How is SEBI Pushing For Growth and Transparency in AIFs?

India’s financial landscape is undergoing a transformative shift, fuelled by a confluence of factors. A decade-long surge in wealth has seen AIF funds experience more than 100-fold increase in AUM, boasting a robust 56% CAGR between FY14 (Rs 0.13 lakh crore) and FY24 (Rs 11.35 lakh crore). The growing population of affluent Indians (ultra HNIs), projected to double by 2026 as per a Knight Frank Wealth Report, have created a fertile ground for diverse investment opportunities in AIFs. 

India’s booming economy and youthful demographic profile have positioned it as a prime market for alternative investments. SEBI, recognising this potential, has taken proactive steps to modernise the regulatory framework for AIF funds. Recent circulars issued in 2024 aim to streamline processes, enhance transparency, and address emerging challenges in these investment products. These initiatives show the regulator’s commitment to fostering a robust and investor-friendly financial ecosystem.

As India continues its trajectory of growth, it is poised to become a global financial hub. The increasing sophistication of Indian investors, coupled with a conducive regulatory environment, will further propel the growth of alternative investments.

Here is a look at a few of these circulars on AIF funds and their implications for investors. 

• Facilitating Debt Raising by AIFs through Encumbrance Creation

In a circular dated April 26, 2024, SEBI introduced a framework allowing Category I and II AIFs to create encumbrances on their equity holdings in investee companies. That is, AIF funds can pledge their shares in investee companies. This move aims to ease debt raising for these companies, particularly those operating in infrastructure sectors. While this provides much-needed flexibility, it is crucial to understand the accompanying conditions:

• Encumbrances are restricted to specific purposes: SEBI explicitly limits the use of encumbrances to borrowing for the development, operation, or management of projects within infrastructure sub-sectors defined by the Central Government.
• Transparency and investor consent are paramount: AIFs are mandated to disclose encumbrances and their associated risks in their Private Placement Memorandums (PPMs). For encumbrances created before the circular’s issuance, specific consent requirements from investors apply.
• Strict usage of borrowed funds: SEBI emphasized that borrowings against encumbered equity investments can only be utilized for the intended infrastructure project and prohibits their diversion into other investments, including investments in other companies. This restriction must be explicitly included in the investment agreement between the AIF and the investee company.
• Duration limitations and considerations for foreign investments: The encumbrance duration is capped by the scheme’s remaining tenure, preventing extended encumbrances beyond the AIF’s lifespan. Additionally, AIFs with substantial foreign investment face stricter requirements aligned with the RBI Master Direction on Foreign Investments in India.
• Investor protection and the prohibition of guarantees: The circular safeguards investors by ensuring they are not exposed to liabilities exceeding the encumbered equity in case of default. Additionally, AIFs are explicitly barred from issuing guarantees for the investee company.

The circular mandates the Standard Setting Forum for AIFs (SFA) to develop implementation standards ensuring proper encumbrance utilisation. Compliance with these provisions forms a crucial part of the AIF’s Compliance Test Report.

Thus, share pledging by AIFs in infrastructure companies is like a double-edged sword. This strategy is not without its risks. Fluctuations in share prices can expose AIFs to potential losses and the risk of default by the investee company can damage the fund’s reputation. 

However, it enables AIFs to unlock additional capital, enhance returns, and adapt to market dynamics. By using their existing equity investments as collateral, AIFs can secure loans without liquidating their assets, thereby maximizing returns for both the fund and its investors. 

• Simplifying PPM Changes for AIF Funds

In another circular issued on April 29, 2024, SEBI eased the process for AIFs to intimate changes in their PPMs (private placement memorandum) by exempting certain changes from the mandatory involvement of a merchant banker. This relaxation aims to reduce compliance costs and streamline procedures for AIFs. That is, PPMs of AIF funds can be submitted directly to the regulator rather than through a merchant banker.

PPM is a key document for AIF funds which discloses essential information to investors, following a mandated template. These include fee details, history, exit process and more. 

A detailed list of changes eligible for direct filing with SEBI is also mentioned in the circular. These include updates to market outlook sections, changes in contact details or service providers, adjustments to fund size or commitment periods, and the inclusion of new disclosures mandated by regulations.

Large Value Funds for Accredited Investors receive further exemption, allowing them to directly file any PPM changes with SEBI, accompanied by an undertaking signed by key personnel of the AIF Manager.

• Strengthening Due Diligence Requirements for AIFs

Based on the circular issued on October 8, 2024, SEBI underlined the commitment to investor protection and regulatory compliance by strengthening due diligence requirements for AIFs, their managers, and key personnel.

SEBI identified specific areas requiring stringent due diligence checks:

• Preventing ineligible investors from accessing QIB benefits: The circular aims to prevent investors who wouldn’t qualify for Qualified Institutional Buyer (QIB) status individually from obtaining these benefits through AIFs.
• Preventing ineligible investors from accessing QB benefits: Similar to the QIB provision, this measure ensures that only investors who qualify as Qualified Buyers (QBs) under the SARFAESI Act can access the benefits associated with this status through AIFs.
• Addressing the issue of evergreening of stressed assets: The circular tackles the practice of RBI-regulated lenders using AIFs to mask the true status of stressed loans or assets, ensuring compliance with RBI’s norms on income recognition, asset classification, provisioning, and restructuring.
• Ensuring compliance with FDI regulations for investments from bordering countries: This provision ensures AIF funds comply with the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019, specifically regarding investments originating from countries sharing land borders with India.

The market regulator further mandates adherence to implementation standards developed by SFA for conducting these due diligence checks. The circular outlines consequences for failing these checks, including the exclusion of problematic investors or the complete prohibition of the investment. Existing investments also fall under the purview of these due diligence requirements, with reporting obligations for non-compliant investments.

• Providing Flexibility in Managing Unliquidated AIF Investments

Another circular provides AIFs and their investors with much-needed flexibility in managing unliquidated investments during the closing stages of a scheme. It introduces the concept of a ‘Dissolution Period’, providing an additional avenue for liquidating remaining investments after the initial Liquidation Period. 

The Dissolution Period requires approval from at least 75% of investors and necessitates specific conditions, including arranging bids for a minimum percentage of unliquidated investments.

The circular also introduces mandatory in-specie distribution of unliquidated investments if the AIF funds cannot secure the required investor consent for the Dissolution Period or in-specie distribution during the Liquidation Period. This provision streamlines the process for handling unliquidated assets, ensuring a clear path forward even when consensus is challenging.

Recognising the challenges faced by schemes with expiring Liquidation Periods, the circular grants a one-time extension to schemes whose Liquidation Period expires on or before July 24, 2024. This fresh Liquidation Period extends to April 24, 2025, providing these schemes with additional time to liquidate their assets or utilize the newly available options for handling unliquidated investments.

Finally, SEBI discontinued the option of launching new Liquidation Schemes from April 25, 2024, onward, while existing Liquidation Schemes will continue to operate under the previous regulations.

Takeaway 

Changes like simplification in PPM and addressing emerging challenges like liquidation period extensions foster an environment of ease while also ensuring transparency for AIF Funds in India, a segment that has seen a massive spike in assets under management. The recent regulatory measures reflect SEBI’s commitment to promoting a healthy AIF ecosystem as India continues its trajectory of growth and aims to become a global financial hub.

References: 

https://privateclient.cyrilamarchandblogs.com/2024/07/alternative-investment-funds-dealing-with-unliquidated-investments/

https://taxguru.in/sebi/relaxed-intimation-rules-aifs-private-placement-changes-via-merchant-bankers.html#google_vignette

https://tta.in/sebi-amends-regime-for-creation-of-encumbrances-by-category-i-and-category-ii-aifs/

https://mehta-mehtaadvisory.com/sebi-update-framework-for-category-i-and-ii-alternative-investment-funds-aifs-to-create-encumbrance-on-their-holding-of-equity-of-investee-companies/

https://corporate.cyrilamarchandblogs.com/2024/10/sebi-prescribes-due-diligence-norms-for-aifs-to-curb-regulatory-circumvention/

https://indiacorplaw.in/2024/02/sebi-greenlights-pledging-of-equity-investments-by-alternative-investment-funds.html