A number of foreign jurisdiction permit segregation (commonly known as, side-pocketing) of illiquid funds, however, few allow side-pocketing by mutual funds since it comprises of both sophisticated and unsophisticated investors and the investments may vary from short to long term. On December 28, 2018, SEBI issued the much-awaited circular permitting segregation of illiquid funds (“the segregated fund”) from the liquid portion of a mutual fund (“the main fund”). Under this, the unit-holders of a fund are allotted units of segregated fund on a pro rata basis. Upon segregation, the main fund can continue its business as usual. Any proceeds from realization of segregated fund is distributed among the unit-holders.
The SEBI circular provides for the following:
- Segregated fund may be created on downgrading of a debt, loan or money market instrument to ‘below investment grade’ or on subsequent downgrading.
- The Scheme Information Document of mutual funds must provide for creation of segregated funds; for existing funds compliance with Regulation 18(15A) of the SEBI (Mutual Funds) Regulations, 1996 is necessary. This provision requires a fund to notify any fundamental change in the attributes of the scheme, to the unit-holders of such scheme.
- Decision to segregate must be made immediately after the credit event. Once the said decision is made, an approval from the trustees will be required (within 1 day of credit event) on the said decision, which shall also be disclosed through a press release.
- Suspension of entry and exit from the scheme is also permitted while the trustees’ decision is awaited. Post segregation, the restriction on entry and exit has to be extended to the segregated fund.
- Segregated fund has to be compulsorily listed within 10 days of creation of such fund, to enable exit to the unit holders.
- Funds can charge TER, excluding investment and advisory fees, on the recovery of the investments in segregated fund; however, costs incurred on segregated fund cannot be charged to the main fund.
- The existing disclosure and valuation norms continue to be applicable on both the segregated and main fund.
Although this policy was brought in the backdrop of the debt default by IL&FS (amounting to more than ₹ 910 billion), however, the mutual funds affected by IL&FS’ default would not be able to reap its benefits. This is because segregation is required to be done on the day of the credit event and the trustees have to approve it within one day of the said credit event. Nevertheless, this circular is a step-forward and it will prevent the mutual fund industry from another IL&FS-like crisis situation.
*Mr. Sandeep Parekh is a member of the Mutual Fund Advisory Committee of SEBI.
