SEBI proposes to allow Infrastructure Funds to Secure Loans Taken by Portfolio Companies

Regulation 16(1)(c) and 17(c) of the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”) states that Category I and Category II Alternative Investment Funds shall not borrow funds directly or indirectly or engage in any leverage except for meeting temporary funding requirements for a) not more than thirty days b) on not more than four occasions in a year and c) not more than ten percent of their investable funds.

On May 31, 2023, in a matter involving India Infrastructure Fund II, Global Infrastructure Partners India Private Limited and IDBI Trusteeship Services Limited (“India Infrastructure Fund II Matter”), SEBI held that Category I and II AIFs should not pledge the securities of portfolio companies to secure any loan availed of by such portfolio companies. SEBI held that doing so would be tantamount to indirect borrowing by the AIF. Further SEBI ruled that the prohibition on Category I and II AIFs taking ‘any leverage’ is not confined to leverage availed of by the Category I and II AIFs itself, but also prohibits Category I and II AIFs from being party to any leverage availed of either by Category I and II AIFs or by any other entity.

The primary reason for the ruling by SEBI was to protect investors. The concern was that if an Alternative Investment Fund (AIF) used its portfolio securities as collateral to secure a loan for its portfolio companies, investors could face a total loss of their equity in these companies should any of them fail to repay their debt. SEBI aimed to mitigate the risk of such potential losses to safeguard the interests of the AIF’s investors.

This ruling by SEBI had resulted in a hue and cry since it has a direct impact on the business model of AIFs investing in infrastructure companies. In the infrastructure sector, it is common for shareholders to pledge their equity stake to secure loans to the infrastructure companies in which they have invested.

Consequently, in response to these concerns,  SEBI has issued a consultation paper dated February 2, 2024 (“Consultation Paper”) wherein it has proposed that Category I and II AIFs may create an encumbrance on the equity of an investee company solely for the purpose of securing loans borrowed by the said investee company.  This measure would be allowed solely to secure loans taken by investee companies which are engaged in the development, operation, or management of infrastructure projects that fall within sub-sectors are specified in the Harmonised Master List of Infrastructure, published by the Department of Economic Affairs, Ministry of Finance, Government of India. Once the abovementioned proposal is implemented, schemes of Category I and II AIFs which have not on-boarded investors should disclose explicitly in their PPMs if the creation of any encumbrance on the equity of investee companies is envisaged as part of their investment strategy. In fact, for schemes of Category I and II AIFs which have not on-boarded investors, SEBI is evaluating whether the AIFs should get 100% consent from their investors or if the consent of 75% (seventy-five percent) of investors by value of their investment in the scheme of the AIF, would be sufficient. In the latter case, the dissenting investors shall be forced to go along with the majority and it would not be necessary for them to be given an exit.

Some of the other terms of SEBI’s proposals in the Consultation Paper are as follows:

• The duration of encumbrance on the AIF’s portfolio equity securities shall not be greater than the residual tenure of the scheme of the AIF.
• AIFs cannot create any encumbrance on the equity of a foreign investee company held by them.
• AIFs should not create an encumbrance on the equity of an investee company in order to use the money borrowed by such investee company for equity infusion into another company.
• Schemes of AIFs, whose downstream investments are classified as Indirect Foreign investment in terms of FEM (NDI) Rules, 2019, desirous of pledging equity of their investee companies shall be required to ensure compliance with para 7.11.2 of RBI Master Direction dated January 04, 2018, on ‘Foreign Investments in India’. The aforementioned RBI Master Direction provides that if an investment vehicle whose sponsor or manager or investment manager is not owned and not controlled by resident Indian citizens or is owned or controlled by persons resident outside India, any investment by an investment vehicle in an Indian entity would be treated as Indirect Foreign Investment.
• When creating any encumbrance on the equity of investee companies, investment managers of AIFs should ensure that the AIF is not subject to any outstanding liability of the borrower investee company towards lenders beyond forfeiture of the equity encumbered by the AIF.
• Category I and II AIFs should not extend any form of guarantee for investee companies.

The above proposal from SEBI is a welcome development for infrastructure companies. However, the proposals in SEBI’s Consultation Paper have a few shortcomings. Key issues are listed below:

• SEBI has mandated that the duration of encumbrance on the AIF’s portfolio equity securities shall not be greater than the residual tenure of the scheme of the AIF. However, when a charge is created for the benefit of a lender, it is industry practice to provide that such charge would be in place until the loan is repaid. It is very unlikely that any lender will accept a security offered by an AIF if the security has to be released on a fixed date even if the loan hasn’t been repaid by then. Even if a portfolio company takes a loan which has to be repaid before the AIF’s tenure ends, the lender is unlikely to agree in the loan agreement that the security will be released even if the loan hasn’t been repaid on its maturity.
• SEBI has made it clear that while it is open to allowing Category I and II Alternative Investment Funds (AIFs) to encumber portfolio securities, it will not permit AIFs to provide guarantees for their investee companies. Although the AIF Regulations do not explicitly prohibit AIFs from securing loans for their portfolio companies through encumbrances or guarantees, SEBI’s stance has evolved. Specifically, in the India Infrastructure Fund II matter, SEBI interpreted the act of an AIF creating a charge on its investments to secure a loan for a portfolio company as an indirect form of borrowing, contravening the regulation against AIFs incurring leverage.
• In its recent Consultation Paper, SEBI has further clarified that offering any guarantee by an AIF for a loan to an investee company is also deemed unacceptable. In our view, SEBI ought to consider allowing Category I and II AIFs to provide guarantees to their investee companies, but only for securing loans for projects in the infrastructure sectors as outlined in the Harmonised Master List of Infrastructure by the Indian Government’s Department of Economic Affairs. Moreover, it may be stipulated that any guarantee should not exceed the AIF’s investment value in the specific portfolio company. This proposal, if accepted, would carve out a cautious path for AIFs to support essential infrastructure projects, balancing investor protection with the need for developmental finance.

We hope you have found this information useful. For any queries/clarifications please write to us at insights@elp-in.com  or write to our authors:

Vinod Joseph, Partner – Email – vinodjoseph@elp-in.com
Paridhi Jain, Associate – Email – paridhijain@elp-in.com