SEBI’s allows Infrastructure Funds to create encumbrances

On April 25, 2024, Securities Exchange Board of India (SEBI) amended the SEBI (Alternative Investment Funds Regulations), 2012 (“AIF Regulations”) vide an amendment dated April 25, 2024 (“SEBI April Amendment”) in order to implement proposals contained in a consultation paper released by SEBI on February 2, 2024. The Consultation Paper dated February 2, 2024 (“Consultation Paper”) had 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, provided the investee company is in the business of development, operation or management of projects in any of the infrastructure sub-sectors listed in the Harmonised Master List of Infrastructure issued by the Department of Economic Affairs, Ministry of Finance, Government of India.

The SEBI April Amendment provides for, inter alia, the following:

• “encumbrance” has been defined to have the same meaning as assigned to it under chapter V of the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011.
• Regulation 16 (1)(c) has been newly introduced to enable Category I Alternative Investment Funds (AIFs) to create encumbrances on the equity of their investee companies. This provision applies only to investee companies that are involved in the development, operation, or management of projects across any infrastructure sub-sectors specified in the Harmonised Master List of Infrastructure, which is issued by the Central Government. The regulation stipulates that such encumbrances can only be made to secure borrowings by the investee company.
• A similar provision has been introduced in Regulation 17 to give the same freedom for Category II AIFs.

Pursuant to the SEBI April Amendment, SEBI issued a circular dated April 26, 2024 (“SEBI Circular”) to provide for the following in relation to creation of an encumbrance by an infrastructure fund on the securities of their investee companies, in order to secure any loan taken by such investee companies (“Encumbrance Creation” or “Create an Encumbrance”):

• Existing schemes of Category I or Category II AIFs who have not on-boarded any investors prior to April 25, 2024, may Create an Encumbrance, provided the AIF’s PPM contains explicit disclosures regarding such Encumbrance Creation.
• If a scheme of any Category I or Category II AIF has already Created an Encumbrance, such encumbrance may continue if it was created after making an explicit disclosure in the PPM of the scheme.
• In case such Encumbrance Creation was without making an explicit disclosure in the PPM, such encumbrances may be continued with, only if the consent of all investors in the scheme of the AIF is obtained on or before October 24, 2024. If consent of all investors is not obtained within the aforesaid time period, the encumbrances need to be removed on or before January 24, 2025.
• Any encumbrances created other than as permitted by the SEBI April Amendment and the SEBI Circular may not be continued with and should be removed on or before October 24, 2024.

SEBI has placed an obligation on infrastructure funds that Create an Encumbrance to ensure that the loan taken by the investee company is utilised only for the purpose of development, operation or management of the investee company. In particular, such loan should not be used by the investee company to invest in another company. AIFs that Create an Encumbrance should insert the aforesaid condition as one of the terms of the investment agreement entered between the AIF and the investee company.

The duration of the Encumbrance Created shall not be greater than the residual tenure of the scheme of the relevant AIF.

SEBI has made it clear that permission given to Create an Encumbrance does not tantamount to permission to extend any form of guarantee by the AIF to its investee company. In case of any default by the borrower investee company, neither the AIF nor its investors should face any liability or loss other than having to lose the securities over which the AIF Created an Encumbrance.

• SEBI has prescribed that the duration of the Encumbrance Created shall not be greater than the residual tenure of the scheme of the relevant AIF. This is evidently to ensure that the AIF’s investors receive their investment proceeds at the expiry of the AIF’s term. Usually, for any loan where a third party provides a security, the security provided has to be in place until the loan is repaid. SEBI’s stipulation will ensure that loans availed of by infrastructure companies and which are secured by infrastructure AIFs do not have a term that exceeds the term of the infrastructure AIF.
• Regulation 16(1)(c) and 17(c) of “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 not more than thirty days, on not more than four occasions in a year and 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 SEBI Circular has clarified that though AIFs that invest in infrastructure companies are now allowed to Create an Encumbrance, they cannot give any form of guarantee to their investee companies. This is once again a policy decision. If an AIF can Create an Encumbrance, there is no reason why it cannot give a guarantee to secure a loan taken by its investee companies. However, it is easy to understand SEBI’s position. If an AIF Creates an Encumbrance to secure a  loan, the securities under such encumbrance may be lost if the portfolio company defaults. However, if a guarantee is given either in lieu of or in addition to the Encumbrance Creation, the loss would be even more. This is because, if the portfolio company defaults, the value of the securities of the portfolio company would be substantially reduced and such securities actually become near worthless. However, a guarantee given by the AIF would cause the AIF to shell out money from its funds and thus affect its investors even more.

• Even though it is a common practice in the infrastructure sector for investors in such companies to offer security for loans given to infrastructure companies, there is no reason why AIFs that invest in other sectors should also not be allowed to offer their investments as security for loans taken by their portfolio companies, provided their investors consent to the same and/or there are sufficient disclosures in the PPM.

The SEBI April Amendment can be found here.
The SEBI Circular can be found here.
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