Address by WTM (Shri Ananth Narayan G) - CafeAlt Conference 2024 - The Regulator’s perspective on Alternates

Keynote Address by Shri Ananth Narayan G, WTM SEBI (Speaking Notes) CafeAlt Conference 2024 “The regulator’s perspective on Alternates” August 23, 2024 At the outset, I thank Cafemutual for giving me this opportunity to address this august audience of stakeholders from the investment industry. In this address, I would like reflect upon the impressive positive trends experienced by this industry over past few years, refer to some points to ponder over, and share thoughts on the way forward. Industry Growth  AIFs have witnessed remarkable rise in investments which has increased to INR 4.1 lakh crore at end of FY24, 4 times as compared to INR 1.1 lakh crore at the end of FY19. Concomitantly, AIF commitments have gone up to INR 11.3 lakh crore at end of FY24, from INR 2.8 lakh crore at the end of FY19.  Assets managed by Portfolio Managers (excluding EPFO/PFs), have increased to over INR 10.0 lakh crore as at end of June-24 from INR 4.5 lakh crore, five years back.  On the back of robust inflows and market price growth, MF AUM has grown from around INR 24.5 lakh crores as of July 2019, to nearly INR 65 lakh crores as of July 2024.  From less than 2 crore unique mutual fund investors as of March 2019, the industry is approaching 5 crore unique investors as of July 2024 - an impressive CAGR of 18% during this period.  An increasing number of investors are bringing in their financial savings into our capital markets. During FY16 to FY21, on average, Mutual Funds, other Domestic Institutional Investors (DIIs), and individuals net infused around INR 40k crores on average each year into our equity secondary markets. From FY22 onwards, this number has grown to average around INR 3.1 lakh crore annually into our secondary markets – nearly 8 times higher than before.  Supported by strong earnings, stable macros, digitization, and formalization, our markets have been amongst the best performing markets globally with around 15% in USD terms over the last 5 years.  Five years ago, India had around 9% weightage in the MSCI EM Index – that now is approaching 20%. 1Points to ponder  While we celebrate the steady transformation of the Indian saver into an investor and the consequent increase in market capitalization, we must consider the current mismatch between the demand for securities & the supply of securities.  In FY24, INR 3.9 lakh crore of net demand for paper brought in by MFs, DIIs, FII and individuals into the primary and secondary market, far exceeds the less than INR 2.0 lakh crore of primary market issuance spanning IPO, FPO, Preferential Allotment, QIP, Rights Issue, and even OFS. This mismatch has only grown in recent times.  Over the past 5 years, more than 40% of all midcap, smallcap, and microcap stocks have grown by over 5 times in price terms. While fundamentals, macros and any other number of factors can be used to explain and justify price movements, industry experts must collectively ponder over this.  As a result of the large inflows from investors into equity capital markets in recent times, the holdings of MFs, DIIs, and individuals have risen from 54.3% of the free float of all midcap and smallcap companies as of March 2020, to 60.6% as of March 2024. During the same period, the Mutual Funds’ holding in Mid and Small cap companies has increased from around INR 2.2 lakh crore to INR 11.5 lakh crore.  To address the question what would happen in the hypothetical stress event of large redemptions from mutual funds, particularly in case of arguably less-liquid midcap and smallcap schemes, MFs conducted their own stress tests of their individual schemes and made the results of such tests public. While individual stress tests are useful to describe idiosyncratic risks of redemptions from one scheme or one fund house, to capture system-wide risk, it is also important to conduct industry wide analysis.  In view of the above, SEBI is conducting a stress test to examine how many days it would take for all equity mutual funds to cater to say a hypothetical sudden and large 10% or 20% redemption of funds. The preliminary results are encouraging, with some caveats. The initial findings suggest that despite the substantial increase in MF holdings of stocks over time, the number of days to cater to a hypothetical sudden 10- 20% redemption have not really changed between March 2020 and March 2024. There are of course, caveats that need to be kept in mind. Secondary market turnover and average daily delivery volumes have increased substantially over the past few years – and this accounts for why the number of days to reduce MF positions hasn’t really changed over time. Whether markets would be as welcoming of supply of paper from individuals and mutual funds, as they have been for demand of paper, remains to be seen.  Many of the new investors entering the capital markets ecosystem may not have really experienced a full market cycle. It is vitally important that risk-awareness should accompany increased participation in securities markets. Improving upon the current Risk-O-Meter, we perhaps need to explore better ways of conveying the risk 2associated with a financial product which may truly reflect the volatility (both implied as well as realised) and liquidity profile of the product.  The ecosystem must ensure that a product or offering sold to an investor is suitable and appropriate for her, and that she fully understands the associated risks. Given that distributors are paid by the manufactures and not by the investor, and given that distributers are in effect an extension of the manufacturer, there is a need to ensure that the investors best interests are protected by the manufacturer.  To mitigate operational risks, as an industry we also need to be more efficient, more resilient to the financial and cyber risks, and ensure that businesses continue to operate with minimal disruption and inconvenience to the investors. Ease of Doing Business  To ensure consultation at the operational level, SEBI has put together a Standards Forum for AIFs (SFA), through which the AIF industry itself formulates standards for implementation of specific regulatory objectives, in consultation with SEBI.  As we have often highlighted, SEBI has seen egregious cases of AIFs being used as structures to circumvent different financial sector regulations. In order to ensure a targeted response that prevents wrongdoing, without coming in the way of productive capital formation, the SEBI Board now requires AIFs and their KMPs to ensure that such circumvention does not happen. The specific do & don’ts for AIFs and their KMPs are being are devised by the managers themselves (through SFA), to ensure that they are practicable and yet achieve the regulatory intent.  Dematerialization of AIF Units and Assets - Furthering the benefits of digitalisation, almost all assets and liabilities of AIFs will be in demat form. This reform will ease the reporting and compliance requirements, enhance investor experience and protection, and bring in more transparency while reducing operational risks.  Earlier, AIFs that could not exit from some investments beyond the original tenure faced regulatory action. SEBI has now provide flexibility for AIFs to deal with unsold investments after the tenure of the fund, to enter into an extended dissolution period with appropriate investor approval.  Flexibility to Venture Capital Funds (VCFs)- To address the issues faced by VCFs registered under the erstwhile VCF Regulations with respect to their inability to fully liquidate the investments of their schemes within the tenure of the scheme, an option to such VCFs to migrate into AIF Regulations and avail the facilities available for AIFs to deal with unliquidated investments has been provided. 3 Category I and II AIFs are now permitted to create an encumbrance on the equity of its investee companies in infrastructure sector to facilitate raising of debt/ loan by such investee companies.  AIFs are the first vehicle regulated by SEBI that have been permitted not just to buy protection via Credit Default Swaps, but also sell protection in order to create a synthetic long position in the underlying credit.  To provide flexibility and facilitate ease of accreditation of investors, the requirements and process for grant of accreditation to investors, by accreditation agencies, has been significantly simplified.  To facilitate ease of doing business and to reduce cost of compliance for AIFs, changes in certain terms of PPM are no longer required to be submitted through a merchant banker, and can be filed directly with SEBI.  Subject to certain checks and balances, AIFs have been allowed to borrow funds for up to 30 days, including to cater to delays in collecting drawdowns from their investors. This will facilitate ease of doing business and provide operational flexibility to the Funds. Way Forward  SEBI proposes to leverage internally housed and trained LLM tools to assist PPM processing.  Consistency and credibility of valuations, particularly of illiquid investments, remains an area that warrants ongoing industry attention.  Even as we look to enhance investor protection and market stability in areas such as F&O, we would like the professionally managed fund industry offer solutions with different risk characteristics to investors. The proposal for a new asset class within the MF world with risks in between regular funds and that of PMS/ AIF should be seen in this light.  With the checks and balances that the code of conduct for AIFs is expected to provide, and subject to some guardrails around differentiating across different class of units, we are open to allowing more categories of investors (such as multilateral and government agencies) to subscribe to junior tranches of funds.  Industry should become a trusted advisor to regulators and the entire ecosystem. If you see something, say something. There is a need for all stakeholders to talk to each other, as opposed to talking past each other. For our part, we commit to continuing and further deepening our engagement with industry. 4 The AIF industry should have associations with wider representation for creating better dialogue among the members, practice some level of self-regulation and for better communication with regulators and other stakeholders.  Lastly, the industry needs to streamline the operations, develop resilience to the emerging risks like cyber risks and participate more actively in investor education and awareness activities. ***** 5