New Delhi, May 20 -- In the mid-1970s, the American Congress enacted the 1974 Employee Retirement Income Security Act (ERISA), a comprehensive and complex regulatory scheme generally applicable to private US retirement plans.
ERISA inter alia contained provisions on the 'prudent man principle' to protect private pension plans from mismanagement which was interpreted as requiring pension fund managers to avoid risky investments, thereby severely limiting their ability to invest in venture capital or new business ventures. This had the impact of many pension funds avoiding venture capital entirely, since it was felt that investment in a start-up could be seen as imprudent.
However, after a clarification was issued in 1979 stating that an allocation of a small fraction of a portfolio to venture capital funds would not be seen as imprudent since the risk calculation pertained to the entire portfolio rather than each individual investment, commitments into venture capital funds skyrocketed without which, Silicon Valley as we know today would perhaps not exist.
Indian context In India, venture capital is classified as Category I Alternative Investment Fund (AIF) under the Securities and Exchange Board of India (AIF) Regulations, 2012. While SEBI does not place any restrictions on institutional investors such as domestic and international insurance companies, pension funds, family trusts from investing in AIFs, institutional investors have to comply with limits imposed by respective sectoral regulators.
The domestic pension regulator, PFRDA releases separate investment guidelines (for both government and non-government sector) defining permissible asset classes under its flagship National Pension System (NPS). Although investment in Category I and II AIFs, classified as Scheme A (alternate assets), was permitted for the non-government sector since 2016, actual inflows in Scheme A have remained limited. This is primarily because subscribers were reluctant to actively select Scheme A, given that it comprised of instruments such as AT-1 bonds, REITs, InvITs, AIFs and liquid funds, because they were less popular, people knew less about them than other asset classes, higher risk associated with them and so on. Pension funds, remained cautious of investment in AIFs, in particular, due to its ticket size requirements, and structural liquidity constraints, thereby maximising allocations to other permissible instruments within Scheme A and limiting exposure to AIFs.
Recent policy support These constraints were eased through a recent policy change: for non-government sector subscribers, the instruments hitherto under the Scheme A were re-classified into Scheme E (equity and related instruments) and Scheme C (corporate debt), based on the resemblance of these alternate instruments with the respective re-classified asset classes, with the maximum permissible limit being 5% of the respective scheme's total assets under management (AUM). For government sector subscribers, investment in categories I and II AIFs has now been permitted under Scheme A up to 1% of the scheme AUM.
By reclassifying AIFs into Scheme E and C, the computation base for exposure norms has been raised, thus enabling a possible higher fund allocation to AIFs.
This reclassification also enables pension fund managers to diversify across a broader universe of instruments in respective asset classes, thereby addressing liquidity concerns, since in case of redemption requests, other instruments within the Scheme can be easily sold off by pension fund managers to fulfil these requests. While such reclassification does not completely address inherent AIF liquidity concerns, it does provide a broader universe to effectively manage liquidity considerations while processing redemption requests.
Further, investments by pension funds are also subject to conditions inter alia including compliance with PFRDA Act 2013, AIF corpus being at least Rs. 100 crore, exposure to single AIF being limited to 10% of the AIF size, and so on.
While investment in alternate asset class is risky, we cannot ignore that private credit is primed to play a central role in the country's financial ecosystem. Further, the government is also making a push for increased investment in domestic companies by rolling out SIDBI Fund of Funds and the Research, Development and Innovation (RDI) Fund by the Department of Science & Technology (DST).
Conclusion Sovereign wealth funds and international private pension funds such as California Public Employees and Retirement System (CalPERS) and Canadian Pension Plan Investment Board regularly make headlines for investing in Indian companies, showing their commitment and trust in the Indian start up story, domestic pension funds often lag behind.
Taking a cue from how Silicon Valley was created largely aided by a change in US policy coupled with Indian graduates from premier institutions playing a key role, PFRDA's move to shift AIF categorisation, eventually opening the door for increased investment represents a strategic step towards deepening domestic institutional capital in private markets.
By encouraging pension funds to access diversified AIF portfolios within a robust governance framework, even 1% of the eligible NPS AUM would make a considerable difference, showing both, an enduring commitment to fostering India's growth trajectory and also increasing avenues for diversification for subscribers.
To sum up, domestic pension funds are important vehicles of institutional funding, with long-term investment horizons. Thus, enabling pension investment in AIFs will hit the nail on the head on three separate fronts, namely, long term growth capital for AIFs, unique investment opportunities for NPS subscribers and facilitating India's progress as a fund management hub.
The road to Atmanirbharta and Viksit Bharat should be paved with private credit, focusing not only on indigenous production but also on indigenous capital.
(Anita Jain is one of the Founding Partners of Aequitas Law Partners and Priyanka Pai is an Officer in Pension Fund Regulatory and Development Authority (PFRDA).)
Published by HT Digital Content Services with permission from VC Circle.