Explained: Why the 'sponsorless' mutual funds could be a good idea

Sebi has come to the conclusion that, while a sponsor may be useful in the initial years of AMC operations, the role of the sponsor is much reduced

The Securities and Exchange Board of India (Sebi) has just released a proposal to alter the regulations pertaining to the sponsor system for mutual funds. One of the reasons for the proposed changes is that there are two conflicting regulations that need to be clarified. The other reason is that the sponsor system may itself be outdated as it stands, and the proposed changes would allow new entities such as private equity funds and portfolio management services to enter this space.

The concept of the sponsor, as defined by Sebi, is any entity that sets up a mutual fund (perhaps in concert with other entities which are also sponsors.) The sponsor needs to have a five-year track record of positive net worth, a three-year track record of profits after tax, and a five-year history in the financial services industry. The net worth of the sponsor must be more than Rs 100 crore and the total net worth must exceed the proposed contribution by the sponsor to the asset management company (AMC). Each sponsor must contribute 40 per cent to the net worth of the AMC.

However, another regulation (Regulation 7B (1) of Mutual Fund Regulations) says that the sponsor must not hold more than 10 per cent stake directly or indirectly in more than one AMC. This can create conflicts in that, for example, the UTI AMC has sponsors and promoters such as the State Bank of India (SBI), Life Insurance Corporation of India (LIC), Punjab National bank (PNB) and Bank of Baroda (BoB), with a present combined holding of 45.21 per cent in the paid up capital of UTI AMC Ltd. However, these entities also run their own AMCs, and operate their own mutual funds, hence, they are in breach of this regulation.

The sponsor or sponsors of a mutual fund are supposed to go through the entire process of setting up the AMC, structuring mutual funds, running them, and so on. Originally the sponsor was supposed to be a backstop. If a debt fund went into bankruptcy or difficulties because some portion of the portfolio was in default, the sponsor was supposed to sort out the problems.

For example, if a debt security in a fund portfolio was in default, the sponsor could buy that security off the fund and thus, it would no longer be counted towards net asset value (NAV). This has happened with Franklin, for example.

Also, if there were temporary redemption pressures, the sponsor could use its own collateral to raise loans from the money markets. For example, let’s say there are redemption pressures today and the fund will receive an interest payment tomorrow from some security it holds. The sponsor can put up collateral, take a money market loan, and redeem it tomorrow. Plus, in case a fund was being wound up, the sponsor would take care of the processes and ensure unit-holders got redemption. Earlier too, there was a concept of “capital guaranteed” funds, which meant that sponsors had to plug gaps if the NAV went negative.

Capital-guaranteed funds no longer exist. Most of the bankruptcy-related issues don’t arise in the case of an equity fund – if a stock plummets in value, too bad. Also, even in the case of a debt fund, the balance sheet of the fund itself eventually grows large enough to not need the sponsor to put up collateral in case of loans being required to meet redemption pressures. Also AMCs are now brand names in themselves, and they hold enough assets and liquid assets to be independently eligible to be sponsors.

So Sebi is reviewing this situation and it has come to the conclusion that, while a sponsor may be useful in the initial years of AMC operations, the role of the sponsor is much reduced. A working group has made some recommendations that are being released for public comment.

It’s proposed to change the net worth criteria to “liquid net worth,” meaning net worth deployed in unencumbered liquid assets such as cash, money market instruments, government securities, T-bills and repo on government securities. The average annual profit after tax (PAT) for the prior five years should be Rs 10 crore and the sponsor must maintain Rs 50 crore of liquid net worth. The AMC itself must have a positive liquid net worth of at least Rs 150 crore until such time as it has shown PAT for five consecutive years. There are also some alternative criteria proposed. In case the PAT norms are not met, the net worth for sponsors will be raised to Rs 150 crore. After five years however, sponsors can exit AMCs, selling off their stake or transferring it.

There's a lot of fine print obviously in the proposal but these are the salient points. If these changes are accepted, it would allow for the conflict between the regulations to be resolved. For example, SBI, BoB, LIC, etc, may exit the UTI AMC (the UTI AMC has more than enough resources to be a self-sponsor). There is also a chance that innovative PE firms, and other entities that meet the net worth requirements could enter this space and that might, in turn, lead to more investment and activity in the bond markets.

The current regulations

TO READ THE FULL STORY, SUBSCRIBE NOW NOW AT JUST RS 249 A MONTH.

MONTHLY

₹ 249

Select

ANNUAL

₹ 1799

Select

Best Offer

SMART ANNUAL

₹ 1499

₹ 1799

Opt for auto renewal and save Rs 300

Select

What you get on Business Standard Premium?

Unlock 30+ premium stories daily hand-picked by our editors, across devices on browser and app.
Full access to our intuitive epaper - clip, save, share articles from any device; newspaper archives from 2006.
Curated newsletters on markets, personal finance, policy & politics, start-ups, technology, and more.
Pick your 5 favourite companies, get a daily email with all news updates on them.
26 years of website archives.
Preferential invites to Business Standard events.