The Securities and Exchange Board of India (SEBI) on April 25, 2024 vide the SEBI (Alternative Investment Funds) (Second Amendment) Regulations, 2024 (Amendment Regulations) introduced significant reforms to the regulatory framework governing Alternative Investment Funds (AIFs).
Prior to enactment of the Amendment Regulations, investments held by an AIF which remain unliquidated at the expiry of the tenure of an AIF could either be transferred to a separate close-ended scheme i.e., a ‘liquidation scheme’ launched with investor approval and no possibility of extension or be distributed to investors in specie. A number of practical concerns had emerged such as increased costs and expenses linked with the launch of a new scheme along with the tax implications on investors owing to the transfer of assets from the original scheme to a liquidation scheme and replacement of erstwhile units held by investors with units of a liquidation scheme. The amendments were introduced with the objective of addressing the aforesaid concerns of AIFs and investors.
Key highlights of the Amendment Regulations include:
Unliquidated investments and option of entering into a dissolution period
- Dissolution period has been defined as the period following the expiry of the liquidation period of the scheme for the purpose of liquidating the unliquidated investments of the scheme of the AIF.
- AIFs are permitted to (i) enter into a dissolution period post expiry of the liquidation period (lasts for 1 (one) year after the end of the tenure of the AIF or scheme of an AIF) subject to obtaining consent of at least 75% (seventy-five percent) of the investors by value of their investment in the scheme, during which efforts for liquidation of remaining investments can be carried out by the AIF. The dissolution period shall not be more than the original tenure of the scheme and cannot be extended further or (ii) undertake in specie distribution of investments to investors.
- In terms of its circular dated April 26, 2024, SEBI has issued comprehensive guidelines with respect to the procedure for obtaining investor consent, arranging bids for unliquidated investments, valuation norms and reporting and disclosure requirements in relation to performance of the AIF manager during dissolution and aspects required to be disclosed to investors before obtaining their consent.
- In case an AIF fails to obtain consent from 75% (seventy-five percent) of its investors (by value of investments) to enter into a dissolution period, the AIF would need to proceed with mandatory in-specie distribution of unliquidated investments.
Discontinuation of liquidation schemes
With effect from April 25, 2024, AIFs are no longer permitted to launch any new liquidation schemes as a means to deal with their unliquidated investments. However, any existing liquidation schemes launched prior to the enactment of the Amendment Regulations will continue to be governed by the earlier regulations and related circulars until such schemes are wound up.
Encumbrance by Category-I and II AIFs
- In terms of the Amendment Regulations, Category-I and II AIFs are permitted to create encumbrances on their equity holdings in investee companies involved in the infrastructure sector for facilitating borrowing by such investee companies for carrying out its development, operation, or management subject to specific conditions.
- In terms of its circular dated April 26, 2024, SEBI has stipulated conditions for creation of encumbrances by Category-I and II AIFs e., all borrowings made by the investee company against encumbrances created against its equity instruments shall not be utilized for any purpose other than specified above including to invest in another company and that this usage restriction be included as one of the terms of the investment agreement entered between the AIF and the investee company.
- Additional conditions in this circular inter-alia relate to disclosure requirements, limitations on the duration of encumbrance, compliance with foreign investment regulations in the case where the AIF is a person resident outside India in terms of foreign exchange regulations, and capping of liability of the AIF and its investors to the extent of the encumbered equity holdings in the case of default by the investee company.
- SEBI has also clarified that this permission of creation of encumbrance granted to Category-I and II AIFs shall not be construed as permission to extend guarantee(s) for an investee company in any form.
Due diligence obligations
In terms of the Amendment Regulations, AIFs, investment managers, and key management personnel (KMP) are required to conduct specific due diligence as may be specified by SEBI, in respect of their investors and investments received from investors in order to prevent any attempts at circumvention of laws, rules and regulations framed by a financial regulator including SEBI. This amendment has been made pursuant to SEBI’s consultation paper dated January 19, 2024 wherein SEBI observed that there is a necessity for regulatory arbitrage since AIFs were being set up by foreign investors with managers/sponsors domiciled in India to circumvent Indian foreign exchange laws (since downstream or indirect foreign investment by AIFs is dependent on the ownership and control of the investment manager or sponsor of such AIF) by investing in (a) sectors prohibited for foreign investment beyond the permissible limits; and (b) debt securities, evading the foreign portfolio investment/external commercial borrowing route.
The agenda for SEBI’s board meeting dated March 15, 2024 on the requirement of due diligence of investors listed out all relevant financial sector regulations inter-alia those formulated by the Reserve Bank of India (RBI) under foreign exchange laws and those formulated in terms of the Insolvency and Bankruptcy Code, 2017 for which specific due-diligence checks shall be laid down by SEBI to prevent circumvention of such regulations through the AIF route. Further, it was stipulated in the agenda that the specific implementation standards for conduct of due diligence on investors and investments of AIFs will be developed by the pilot Industry Standards Forum for AIFs, in consultation with SEBI. The aforesaid due diligence checks and implementation standards for conducting due diligence of investors are yet to be issued by the SEBI.
Conclusion
The amendments are expected to have a significant impact on the AIF regulatory landscape in India. The introduction of a dissolution period framework is a welcome move providing a more feasible mechanism to deal with unliquidated investments as compared to the requirement to launch liquidation schemes which entailed higher costs. However, AIFs and their managers are expected to face increased operational costs and regulatory burden in light of stringent due diligence required to be undertaken on its investors.