Financial QoE, legal, tax, tech, forensic, ESG | |
| Final IC Approval & Definitive Docs | Final Investment Committee sign-off, SHA/SSA | |
| Disbursement & Closing (8 - 12 Deals) | Conditions Precedent (CP) satisfaction, Escrow |
The Due Diligence Matrix
| Diligence Stream | Investigative Focus | Typical Red Flags Uncovered |
|---|---|---|
| Financial & Quality of Earnings (QoE) | Normalizing EBITDA, analyzing revenue recognition policies, working capital seasonality, hidden debt, off-balance-sheet commitments. | Aggressive revenue capitalization, circular invoicing, bloated inventory valuations. |
| Legal Due Diligence | Corporate title ownership, capitalization table verification, intellectual property ownership, encumbrances, pending litigation. | Defective share issuance titles, unassigned founder IP, material undisclosed legal disputes. |
| Forensic Diligence & Background Checks | Promoter integrity, political exposure, related-party transactions, shell entity networks, vendor kickbacks. | Diversion of corporate funds to promoter-controlled entities, inflated capex invoices. |
| Tax Due Diligence | Direct and indirect tax compliance, open tax assessment orders, transfer pricing documentation, withholding tax compliance. | Massive unrecorded GST or income-tax demand liabilities. |
| Environmental, Social & Governance (ESG) | Workplace safety, environmental discharge permits, labor standards, supply-chain child labor risks, board independence. | Severe environmental contamination liabilities, systemic labor law violations. |
Structuring Definitive Agreements: SSA and SHA
Upon completion of satisfactory due diligence, the transaction is codified through the Share Subscription Agreement (SSA) and the Shareholders’ Agreement (SHA):
- SSA: Governs the primary issuance of securities, subscription price, closing mechanics, and Conditions Precedent (CPs) that must be fulfilled prior to capital release.
- SHA: Governs ongoing corporate governance, shareholder relationships, board control, and exit mechanisms.
| GOVERNANCE & CONTROL • Affirmative Voting (Veto Matters) • Board Representation & Observers • Information & Inspection Rights | TRANSFER & EXIT RIGHTS • Right of First Refusal (ROFR) • Tag-Along Rights • Drag-Along Rights (Exit Enforcement) |
|---|---|
| ECONOMIC CAPITAL PROTECTION | ANTI-DILUTION PROTECTION |
| • Liquidation Preference (1x / 2x) | • Broad-Based Weighted Average Ratchet |
| • Pre-emptive Rights on New Issues | • Full Ratchet (Rare / Aggressive) |
Detailed Examination of Key Protective Rights
- Affirmative Voting Rights (Reserved Matters): The company cannot execute critical decisions without the explicit prior written affirmative consent of the AIF investor. Typical reserved matters include:
- Alteration of charter documents (MOA/AOA) or share capital.
- Incurrence of debt beyond agreed EBITDA leverage thresholds.
- Related-party transactions and changes in executive compensation.
- Material deviations from the approved annual operating budget.
- Mergers, acquisitions, spin-offs, or voluntary liquidation.
- Liquidation Preference: In the event of a sale, merger, or liquidation, the AIF is contractually entitled to receive its invested capital (1x or 2x preferred) plus unpaid dividends before any proceeds are distributed to common equity holders (promoters/founders).
- Anti-Dilution Protection: Protects the fund against "Down Rounds" (subsequent capital raises at a lower valuation). The standard formula applied is the Broad-Based Weighted Average Ratchet:
Where:
- $P_1$ = Old conversion price per share.
- $P_2$ = New adjusted conversion price per share.
- $A$ = Number of shares outstanding prior to the new issuance (fully diluted basis).
- $B$ = Number of shares that would have been purchased at the old price $P_1$ using the new capital.
- $C$ = Actual number of shares issued in the down round.
Governance Mechanics within the AIF Structure
To protect the interests of unit-holders and address inherent conflicts of interest, SEBI mandates a rigorous governance architecture within Category I and II AIFs:
TRUSTEE / TRUST BOARD
| Fiduciary custodian of fund | Details 2 | Details 3 |
|---|---|---|
| INVESTMENT COMMITTEE | LIMITED PARTNER ADVISORY COMMITTEE | |
| • Evaluates & approves all investments | (LPAC) | |
| • Key investment personnel & experts | • Representative body of institutionalLPs | |
| • Joint fiduciary liability for breaches | • Resolves conflicts of interest | |
| • Must ensure compliance with PPM | • Approves related-party transactions | |
| and regulatory concentration caps | • Consents to key-person replacements |
1. The Investment Committee (IC) Mandate
- Regulation 20(6) of the SEBI AIF Regulations holds members of the Investment Committee jointly and severally responsible along with the Investment Manager for ensuring that fund investments adhere strictly to the stated investment objective, concentration limits, and investment criteria set forth in the PPM.
- IC members owe a direct fiduciary duty to the fund and its unit-holders.
2. The Limited Partner Advisory Committee (LPAC)
- Composed of independent representatives from major institutional LPs.
- The LPAC does not make commercial investment decisions (which would compromise the LPs' limited liability shield). Instead, the LPAC serves as a governance firewall:
- Reviewing and approving Related-Party Transactions (e.g., fund investing in a company where the Sponsor holds a personal stake).
- Approving waivers of PPM concentration caps or investment period extensions.
- Reviewing valuation policy modifications and key-person substitution events.
3. SEBI Code of Conduct
Managers, Key Management Personnel, and Trustees must adhere to SEBI's statutory Code of Conduct:
- Exercising high standards of integrity, due diligence, and professional care.
- Refraining from unfair, manipulative, or fraudulent practices.
- Ensuring equitable treatment of all unit-holders across classes without prejudicial preference.
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