Sebi recently came out with a proposed regulatory regime for alternative investment funds ( AIF). While the regulator has its heart in the right place, the proposals need to be thought through from the ground up.

It would be useful to summarise briefly what Sebi is seeking to do with these pools of money with highly sophisticated investors with a minimum investment of Rs 1 crore, who can broadly take care of themselves. The Sebi paper itself recognises how important the industry is and sings paeans to the 'patient source of active capital' which 'plays a very important role in the growth of the corporate sector' and that the capital brings 'a lot of governance and good quality money'.

The fund industry is composed of foreign and domestic funds. Of these, foreign funds can come chiefly via FDI, FII or foreign venture capital investment (FVCI). FII, FVCI and domestic venture capital (VC) funds are registered by Sebi, which considers registering as VC or FVCI as optional.

What Sebi now seeks to do is create an umbrella regulatory regime for all funds. Sebi's stated objective is three-fold. First, create a regulatory framework which registers different types of funds based on investment objective like private equity, real estate, venture capital, debt, infrastructure, SME, social venture and strategy funds. This would enable targeted benefits for a particular sector. Second, to get a handle on systemic risk. As some overseas funds may be highly leveraged they may cause system-wide instability.

Third, to improve disclosures, provide for conflict of interest and prohibit fraudulent acts. It is difficult to argue with these goals. Unfortunately, while talking about these, the paper ends up doing something quite different. It seeks to impose investment and other restrictions on these funds, which would hurt the industry without any regulatory benefit.

In Greek mythology, Procrustes, the son of a god, had an iron bed in which he invited every passerby to spend the night, and where he set to work on them with his smith's hammer, to stretch them to fit if they were too short and if the guest proved too tall, Procrustes would amputate the excess length; nobody ever fit the bed exactly because secretly, Procrustes had two beds. Sebi has many investment beds, and its proposals are no less dangerous.

The most damaging aspect of the proposal is that the paper seeks to create investment silos and imposes restrictions on where each type of fund may invest. This takes away the only free lunch available in the financial markets - of diversification in different types of companies. Thus, a fund which wants exposure in SMEs, early stage companies and listed companies would be prohibited from investing unless they create three different pools.

The proposal seeks to mandate the types of companies which are kosher for a particular fund, including whether investment should be in listed or unlisted debt securities. There is a provision for the fund size to be a minimum of Rs 20 crore, the minimum investment per investor to be 0.1% of the fund size. (Economic Times)