The Securities and Exchange Board of India (SEBI) via circular no. SEBI/HO/AFD/AFD-POD-1/P/CIR/2024/112 amended the borrowing norms for Category I and II Alternative Investment Funds (AIFs) to give them more operational flexibility and promote ease of doing business. AIFs can now borrow to bridge shortfalls in drawdown commitments. The move is expected to help AIFs with liquidity concerns due to delayed capital contributions from investors.
This article delves into the critical issues surrounding these regulatory changes, including the impact of delayed capital contributions on AIF liquidity, the potential risks associated with increased borrowing, and the balance between operational flexibility and investor protection. Additionally, it also covers SEBI's recent proposal to allow AIFs to pledge equity holdings in infrastructure investee companies, a significant shift aimed at facilitating debt raising for capital-intensive projects.
Earlier, Category I and II AIFs were not allowed to borrow except for meeting temporary needs or covering operational expenses. Borrowing for this purpose was restricted to a period of 30 days for not more than four times a year. However, as per the new norms introduced by SEBI on August 19, 2024, Category I and II AIFs are permitted to borrow funds specifically to meet drawdown shortfalls subject to certain conditions.
However, there are certain prerequisites. AIF shall disclose the intention to borrow for drawdown shortfalls in its PPM (document disclosing material information about the AIF to the prospective investors to raise funds through private placement).
Borrowing shall only be allowed in case of emergency where an investment opportunity is on the horizon and despite best efforts, the manager has not been able to obtain the required drawdown amount. The borrowed amount cannot exceed:
The costs of the borrowings are for the account solely of the investors who have not made their committed drawdown amount available. AIFs must maintain a 30-day cooling-off period between borrowing periods. The details relating to borrowings and lending, including, where relevant, amounts borrowed and details on the use and investment of monies borrowed or raised through leverage, shall be disclosed at least once a year to all investors.
These are intended to make sure that borrowing is resorted to as a last measure and it does not become an undue burden on the compliant investors. This in-built mechanism also addresses risks such as over-dependence on borrowed funds and ensures that AIFs adopt a more balanced approach to liquidity management, which may not be possible if the incentives are stacked heavily in favor of short-term returns.
The new regulations strike a balance between providing AIFs with the flexibility to manage liquidity challenges and maintaining investor protection. There are various managing risks associated with borrowing, such as higher costs for delinquent investors and administrative complexities. SEBI’s move brings Indian AIFs closer to international standards.
SEBI’s relaxation of borrowing rules for Category I and II AIFs represents a pivotal shift in India's regulatory framework for alternative investments. By enabling funds to address drawdown shortfalls through borrowing, the regulator has provided a solution to time-sensitive investment opportunities while ensuring that the burden of such borrowing falls squarely on delinquent investors.
One more significant development happened on February 2, 2024, when SEBI issued a consultation paper proposing that Category I and II AIFs be allowed to create an encumbrance on their equity holdings in infrastructure sector investee companies. The objective is to facilitate raising debt for these companies, which often require equity pledges to secure loans for capital-intensive projects.
Infrastructure projects, especially those in sectors such as transport, energy, and telecommunications, are characterized by high leverage. However, lenders usually seek equity collateral to safeguard themselves from undue risks associated with these projects. AIFs, specifically those focused on infrastructure assets have been constrained by the extant regulations which prohibit the use of equity collateral by AIFs to raise debt for investment in their investee companies.
Earlier, SEBI prevented Category I and II AIF from pledging shares to obtain loans as investors of AIF may lose money in the fund if investee companies default on loan repayment. However, it says it will allow AIFto pledge equity shares of investee companies in the infrastructure sector in order to provide ease of doing business for AIFs and to foster an ecosystem wherein private capital effectively complements the various modes available for infrastructure financing.
The above-discussed regulatory changes for Category I and II AIFs mark a significant shift towards greater flexibility and efficiency in the Indian investment landscape. By allowing AIFs to borrow to bridge drawdown shortfalls and pledge equity in infrastructure projects, SEBI has addressed liquidity challenges. These amendments enhance AIFs' operational capabilities while balancing investor protection, aligning Indian regulations with international standards, and fostering a more dynamic investment environment.