[Khushi Patel and Kritika Jain are 3rd year BBA LLB (Hons.) students at Gujarat National Law University, Gandhinagar]
Earlier this month, SEBI proposed amendments to regulation 17(a) of the SEBI (Alternative Investment Funds) Regulations, 2012 (the ‘AIF Regulations’), allowing category II alternative investment funds (AIFs) to meet their 50% unlisted investment requirement by including listed debt securities rated ‘A’ or below. This move responds to recent amendments to the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (the ‘LODR Regulations’), which have reduced the availability of unlisted debt, thereby creating compliance challenges for these funds. By expanding investment options, the Securities and Exchange Board of India (SEBI) aims to balance regulatory and compliance requirements while maintaining the risk-taking role of AIFs in the debt market.
Regulatory Backdrop and Recent Amendments
Category II AIFs are investment vehicles in India that pool capital from sophisticated investors to invest primarily in unlisted securities. According to regulation 17(a) of the AIF Regulations, these funds are mandated to allocate more than 50% of their investible funds to unlisted securities.
However, amendments in the year 2023 to the LODR Regulations, specifically the introduction of regulation 62A, have altered the landscape for debt securities. Under this framework, any entity that had issued listed non-convertible debentures (NCDs) on or before January 1, 2024, which remain listed, is precluded from issuing unlisted NCDs. Moreover, if an entity proposes to issue listed NCDs on or after January 1, 2024, it is mandated to list all previously issued unlisted NCDs, thereby inadvertently reducing the availability of unlisted debt instruments, as companies are now compelled to list their debt offerings.
This regulatory shift has created a conflict for Category II AIFs. While the AIF Regulations require these funds to invest predominantly in unlisted securities, the amendments to the LODR Regulations have diminished the pool of unlisted debt instruments, making compliance challenging.
SEBI’s Proposal: Expanding Investment Flexibility for Category II AIFs
SEBI’s proposed amendment to regulation 17(a) of the AIF Regulations aims to address the investment challenges faced by Category II AIFs due to the recent LODR amendments. To resolve the issue, SEBI has proposed allowing Category II AIFs to meet their 50% unlisted investment mandate by including listed debt securities with a credit rating of ‘A’ or below. This move ensures that these funds continue to take on credit risk, which aligns with their role in providing alternative debt financing.
By expanding the scope of permissible investments, SEBI firstly seeks to preserve the role of Category II AIFs in funding businesses with higher risk exposure, particularly those that lack access to traditional financing options. At the same time, this amendment introduces regulatory flexibility, enabling AIFs to maintain compliance with both the AIF Regulations and the LODR Regulations without facing undue investment restrictions. Additionally, by allowing investments in lower-rated listed debt, SEBI aims to maintain market stability while ensuring that these funds continue to contribute to the broader corporate financing ecosystem.
Implications of SEBI’s Proposal on Private Capital Access and Unlisted Debt Markets
Category II AIFs includes private equity and debt funds that primarily invest in diversified financial instruments with limited borrowing solely for operational requirements. The intent behind the threshold of 50% appears to be twofold: firstly, to facilitate capital access for the sectors that may otherwise struggle to secure funding through traditional channels and, secondly, to provide investors with opportunities for higher returns through investments in less accessible yet potentially lucrative segments of the market.
This is particularly beneficial for early-stage companies or those not yet prepared for a public offering, as private debt placements offer an alternative route to raise capital without the financial burden of the entire listing process. Moreover, while unlisted debt investments provide for potentially higher risk returns, they are accompanied by persistent liquidity concerns as unlisted debt is not actively traded on stock exchange. However, the recent conflict and the subsequent SEBI proposal appears to have neglected broader market ramifications due to the diminishing scope of unlisted debt investments.
Regulatory Constraints on Unlisted Debt and the Increasing Compulsion for Listing
SEBI’s proposal to amend regulation 17(a) of the AIF Regulations fundamentally alters the investment landscape for unlisted companies and those choosing not to list their debt securities. The mandatory listing of all unlisted debt securities under regulation 62A of the LODR Regulations poses several challenges. One of the most immediate effects is the limitation of investment opportunities for Category II AIFs, forcing them to either restructure their investment models or look for alternative asset classes. Additionally, listing these instruments brings with it increased regulatory and compliance costs for issuers, potentially discouraging smaller or mid-sized companies from issuing debt securities at all. While the intent behind the regulation is to enhance transparency and investor protection, it may inadvertently create barriers for companies that relied on the private credit market to raise funds efficiently. Furthermore, the requirement to list non-convertible debentures could lead to unequal funding opportunities since larger corporations with robust financials may comply easily while smaller entities may struggle with additional compliance burdens and costs, making access to credit even more challenging.
The permissibility of AIFs to invest in lower rated debt instruments reduces the dependency on unlisted debt since investors may prioritise lower rated debt instruments due to better liquidity and easier exits. This substantially reduces the capital availability for unlisted companies, making it harder for them to secure funding, thus increasing their cost of capital. The central issue with the introduction of regulation 62A is that the listing requirements come with increased procedural and compliance burdens which lead to unequal access to capital markets leading to unequal playing field.
An unintended consequence of this regulatory shift is the potential for regulatory arbitrage, wherein issuers may structure their debt instruments in a manner that obscures the distinction between listed and unlisted securities, enabling them to access AIF investments while circumventing full compliance with listing regulations. To mitigate such risks, SEBI may need to introduce additional safeguards and clarifications to prevent the exploitation of regulatory gaps and ensure the integrity of the investment framework.
Therefore, while SEBI’s proposal increases investment flexibility for AIFs, it poses new challenges for unlisted companies, potentially reshaping India’s corporate debt market in ways that favour publicly listed instruments over private capital.
Way Forward and Conclusion
SEBI’s amendments to regulation 17(a) of the AIF represent a significant regulatory shift, balancing investment flexibility for Category II AIFs while inadvertently restricting the financing landscape for unlisted debt instruments. While the proposal allows AIFs to include listed debt securities rated ‘A’ or below to meet their unlisted investment mandate, it raises concerns over capital access for unlisted companies, increased regulatory burdens, and the potential for market distortion.
A more balanced approach would require SEBI to refine the regulatory framework to preserve the original intent behind Category II AIFs, ensuring that capital remains accessible to sectors that depend on unlisted debt financing. This could involve introducing a phased transition mechanism, allowing AIFs to gradually shift investment allocations rather than an abrupt change that disrupts capital markets. Additionally, SEBI should consider introducing an exemption for smaller issuers or companies that meet specific financial thresholds, ensuring that mid-sized enterprises are not disproportionately disadvantaged by listing requirements. Further, regulatory clarity is needed regarding the treatment of debt securities that transition from unlisted to listed status, preventing compliance ambiguities for both issuers and investors. Increased regulatory oversight should also be a pressing priority to curb potential market manipulation and regulatory arbitrage, where issuers may deliberately structure debt offerings to maintain investor interest while avoiding full listing compliance. SEBI may need to strengthen disclosure norms specific to Category II AIFs to prevent circumvention of regulatory objectives.
In conclusion, while SEBI’s proposal seeks to align AIF investment norms with evolving market realities, it inadvertently diminishes the role of unlisted debt markets and creates new barriers for private financing. A calibrated policy response that balances investment flexibility, compliance feasibility, and continued access to unlisted capital markets is imperative to prevent unintended disruptions in India’s corporate debt market.
– Khushi Patel & Kritika Jain