On January 12, 2024, SEBI released a Consultation Paper outlining proposals designed to offer increased flexibility to Alternative Investment Funds (AIFs), Venture Capital Funds (VCFs), and their investors in managing unliquidated investments post the conclusion of scheme tenures.
Current position for AIFs with unliquidated investments
Under the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (“SEBI AIF Regulations”), the term of an AIF can be extended for up to two years, provided the extension is approved by two-thirds of the unit holders by value of their investment in the AIF.
If an AIF cannot liquidate its investments by the end of the extended term, despite best efforts in good faith, the fund manager has three options. One option is to make an in-specie distribution of the fund’s investments, which would require the consent of 75% of the unit holders by value of their investment in the fund. The second option is to sell the investments of the fund for whatever price they fetch and distribute to investors. Either of these options must be exercised within the period called the “Liquidation Period”, which is defined in the AIF Regulations as one year following the expiry of the fund’s term after any extension.
The third option was introduced in the AIF Regulations with effect from June 15, 2023, and it involves launching a new close-ended scheme, called a “Liquidation Scheme”, and transferring the unliquidated investments to that new scheme. The AIF would need the consent of 75% of its investors by value to do this. The new scheme is exempt from a number of requirements such as the 25% cap on investments in each investee company or the need for each scheme to have corpus of at least INR 20 crores or the mandate that each investor in a scheme should invest one crore rupees.
However, launching a Liquidation Scheme and transferring the unliquidated investments to this Liquidation Scheme is tax inefficient. For one, capital gains tax may be payable at the time of such transfer. Secondly, when the investments are ultimately liquidated, they may be subject to short term capital gains (instead of long term capital gains) since the time period for determining capital gains tax would be re-set at the time of transfer. Further, setting up a Liquidation Scheme would entail expenses and such expenses would have to be borne by the investors of the relevant scheme.
SEBI’s proposal’s for AIFs
Therefore, SEBI has now proposed in the Consultation Paper that, on expiry of tenure (including any extension), an AIF can opt for a Dissolution Period 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. The biggest advantage of having a Dissolution Period is that the unliquidated investments would not have to be transferred to another scheme and thus the two tax disadvantages mentioned above would be addressed.
The Dissolution Period/Process shall commence from the date of expiry of the Liquidation Period and shall not be more than the original tenure of the scheme. The Dissolution Period/Process of a scheme of the AIF cannot be extended upon expiry. If the unliquidated investments are not sold by the end of the Dissolution Period/Process, such investments must be mandatorily distributed in-specie to the investors.
Just as in the case of a Liquidation Scheme, dissenting investors of the scheme who did not consent to opt for Dissolution Period/Process, should be offered an option to fully exit the scheme. For this purpose, the AIF (or its investment manager) is required to arrange a bid for 25% of the unliquidated investments.
Proposal for schemes whose Liquidation Period has expired
At present, the option to launch a Liquidation Scheme is not available to schemes whose Liquidation Period has expired prior to June 15, 2023.
SEBI is now suggesting that AIF schemes, whose liquidation period has either already lapsed or is set to expire within one month from the notification date implementing the proposals in the Consultation Paper, and have no outstanding investor complaints regarding fund/investment non-receipt, be granted a new one-time liquidation period. This extension will allow them the option to undergo a dissolution period/process.
Current regulatory position of VCFs
When the SEBI AIF Regulations came into effect on May 21, 2012, the Securities and Exchange Board of India (Venture Capital Funds) Regulations, 1996 (“SEBI VCF Regulations”) were repealed. However, the SEBI AIF Regulations provide that VCFs shall continue to be regulated by the SEBI VCF Regulations till the existing fund or scheme managed by the fund is wound up. The SEBI AIF Regulations provided an option to VCFs to seek re-registration under the SEBI AIF Regulations subject to the approval of two thirds of the VCF’s investors by value. Unlike in the case of AIFs, the SEBI VCF Regulations do not permit any extension of tenure of a scheme.
Proposal for VCFs
The Consultation Paper proposes to extend this same flexibility to VCFs as it has done for AIFs to deal with unliquidated investments at the end of their tenure, even if their tenure has expired. For this purpose, a new Chapter III-D shall be inserted in the SEBI AIF Regulations to create a new sub-category under Category I – VCFs called “Migrated VCFs” (‘Migrated VCFs’). VCFs registered under the SEBI VCF Regulations may migrate themselves as Category I AIF – VCF (Migrated VCFs) within 6 months of date of SEBI’s notification pursuant to the Consultation Paper.
|In our assessment, SEBI’s proposal in the Consultation Paper, requiring AIFs to secure a bid for 25% of unliquidated investments, poses a challenging task and could potentially lead to unrealistic bids. The funds generated from selling to such a bidder may not be sufficient to provide a viable exit for dissenting investors. Moreover, given the awareness among investors that those who express dissent must be granted an exit, a significant number may choose to dissent, making it challenging for AIFs to obtain the required 75% consent as outlined.
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