Chapter 11: Governance of Funds and Due Diligence

The Rigor of Institutional Operational Due Diligence (ODD)

Because Category III AIFs operate in liquid, high-frequency, leveraged environments, institutional LPs conduct specialized Operational Due Diligence (ODD) distinct from traditional private equity reviews:

Operational Due Diligence Pillars:
┌─────────────────────────────────────────────────────────────────────────────────┐
│ 1. Algorithmic Risk Controls & Kill-Switches: Pre-trade margin limits, fat-finger│
│    checks, automated position liquidation gateways                              │
├─────────────────────────────────────────────────────────────────────────────────┤
│ 2. Counterparty & Clearing Risk: Solvency of Professional Clearing Member (PCM),│
│    margin haircut models, segregated collateral accounts                        │
├─────────────────────────────────────────────────────────────────────────────────┤
│ 3. Trade Reconciliation & Valuation: Daily 3-way reconciliation (Broker,       │
│    Custodian, and Internal OMS), independent registered valuer oversight        │
├─────────────────────────────────────────────────────────────────────────────────┤
│ 4. Cybersecurity & IT Infrastructure: Colocation security, air-gapped backups, │
│    CISO appointment, compliance with SEBI CSCRF 2024 mandates                   │
└─────────────────────────────────────────────────────────────────────────────────┘

Key Risk Dimensions Evaluated in ODD

1. Trade Execution & Order Management Systems (OMS): Ensuring algorithmic trading code contains robust fail-safe mechanisms, automated risk cutoffs, and latency-monitoring alerts.
2. Key Person Risk & Operational Independence: Verifying that trading models, risk management, and back-office reconciliation are institutionalized rather than concentrated in a single proprietary trader.
3. Disaster Recovery & Business Continuity Planning (BCP): Maintaining real-time mirrored secondary data centers capable of seamless trade routing failover during primary exchange link outages.

Governance Architecture and Fiduciary Liabilities

                              ┌─────────────────────────────┐
                              │     TRUSTEE / TRUST BOARD   │
                              │ Fiduciary custodian of fund │
                              └──────────────┬──────────────┘
                                             │
                      ┌──────────────────────┴──────────────────────┐
                      ▼                                             ▼
┌──────────────────────────────────────────┐   ┌──────────────────────────────────────────┐
│           INVESTMENT COMMITTEE           │   │         COMPLIANCE & RISK OFFICER        │
│ • Formulates and approves trading theses │   │ • Monitors 2x gross leverage cap daily   │
│ • Enforces statutory 10% single-investee │   │ • Ensures SDD and PIT compliance         │
│ • Joint fiduciary liability for breaches │   │ • Validates independent NAV computation  │
└──────────────────────────────────────────┘   └──────────────────────────────────────────┘

Fiduciary Duties of the Investment Committee

• Under Regulation 20(6) of the SEBI AIF Regulations, members of the Investment Committee are jointly and severally responsible with the Investment Manager for ensuring that fund investments adhere strictly to the PPM investment mandate.
• In Category III AIFs, the IC establishes hard leverage caps, maximum allowable daily VaR budgets, sector concentration limits, and stop-loss protocols.

Mitigating Structural Conflicts of Interest

Category III AIF managers managing multiple schemes, proprietary trading books, or offshore funds face inherent potential conflicts of interest:

1. Trade Allocation Policy:
   • Where the manager executes block trades across multiple funds or client accounts, trades must be allocated on a strict, time-stamped pro-rata basis at the volume-weighted average price (VWAP). Cherry-picking profitable trades for preferential funds is strictly prohibited under SEBI regulations.
2. Proprietary Trading Segregation:
   • Personal trading by fund managers, research analysts, and directors must comply with strict pre-clearance procedures and mandatory minimum holding periods to eliminate front-running.
3. Co-Investment Guidelines:
   • Any co-investment offered to select institutional LPs alongside the main Category III AIF must be executed under a formal Co-Investment Portfolio Management Services (PMS) framework and cannot prejudice the main fund's liquidity or execution pricing.
4. SEBI Statutory Code of Conduct:
   • Managers, Trustees, and key personnel must act with integrity, avoid manipulative trading practices, maintain fair competition, and provide truthful disclosures to investors.