This blog has been written by Kartavya Rajput and Sneha Smriti, 4th year students at West Bengal National University of Juridical Sciences, Kolkata
On August 19, 2024, the Securities and Exchange Board of India (“SEBI”) issued a circular (“the Circular”) in which it has notified guidelines for borrowing by Category I and II Alternative Investment Funds (“AIFs”) and maximum permissible limit for the extension of tenure by Large Value Fund for Accredited Investors (“LVFs”). In this post, the authors aim to critically appraise the SEBI’s recent move in light of its previous initiatives that have culminated in this change. SEBI brought these changes to facilitate ease of doing business and provide operational flexibility. However, the authors have underlined several shortcomings of the SEBI’s move that vitiates the purpose of achieving operational flexibility and fostering investor’s interests. Towards the end, the authors have proposed certain suggestions that SEBI may consider at the time of amending the SEBI AIF (Regulations) 2012 to implement changes stemming from the circular.
Prelude
The recent circular of SEBI intends to further regulate borrowing aspects of only Category I and II AIFs. This step has been undertaken in the backdrop of several previous developments starting with SEBI (AIF) Regulations, 2012. As per Regulation 16(1)(c) and Regulation 17(c), Category I AIFs and Category II AIFs were prohibited from borrowing or leveraging, directly or indirectly, except for meeting temporary funding requirements for not more than 30 days, on not more than four occasions in a year and not more than 10% of the investable funds.
On May 18, 2023, SEBI released a consultation paper in which it highlighted that the funds borrowed by Category I and II AIFs were supposed to be utilized for meeting operational requirements and not for the purpose of making investments, but these funds were frequently used for investment purposes in the market. SEBI made recommendations to address the anomalies. Subsequently, a board meeting was held on June 27, 2024, wherein a cooling-off period was included to curtail any possible rollover of borrowings. Also, the purpose of meeting a temporary shortfall in drawdown from investors while making investments was approved to be included in the borrowing conditions by the board. Thereafter, the changes proposed in the consultation paper and board meeting have taken effect through SEBI (AIF) (Fourth Amendment) Regulations, 2024.
On June 24, 2022, SEBI issued a circular according to which LVFs were allowed to extend their tenure beyond two years as per the terms of the contribution agreement or Private Placement Memorandum (“PPM”). Later on, the consultation paper issued on May 18, 2023, apprehended that the flexibility of having no upper limit on the extension of terms of an LVF may result in close-ended funds acquiring the colour of the perpetual funds, wherein investors may get locked in for an uncertain period of time. Thus, it proposed an extension of tenure up to 4 years, subject to the approval of 2/3rd of the unit holders by the value of their investments in the LVF. Subsequently, in the board meeting, the extension of tenure was proposed to be up to five years instead of four years. Proviso to Regulation 13(5) was amended to impose a maximum permissible limit on the extension of tenure of LVFs to 5 years.
Impact of Circular on Existing Regulatory Discourse
The circular released on August 19, 2024, engendered the following changes to the existing discourse:
(i) If AIF intends to borrow funds to meet the shortfall in the drawdown amount, the same shall be disclosed in the PPM of the scheme.
(ii) The borrowing to meet the shortfall in the drawdown amount can be done only in case of emergency and last resort. The terms ‘emergency’ and ‘last resort’ refer to circumstances when the investment opportunity is imminent to be closed, and the drawdown amount from the investor(s) has not been received, in spite of best efforts by the manager to obtain the drawdown amount from the defaulting investor (s).
(iii) The borrowing amount shall not exceed the lowest of the three amounts: (a) 20% of the investment proposed to be made in the investment company; (b) 10% of the investable funds of the scheme of AIF; (c) the commitment pending to be drawn from the investors other than the defaulting investors.
(iv) The cost of borrowing shall be borne by the defaulting investors, and different drawdown timelines can’t be provided to investors.
(v) It also specified that the cooling-off period of 30 days will be calculated from the date of repayment of the previous borrowing.
(vi) All existing LVF schemes must align with the five-year limit on the extension of tenure of LVFs on or before November 18, 2024. While revising the period of extension of tenure to align with the mandate of the circular, existing LVF schemes have to obtain the consent of all investors of the scheme.
Notably, this circular has indeed improved borrowing conditions for Category I and II AIFs, enhancing the ambit of the condition of borrowing to include a temporary shortfall in the drawdown amount. In toto, this circular ensures that borrowing is a short-term solution to liquidity issues rather than a long-term strategy, thus enhancing financial stability.
Shortcomings of SEBI’s move
Upon a meticulous analysis of the recent circular, the authors have ascertained several shortcomings in the circular that SEBI can fix in the upcoming amendments.
Firstly, restrictions like a 30-day cooling off period and a cap of only four instances of borrowing in a year fail to address the dynamic needs of the market. The investment opportunities arise unpredictably and such opportunities may not align with the permissible borrowing windows. Thus, some lucrative investment opportunities may be missed. This would be further exacerbated by the restriction on the borrowing at twenty percent (“20 %”) of the investment proposed or ten percent (“10 %”) of the investible fund. In case the AIF suffers from the shortfall which is higher than the specified limit, it would not be able to complete the deal.
Secondly, Regulation 4.2 of the circular makes use of the terms “emergency”, “as a last resort,” and “in spite of best efforts,” which have been vaguely explained and would create ambiguity as to when the AIF is allowed to borrow. Different managers, investors, and regulators would have varying views on what would be an ‘emergency’ for the AIF and what would constitute ‘best efforts’ to collect the shortfall amount. This would lead to potential conflicts and misuse of the provision.
Thirdly, with respect to the LVF, the Circular provides that to realign the period of extension in tenure, the scheme needs to obtain the consent of all the investors. This poses significant practical challenges as achieving unanimous agreement in a collective investment fund, with diverse investors and their liquidity needs, would be next to impossible. In practice, the provision would only become applicable in the rarest of rare cases, defeating the intended purpose of the amendment.
Lastly, the Circular allows the AIFs to borrow funds when there is a shortfall in the drawdown from the investors and holds these defaulting investors responsible for bearing the cost of the borrowing. However, even if these investors fail to pay both the drawdown amount and the borrowing cost, the AIF would still be liable to repay the borrowing within 30 days, imposing financial strain on the AIF. This could force the funds to use their own resources or pass the burden to the compliant investors. Repeated defaults would thus create a cycle of unpaid debts and destabilize the fund.
Way Forward
To improve the current standing of the borrowing regulations for Category I and II AIF, several ameliorations are essential.
Firstly, there needs to be increased flexibility with respect to the limited borrowing cap along with “dynamic cooling off periods” during critical situations. With the required investor approval, the AIFs should be allowed to borrow a larger sum of money, which would enable them to seize the market opportunity without risking financial stability.
Secondly, the provisions need to provide an illustrative list or guidelines specifying what would qualify as an “emergency” or “best effort”. While the presence of an exhaustive list would narrow down the scope of the provision, an illustrative list would ensure greater transparency while reducing the risk of abuse of the provision.
Thirdly, the amendment fails to provide reasoning for a unanimous approval for realigning the period of extension in tenure. The approval of two-thirds of the unit holders, as it stands under Regulation 13(5) of the SEBI (AIF) Regulations, 2012, would be enough to address the needs of the investors.
Lastly, the provisions need to provide a penalty for the defaulting investor if they fail to pay the borrowing cost as well. This would serve as a deterrence for the investors while ensuring that the AIF does not go through a downward spiral. SEBI may incorporate the proposal in the consultation paper that restricts AIF from borrowing more than once to meet the shortfall due to same defaulting investor.