India’s alternative investment funds (AIF funds), which includes private equity funds, debt funds, real estate funds, and funds of funds, has grown from 2.08 lakh crore (June 2019) to Rs 9.33 lakh crore (June 2024) in a span of five years. An annual average growth of 35%!

So, considering the growth potential, it is understandable that the Securities and Exchange Board of India (SEBI) is sitting up and taking notice for better protection of investors’ interest.

SEBI’s recent circular on October 8 this year is one such example. The market regulator has introduced stricter due diligence requirements, sparking a wave of discussions and debate within the industry. While some view the new regulations as an unnecessary burden, others believe they represent a crucial step toward greater transparency, accountability, and ultimately, investor protection.

Need for change

AIF funds are a diverse range of asset classes including private debt, private equity, venture capital, hedge funds, SME funds, infrastructure funds, and more, catering to high-net-worth individuals and sophisticated investors. These funds often operate in complex structures compared to traditional investment avenues such as mutual funds or fixed deposits. This complexity can create opportunities for regulatory arbitrage, and entities might work in a grey area of regulation.

SEBI’s circular aims to address this issue by plugging potential loopholes and ensuring a level playing field.

For instance, there are reports of misuse of benefits intended for specific categories of investors. Qualified Institutional Buyers (QIBs) and Qualified Buyers (QBs), as defined under various regulations, enjoy certain privileges, such as preferential allotment in IPOs and access to specific financial instruments. The SEBI circular seeks to prevent AIFs from being used as a conduit for ineligible investors to access these benefits. By mandating thorough due diligence, particularly when investors contribute significantly to a scheme’s corpus, SEBI aims to ensure that only genuinely qualified individuals or entities reap these advantages.

The change

The core objective is to ensure that AIFs are not used as a vehicle to bypass regulations established by various financial sector regulators, including SEBI and the Reserve Bank of India (RBI). As such, the circular outlines four key areas for the application of the new due diligence norms.

• Streamlining investment by QIBs and QBs

One key area of focus is preventing ineligible investors from accessing benefits intended for Qualified Institutional Buyers (QIBs) and Qualified Buyers (QBs).

QIBs are sophisticated investors with substantial financial resources and expertise. They include entities like mutual funds, scheduled commercial banks, multilateral financial institutions, systematically important NBFCs, and Foreign Venture Capital Investors (FVCIs).

And QIBs typically include financial institutions with experience in investing in and managing distressed assets. This circular applies to both AIFs as QIBs under ICDR Regulations and QBs under SARFAESI Act.

The regulations specifically target practices of such AIFs pooling capital from smaller entities that don’t individually qualify as QIBs to gain access to benefits like preferential share allocations in IPOs.

Similarly, regulations address concerns about AIF funds being used by group entities to gain QB status under the SARFAESI Act, which allows them to subscribe to Security Receipts (SRs) issued by Asset Reconstruction Companies (ARCs) and potentially influence the management of underlying assets.

• What’s the change?

AIF fund managers are required to perform thorough due diligence when an investor or a group of related investors contributes 50% or more to a scheme’s corpus. This due diligence aims to verify whether the investor(s) independently qualify as QIBs or QBs based on their own financial standing and expertise, or if they are government-backed entities.

• Investments from countries sharing land borders

Similar due diligence process will be required for AIFs that receive investments from entities located in countries sharing a land border with India. These requirements stem from the Foreign Exchange Management Act (Non-Debt Instruments) Rules, 2019 (NDI Rules). This stipulates that such investments require government approval to invest in the equity instruments of Indian companies.

• What’s the change?

As such AIF schemes where 50% or more of the corpus is contributed by investors who are citizens of or have beneficial owners situated in a land bordering country must undergo specific due diligence checks. This check must align with the standards set by the Standard Setting Forum for AIFs (SFA), which was established by SEBI.

If the due diligence reveals that 50% or more of the AIF fund is contributed by such investors, the AIF manager must report details of those investors and the scheme to their custodian within 30 days of the investment. Custodians then compile this information received from AIFs every month and report it to SEBI within 10 working days from the end of each month.

AIFs and evergreening

Evergreening refers to the practice of extending new loans to borrowers solely to enable them to repay existing loans that are nearing default. This practice masks the true financial health of the borrower and the lender’s asset quality. It allows lenders to avoid classifying loans as non-performing assets (NPAs).

In this regard, there are concerns about RBI-regulated lenders, such as banks and non-banking financial companies (NBFCs), potentially using AIFs as a conduit for evergreening their stressed loans. This is achieved by structuring investments in AIFs in a way that allows these lenders to indirectly support their borrowers without triggering the RBI’s asset classification and provisioning norms.

SEBI and the Reserve Bank of India (RBI) have introduced several measures to address the issue of evergreening through AIF funds.

• What’s the change?

SEBI’s circular mandates stringent due diligence for AIF funds where RBI-regulated investors contribute 25% or more to the corpus or have significant influence over investment decisions.

The AIF fund manager must ensure that the scheme’s investments do not enable the RBI-regulated investor to indirectly acquire an interest or exposure in the investee company beyond permissible limits. This involves scrutinising the RBI-regulated investor’s existing financial exposure to the proposed investee and verifying compliance with relevant RBI circulars and directives on income recognition, asset classification, provisioning, and loan restructuring.

SEBI has banned AIF funds that prioritise distributions to certain investors and the RBI has restricted RBI-regulated entities from investing in AIFs with downstream investments in their debtor companies, unless they make 100% provisions for such investments. This prevents the use of AIF structures to mask the true nature of the lender’s exposure to the borrower.

Takeaway

The stricter due diligence requirements introduced by SEBI for AIF fund managers, particularly for investments from RBI-regulated entities and those from countries sharing land borders with India, could significantly increase the cost and complexity of managing AIF funds. This may divert resources away from investment activities and could prolong the onboarding process for new investors, especially those from countries sharing land borders.

While the circular doesn’t explicitly state how to handle investments that don’t meet the due diligence criteria, but it is implied that they would require government approval (Investments from countries sharing land borders). This could impact the AIF fund’s ability to quickly deploy capital.

Further, the increased compliance burden and reporting requirements may deter large investors seeking efficient and flexible investment structures, especially those specialising in niche opportunities or catering to investors with higher risk appetites. This could drive such investors towards other assets, potentially discouraging large investors.

Overall, this is a significant step by SEBI to tighten AIF fund rules to ensure enhanced stability of the Indian financial ecosystem.

Source:

https://www.sebi.gov.in/legal/circulars/oct-2024/specific-due-diligence-of-investors-and-investments-of-aifs_87434.html

References:

https://www.livemint.com/market/aifs-sebi-rules-alternative-investment-funds-due-diligence-investor-protection-investors-qibs-qbs-rbi-11728631232843.html

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