SEBI’s New Framework for Subordinate Units in InvITs

[Naman Kasliwal is a final year law student at Gujarat National Law University]

The Government has estimated an investment requirement of around $1.4 trillion by 2025 in India’s infrastructure sector. To bridge this gap and fund this crucial sector, innovative financing mechanisms are essential. Infrastructure investment trusts (“InvITs”), introduced by the Securities and Exchange Board of India (“SEBI”) in 2014, have emerged as a significant instrument for channelling investments into infrastructure, with 17 InvITs raising approximately Rs. 115,000 crores as of January 2024. These trusts provide a platform for both retail and institutional investors to participate in infrastructure development and earn stable returns.   

While the SEBI (Infrastructure Investment Trusts) Regulations (“InvIT Regulations”) were enacted in 2014, the landscape surrounding InvITs is still in a nascent stage. Consequently, SEBI has periodically introduced various amendments and consultation papers to clarify these regulations. In a significant development, SEBI has recently introduced new regulations focusing on subordinate units—a specific class of units with inferior rights compared to ordinary units—through the SEBI (Infrastructure Investment Trusts) (Amendment) Regulations, 2024(“Amendment”). This Amendment, notified on 27 May 2024, represents a pivotal step in the evolution of InvITs, addressing key challenges related to project valuation and sponsor alignment. The introduction of a comprehensive framework for subordinate units aims to bridge valuation gaps between sponsors and InvITs, potentially facilitating more infrastructure asset acquisitions and fostering growth within the sector.

This post delves into the intricacies of SEBI’s new framework for subordinate units in InvITs, exploring its key features, potential impacts, and implications for the infrastructure investment landscape.

Understanding Subordinate Units

One of the guiding principles governing the subordinate units is that no unitholder shall have superior voting or other rights compared to others. The sole exception to this rule pertains to the issuance of subordinate units to sponsors and their associates by the InvIT, wherein such subordinate units possess inferior rights compared to ordinary units. The concept of subordinate units was first introduced into the InvIT Regulations through an amendment in 2016. Subordinate units are characterized to be special instruments issued by an InvIT with the specific purpose of being reclassified as ordinary units at a later date. They do not carry any voting or distribution rights and are not allowed to be listed on the stock exchange. Their primary usage is as part of the acquisition consideration for infrastructure projects, aiming to address valuation gaps between the sponsor (seller of the asset) and the InvIT (buyer of the asset).

SEBI’s Framework for Subordinate Units

While the 2016 amendment allowed the issuance of subordinate units to sponsors and their associates, there was the lack of a structured approach or detailed guidelines concerning various aspects, such as the mechanism for issuance and the terms and conditions applicable to such subordinate units. The absence of clear guidelines led to potential inconsistencies and uncertainties in their application, necessitating a more comprehensive framework. In order to provide further colour to the same, SEBI released the consultation papers dated 9 December 2023 and 10 January 2024proposing the new framework for subordinate units. Finally, in May 2024, SEBI introduced the detailed guidelines for issuance of subordinate units through the insertion of Chapter IV A in the InvIT Regulations.    

Issuance Conditions

The Amendment stipulates that subordinate units can only be issued by privately placed InvITs upon the acquisition of an infrastructure project. These units are exclusively issued to sponsors, their associates, and sponsor groups. The issuance can be carried out during initial or subsequent offers, providing flexibility in timing.

To prevent excessive dilution and maintain the requisite balance, the framework sets a ceiling on issuing subordinate units. They should not exceed 10% of the acquisition price and 10% of outstanding ordinary units. This dual cap ensures that the interests of existing unitholders are protected while still allowing for meaningful use of subordinate units in acquisitions.

The pricing of subordinate units follows the guidelines for ordinary unit pricing, ensuring fairness and transparency. Moreover, these units must be issued in dematerialized form with a distinct ISIN number, facilitating easier tracking and management.

Reclassification of Subordinate Units

The reclassification of subordinate units into ordinary units involves a thorough certification, review, and approval process. This ensures that the reclassification is based on genuine achievement of pre-set benchmarks rather than arbitrary decisions. The framework mandates that the entitlement date and event for reclassification shall be clearly defined in the term sheet at the time of issuance. This provides clarity and certainty to all parties involved. A minimum time gap of three years is required before reclassification, allowing sufficient time for the project to demonstrate its performance.

Recognizing that infrastructure projects may face unforeseen challenges, the regulations allow flexibility in the reclassification timeline. The reclassification period can be extended twice by one year each, subject to unitholder approval. This provision balances the need for accountability with the realities of infrastructure development. Importantly, if the performance benchmarks are not met, the subordinate units are extinguished without payment. This feature ensures that the sponsor’s interests remain aligned with the project’s performance and the interests of other unitholders.

Transferability Restrictions

To maintain the integrity of the subordinate unit structure, the Amendment imposes strict transferability restrictions. Subordinate units are locked in until reclassification into ordinary units, preventing a premature exit by sponsors. They can only be transferred within the sponsor group, ensuring that the performance incentive remains with those closely associated with the project.

Implications and Analysis

The introduction of this comprehensive framework for subordinate units in InvITs has far-reaching implications for India’s infrastructure investment landscape. By aligning sponsor interests with project performance, it promises to enhance project management efficiency and investor returns. The structured approach to valuation discrepancies is likely to facilitate smoother asset acquisitions, potentially bringing more infrastructure assets under the InvIT umbrella. Increased transparency in the issuance and reclassification processes could boost investor confidence, attracting both retail and institutional investors. This mechanism is likely to encourage more developers to consider InvITs for asset monetization, fostering market growth and diversifying investment opportunities.

While the new framework represents a significant step forward, some areas may require further attention. For instance, the treatment of pre-issued subordinate units under this new framework is unclear. The lack of explicit guidance on this matter could lead to uncertainty and potential inequities between holders of ‘old’ and ‘new’ subordinate units. This ambiguity also complicates valuation processes and creates challenges for InvITs that have existing subordinate units in their structure. To ensure a smooth transition and fair treatment of all unitholders, SEBI may need to provide additional clarification or transitional provisions. This could include guidelines on how existing subordinate units should be treated and what inferior rights they carry.

Further, the effectiveness of subordinate units as a tool for aligning interests relies heavily on the appropriateness of the performance benchmarks set for reclassification. Ensuring these benchmarks are fair, achievable, and truly reflective of project value is crucial to prevent manipulation and maintain the integrity of the system. The process of setting these benchmarks is likely to be complex, requiring a deep understanding of the specific infrastructure asset, market conditions, and realistic performance expectations. There may be a need for regulatory guidance or oversight in this process to ensure consistency across different InvITs and to prevent the setting of overly optimistic or pessimistic benchmarks that could skew the intended alignment of interests.

Conclusion

SEBI’s Amendment is a step in the right direction in providing opportunities for growth and investment in the infrastructure sector and is likely to enhance investor trust in InvITs. However, the success of this new framework will ultimately depend on its adoption by InvITs and acceptance by investors. The initial period of implementation is likely to be crucial as market participants navigate the new rules and adjust their strategies accordingly. There may be a learning curve as InvITs figure out how to utilize subordinate units in their deal structures effectively, and investors learn to evaluate the implications of these units on their investment decisions. Monitoring the practical implementation of these rules will be essential to assess their effectiveness and identify any unintended consequences or areas for improvement. This could involve regular reviews by SEBI, feedback from market participants, and potentially, the establishment of industry best practices. As the market evolves under this new framework, there may be a need for further refinements or additional guidance to address emerging issues or to optimize the use of subordinate units in promoting infrastructure investment.

– Naman Kasliwal