[Prachya J. Bhattacharya and Sahsransh Pandey are 3rd year students at Gujarat National Law University, Gandhinagar]
In an effort to foster the consistent growth of alternative investment funds (AIFs), the Securities & Exchange Board of India (SEBI) introduced a consultation paper on 2 February 2024. The paper aims to allow AIFs to create encumbrance on their equity holdings in infrastructure sector investee companies. This move is intended to facilitate the raising of debt by such investee companies, ultimately promoting infrastructure development and private capital investment in the country.
This post provides an in-depth exploration of the consultation paper’s objectives, delves into its background, outlines the proposed framework and conducts an analysis of the potential impact while shedding light on its significance within the AIF industry.
Brief Overview of the Regulatory Landscape
AIFs, as defined under the SEBI (Alternative Investment Funds) Regulations, 2012 (AIF Regulations), are privately pooled investment vehicles that collect funds from investors to invest in accordance with a defined investment policy. These funds are managed in the interest of all investors, and the managers have a fiduciary responsibility towards the investors. Regulations 16(1) and 17(c) of the AIF Regulations, prohibit Category I and II AIFs from borrowing or engaging in leverage, except for meeting temporary funding requirements. On the other hand, Category III AIFs are allowed to engage in leverage to a certain extent with investor consent.
In its recent order in India Infrastructure Fund II, Global Infrastructure Partners India Private Limited, and IDBI Trusteeship Services Limited, SEBI highlighted that the expression “directly or indirectly” under regulation 16(1)(c) of the AIF Regulations prohibit Category I and II AIFs from being a party to any borrowing, including pledging securities of portfolio companies for loans. The expression “any leverage” extends beyond the AIFs’ own leverage and prohibits them from being involved in any leverage taken by either Category I and II AIFs or any other entity. Therefore, the act of pledging securities held by an AIF in its investee companies for loans taken by those companies violates the AIF Regulations.
This interpretation had broader implications, affecting AIFs and their portfolio companies. It limits their ability to secure debt, particularly in capital-intensive sectors like infrastructure that rely on leverage for operational sustainability. The ruling did not consider that without such pledges, lenders might hesitate to take unsecured exposure to AIF-backed portfolio companies, potentially hindering the growth of the AIF industry in India.
Additionally, the order seemed to deviate from SEBI’s original intent of the AIF Regulations outlined in the 2011 Concept Paper, which referenced global practices, including the European Parliament and Council’s directive proposal. This proposal considered leverage at the investment fund level and did not include leverage at the portfolio company level. Therefore, the act of a shareholder pledging securities to reassure lenders should not be misunderstood as leveraging, as long as it did not result in additional downstream investments or acquisitions.
In light of these considerations, the paper considers that the current AIF regulations do not envision pledging by Category I and II AIFs. The paper states that there is merit in considering allowing AIFs to pledge equity investments in infrastructure sector investee companies, as this could aid these companies in raising debt while ensuring compliance with regulatory frameworks. As mentioned in the paper, SEBI has received representations from industry associations and funds requesting permission to pledge equity investments to secure borrowing by investee companies. They argue that allowing AIFs to create encumbrance on their equity holdings is essential for infrastructure development, particularly in project financing, which often requires pledge of equity shares as collateral; without this provision, project finance could be severely hampered.
Rationale Behind the Proposal
While the prohibition on pledging of securities by AIFs serves to protect investors, it can hinder the development of infrastructure projects. Project financing, which often relies on equity pledges, is crucial for capital-intensive infrastructure projects. Lenders require shareholders to pledge their equity as collateral to secure loans for infrastructure projects. Without this pledge, lenders may be reluctant to extend financial support, impeding infrastructure development in the country.
Decoding the Paper
In light of the potential impact of restricting borrowing by AIFs, the proposal suggests that Category I and II AIFs be allowed to create encumbrance on their equity holdings in infrastructure sector investee companies. This flexibility would be limited to companies engaged in the development, operation, or management of projects in infrastructure sub-sectors listed in the Harmonized Master List (HML) issued by the Department of Economic Affairs.
To allow pledging of equity investments, SEBI has proposed that Category I and II AIF schemes, which have already on-boarded investors, have to explicitly disclose any plans for pledging or encumbering equity investments in their Private Placement Memorandum (PPM). For schemes without on-boarded investors, AIFs must obtain consent from either all investors or at least 75% of them for such encumbrances. In cases requiring 75% investor consent, dissenting investors will be bound by the majority decision.
Lastly, to mitigate potential risks, the encumbrance on equity would not be allowed for foreign investee companies. AIFs would also be prohibited from using the borrowed funds for equity infusion into another company, ensuring that the purpose of the encumbrance is solely to facilitate debt raising. AIF schemes categorized as Indirect Foreign Investments under the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019, must comply with RBI regulations regarding foreign investments in India if they intend to pledge equity from their investee companies. Additionally, AIFs would not be permitted to provide third-party guarantees for investee companies.
Navigating the Potential Impact
The proposed framework for allowing AIFs to pledge their equity investments comes with a set of advantages and disadvantages. On the positive side, share pledging offers AIFs enhanced the returns on their investment in the said company. This is achieved when the infrastructure investee company utilises the loan to successfully complete the project, the cash flows generated from which benefit the shareholders of the company including the AIFs.
Additionally, successful utilisation of the borrowed money leads to appreciation of the value of pledged securities, which allows the AIFs to realise the ideal return on their investment in the equity of the company by using its existing asset instead to new investments. This adaptability enables AIFs to navigate dynamic market conditions and capitalise on favourable investment opportunities while ensuring seamless fund operations. Furthermore, by leveraging their equity investments as collateral, AIFs access capital without liquidating their investments, ultimately maximising returns for both the fund and its investors.
However, there are potential downsides that warrant consideration. Firstly, the volatility of share prices introduces significant risks to the act of pledging shares. A decrease in share prices would diminish the value of the collateral, necessitating AIFs to pledge additional shares or repay the loan to redeem the pledged shares. Additionally, default by the investee company could tarnish the fund’s reputation and erode investor confidence.
Secondly, SEBI has mandated that the duration of encumbrance on the AIF’s portfolio equity securities shall not be greater than the residual tenure of the scheme of the AIF. However, when a charge is created for the benefit of a lender, it is industry practice to provide that such charge would be in place until the loan is repaid. It is very unlikely that any lender will accept a security offered by an AIF if the security has to be released on a fixed date even if the loan has not been repaid by then. This will significantly impact the ability of AIFs to infuse capital into such infrastructure companies which require long-term project financing.
Thirdly, for the effective implementation of the proposal, the AIFs must establish a robust risk management system to consistently monitor their pledged shares and forestall potential loan defaults through effective mitigation strategies. This involves ongoing monitoring and tracking of share price movements, coupled with ensuring the presence of adequate collateral and contingency measures to address any potential setbacks.
Finally, in order to address apprehensions and guarantee investor protection, the proposal should include provisions for regular disclosures post-pledging. These disclosures should provide comprehensive information on the status of pledged shares, associated risks, and the mitigation measures implemented by AIFs. Furthermore, the proposal should incorporate reporting obligations to regulatory bodies such as SEBI and RBI. This would facilitate their assessment of systemic risks arising from financial leverage. Drawing inspiration from the standards set by the EU’s regulation, which mandates pre-investment and periodic disclosures, such transparency measures can enhance investor confidence and contribute to the overall growth of AIFs. The adoption of these measures for equity investment pledging by AIFs is crucial for ensuring sustained growth and encouraging broader investor participation.
Conclusion
SEBI’s consultation paper aims to facilitate ease of doing business and attract private capital for infrastructure development. By allowing AIFs to pledge equity, lenders’ interests can be protected, and vital infrastructure projects can receive the necessary financial support. Although allowing AIFs to pledge equity holdings can facilitate infrastructure financing, it is important to consider potential risks. Excessive leverage, particularly if layered and stacked across multiple entities, can pose a systemic risk to the financial services ecosystem.
– Prachya J. Bhattacharya & Sahsransh Pandey