Three crucial changes in AIF Regulations approved by SEBI’s Board

The 204^th meeting of SEBI’s Board was held in Mumbai on March 15, 2024 and a number of crucial decisions have been taken.  Our alert details key issues which are relevant for Alternative Investment Funds.

On February 2, 2024, the Securities and Exchange Board of India (SEBI) released a consultation paper (referred to as the “February Consultation Paper”). This document proposed that Category I and II Alternative Investment Funds (AIFs) should be permitted to create encumbrances on the equity shares of investee companies. This provision would be specifically for the purpose of securing loans that have been obtained by these investee companies. However, it is important to note that this allowance applies exclusively to investee companies engaged in the development, operation, or management of projects in any of the infrastructure sub-sectors listed in the Harmonised Master List of Infrastructure sub-sectors, as issued by the Government of India. SEBI’s Board has now voted to allow Category I and II AIFs  to  create  encumbrances on their holding in “investee companies in the infrastructure sector” to facilitate  the raising  of  debt/loan  by  such  investee  companies,  subject  to  certain conditions,  including  compliance  with  RBI  regulations.

On January 19, 2024, SEBI released a consultation paper proposing enhanced due diligence requirements for Alternative Investment Funds (AIFs), their managers, and Key Management Personnel (KMP) of both the managers and the AIFs. The proposal mandates comprehensive due diligence on investors and investments prior to each transaction. This initiative aims to deter any attempts to circumvent regulations enforced by financial sector regulators, ensuring a more transparent and regulated investment environment.

If participation of an investor of an AIF in an investment opportunity  has been ascertained which will result in circumvention of any applicable financial regulation, the manager of the AIF shall either not make the investment or shall exclude the particular investor from the investment.

The January 19 Consultation Paper specifically discusses three financial sector regulations, which in SEBI’s opinion, could be circumvented through AIFs structures. These are:

• The Reserve Bank of India’s notification dated December 19, 2023 (“RBI Notification”) which prohibits Banks and NBFCs from investing in any scheme of an AIF which has downstream investments either directly or indirectly in a debtor company of the regulated entity.
• As per paragraph 4 of Schedule VIII to the Foreign Exchange Management (Non-Debt Instrument) Rules 2019, an investment made by an Investment Vehicle into an Indian entity shall be reckoned as indirect foreign investment for the investee Indian entity if the Sponsor or the Manager or the Investment Manager (i) is not owned and not controlled by resident Indian citizens or (ii) is owned or controlled by persons resident outside India. A company is considered as ‘Owned’ by resident Indian citizens if more than 50% of the capital in it is beneficially owned by resident Indian citizens and / or Indian companies, which are ultimately owned and controlled by resident Indian citizens.

Therefore, even if a majority of the investors in an AIF are foreign residents, such an AIF would be treated as a domestic fund if its investment manager and sponsor are both owned and controlled by resident Indian citizens. Downstream investment by an AIF, that is reckoned as foreign investment, shall have to conform to the sectoral caps and conditions / restrictions, if any, as applicable to the company in which the downstream investment is made as per the FDI Policy. It would also have to file a report in the prescribed format with the Reserve Bank of India.

As per the January 19 Consultation Paper, this situation has created a scope for regulatory arbitrage. According to this consultation paper, some AIFs appear to have been set up specifically with the intent to circumvent the provisions relating to regulatory framework for foreign investment in a particular sector, company, security/ instrument, etc. For instance, some foreign investors appear to have set up AIFs with domestic managers/sponsors to invest in sectors prohibited for FDI, or to invest beyond the allowed FDI sectoral limit.

• QIBs, in general, are large, regulated, sophisticated and informed institutional investors/money managers managing the investments of a large number of investors. They are expected to possess the expertise and financial ability to evaluate, invest and manage risks in the capital markets. They are expected to contribute in an expert manner, to price discovery for IPOs/ FPOs, etc. Currently, all AIFs are designated as QIBs. Certain AIFs, which have single or very few investors (often belonging to same investor group), have invested in IPOs under QIB quota, thereby availing benefits available to QIBs under SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018. It is noteworthy that such investors of AIFs would otherwise be ineligible for QIB status on their own.

SEBI’s Board has now approved the proposal (first mooted in the Jan 19 Consultation Paper) to require AIFs, managers of AIFs, and their KMPs to carry out specific due diligence of their investors and investments, so that AIFs do not facilitate circumvention of specified regulations administered by financial sector regulators. In order to ensure that the due-diligence requirements are not open ended or subject to interpretation, the specific implementation standards for verifiable due diligence to be conducted on investors and investments of AIFs shall be formulated by the pilot Industry Standards Forum for AIFs, in consultation with SEBI.

SEBI’s introduction of a rule mandating Alternative Investment Funds (AIFs) to conduct compulsory due diligence before executing investments is a well-intentioned measure. It aims to safeguard the AIF framework from being exploited as a means to sidestep regulations enforced by financial sector regulators, ensuring integrity and transparency in the investment landscape.. However, it is unclear why SEBI has questioned the (sensible and practical) principles set out in the Non-Debt Instrument Rules 2019 and the FDI Policy for determining whether an AIF and other investment vehicles should be treated as domestic or foreign. An AIF will receive and pool funds from a spectrum of investors, some of whom may be non-resident. However, investment decisions are made by the investment manager in accordance with the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 and the private placement memorandum of the AIF. It would be very impractical if every time an AIF makes an investment which is not permitted for foreign investors, either on account of a sectoral cap or the type of instrument being used,  it has to exclude its foreign investors from such investments. In certain cases, the investment in a domestic company may be under the automatic route. However, the investment may be at a valuation which is not as per FEMA norms. Though this aspect has not been expressly covered in the Board meeting’s minutes it would be a logical conclusion that AIFs would have to exclude their foreign investors from investments which, though under the automatic route and in permitted instruments, is not in conformity with FEMA norms for valuation.

On January 12, 2024, SEBI had released a Consultation Paper (“Jan 12 Consultation Paper”) which had proposed that on expiry of tenure (including any extension), an AIF can opt for a dissolution period to deal with unliquidated investments of their schemes upon completion of tenure (including extensions, if any), with the positive consent of 75% of investors by value of their investment in the scheme. The aforesaid investor approval should be obtained by the AIF prior to the expiry of liquidation period of the scheme.

SEBI’s Board has now approved the aforementioned proposal to allow AIFs to enter into a dissolution period during which unliquidated investments which are unsold can be held in the same scheme of the AIF.  The value of such investments carried forward into the dissolution period shall be recognized as per norms specified by SEBI for capturing the track record of the manager and for reporting to Performance Benchmarking Agencies. The said facility of entering into Dissolution Period has been introduced in place of the existing option of launching a new scheme (viz. Liquidation Scheme).

SEBI’s decision to allow AIFs to enter into a ‘Dissolution Period’ during which unliquidated investments which are unsold can be held in the same scheme of the AIF is a very welcome move. SEBI has always considered the tenure of an AIF to be sacrosanct and resisted any possibility of extending the term set out in an AIF’s PPM, until now. This decision permitting a “Dissolution Period” is a defacto change in SEBI’s stand since this amounts to an extension of the tenue of the AIF, for all practical purposes. The minutes of the Board meeting also state that the “said facility of entering into Dissolution Period has been introduced in place of the existing option of launching a new scheme (viz. Liquidation Scheme)”. SEBI introduced the concept of a “Liquidation Scheme” through a circular issued on June 21, 2023. However, this initiative has not attracted significant interest, primarily due to its tax inefficiency. However, because a Dissolution Period does not require the unsold securities to be transferred to a new scheme, it will not give raise to capital gains and hence is likely to be much more popular.

The press release issued by SEBI pursuant to its 204^th Board meeting 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