SEBI proposes to allow Cat II AIFs invest more than 50% of the investible funds in listed securities, but there’s a catch

The Securities of Exchange Board of India (“SEBI”) has issued a consultation paper dated February 7, 2025 (“Consultation Paper”) proposing certain amendments to Regulation 17(a) of the Securities of Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (“SEBI AIF Regulations”).

Currently, Regulation 17(a) of the SEBI AIF Regulations states as follows:

“Category II Alternative Investment Funds shall invest in investee companies or in the units of Category I or other Category II Alternative Investment Funds as may be disclosed in the placement memorandum;

Explanation. – Category II Alternative Investment Fund shall invest primarily in unlisted companies directly or through investment in units of other Alternative Investment Funds.”

SEBI, vide clause 11.1.5 of SEBI Master Circular dated July 31, 2023 for AIFs, has clarified that for the purposes of Regulation 17(a) of the SEBI AIF Regulations, the investment portfolio of a Category II AIF ought to be more in unlisted securities as against the aggregate of other investments. Accordingly, Category II AIFs are required to invest more than 50% of the investible fund in unlisted securities.

A Category II AIF may be a debt fund. Regulation 2(1)(i) of the SEBI AIF Regulations, defines a “debt fund” as “an Alternative Investment Fund which invests primarily in debt securities of listed or unlisted investee companies or in securitized debt instruments as per the stated objectives of the Fund.”

The Securities of Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“LODR”) was amended recently and a new regulation 62A was introduced. Regulation 62A of LODR provides as follows:

• A listed entity, whose non‐convertible debt securities are listed shall list all non‐ convertible debt securities, proposed to be issued on or after January 1, 2024, on the stock exchange(s).
• A listed entity, whose subsequent issues of unlisted non‐convertible debt securities made on or before December 31, 2023 are outstanding on the said date, may list such securities, on the stock exchange(s).
• A listed entity that proposes to list the non‐convertible debt securities on the stock exchange(s) on or after January 1, 2024, shall list all outstanding unlisted non‐ convertible debt securities previously issued on or after January 1, 2024, on the stock exchange(s) within three months from the date of the listing of the non‐convertible debt securities proposed to be listed.

Pursuant to aforementioned amendments to LODR, the entities that had issued listed Non-Convertible Debentures (“NCD”) on or before 1st January 2024, would not be eligible to issue any unlisted NCDs if even one listed NCD is live. Further, debt securities of investee companies which were issued on or after January 01, 2024 and are currently unlisted, would also be mandatorily required to be listed by the investee companies at any time subsequently, in case such investee company propose to list any one of their debt securities in future (in light of Regulation 62A (3) of the LODR).

In light of the above, while a Category II debt fund may have invested in unlisted debt securities, the same may subsequently be mandatorily required to be listed by the investee companies.

SEBI is of the view that the scope of Cat II AIFs to invest ‘primarily’ in unlisted securities (>50%) may be expanded to listed debt securities also. Hence, SEBI proposes to amend Regulation 17(a) of the SEBI AIF Regulations to provide that Category II AIFs should invest more than 50% of their total investible funds in unlisted securities, and/or listed debt securities having credit rating ‘A’ or below, directly or through investment in units of other AIFs.

Even if Cat II AIFs are to be allowed to increase their investments in listed debt securities, SEBI proposes to enable the same in such a manner that Cat II AIFs still assume the due credit risk in the ecosystem. Therefore, SEBI proposes to nudge Category II AIFs to invest in listed debt securities having credit rating ‘A’ or below, in line with higher risk appetite of AIFs.

• The aforesaid SEBI LODR amendments are expected to adversely impact the availability of unlisted debt securities for AIFs, thereby, shrinking the investment universe. Therefore, SEBI has taken the welcome step towards expanding the investment universe for Category II AIFs by permitting them to invest in listed debt securities having credit rating ‘A’ or below. By preventing Category II AIFs from investing a majority of their corpus in debt securities with a rating that is above A, SEBI has made it clear that even debt funds are expected to cater to investors with a higher risk appetite. Investors who wish to invest in funds that invest in debt securities having credit rating above ‘A’ should invest in mutual funds.
• Category II AIFs can continue to invest in listed securities, and/or listed debt securities having credit rating above ‘A’, but such investments should be less than 50% of their total investible funds.

The Consultation Paper can be found here.

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Vinod Joseph, Partner – Email – vinodjoseph@elp-in.com