[Keshav and Pratishtha are students at Institute of Law, Nirma University.]
The crop of alternative investment funds (AIF)Â in the Indian market has risen enormously in recent years. Assuming that the current investment rate remains unchanged, it has been suggested that the portfolio management services and the AIF businesses might potentially have a growth rate of INR 43.64 lakh crore by 2028. On 15Â June 2023, the SEBI (Alternative Investment Funds) (Second Amendment) Regulations 2023 (Amendment Regulations) were notified. The amendment imparts tail-end AIFs with 3 ways to address illiquid and unsold investments. An AIF may transfer unliquidated investments to a new liquidation scheme at the time of winding up or distribute them in-specie in a prescribed manner with the consent of 75% of investors (based on their investment value) while arranging for bids for a minimum of 25% of the unliquidated investments. Unliquidated assets must be disbursed in-specie (cash or kind) if investor permission is not acquired for transfer to a liquidation scheme or in-specie distribution. Should an investor deny in-specie distribution, the amount shall be written off. The Amendment Regulations aim to boost investor confidence and transparency. Still, they have many loopholes regarding asset transfers and reflect SEBI's refusal to prevent tail-end AIFs from extending their tenure beyond the private placement memorandum. As in the case of the Urban Infrastructure Venture Capital Fund, an AIF may want an extension if the exit of unitholders is not profitable. The article shall examine the various complexities arising due to the facets of the amendment and its numerous implications for unliquidated asset distribution.
Our analysis of the impact of the current amendment has been categorised into 4 main limbs - first, the limitations presented by the transfer to a new AIF as stipulated by the amendment; second, the challenges of financial uncertainty in paying out to the existing stakeholders; third, the practical considerations surrounding the transfer of assets through in-specie distribution; fourth, the interests of investors.
Constraints Posed by Transfer to a New AIF
As per the latest amendment, AIFs have been granted permission to carry forward unliquidated investments of an AIF to a new scheme or distribute such investments in-specie (in the regulated manner), provided that they gain agreement from seventy-five percent of the investors by value. Additionally, if enough investor consent is not garnered, the unliquidated investments must be distributed to the investors in a specific way. The AIF must write off these investments if an investor is not interested in receiving such an in-specie dividend. The transfer of unliquidated investments from the tail-end AIF to a new one may result in capital gains that would eventually be liable for taxation. Furthermore, neither the consultation paper nor the amendment clarifies the mechanism for transferring unliquidated investments from the old AIF to the new one. There needs to be more clarity about whether the transfer mentioned above would operate as the deemed winding-up of the old AIF in terms of the AIF regulations. The issue of compensation for existing investors who switch to the new AIF also stands unresolved.
Payout to the Existing Investors: Conundrums of Financial Uncertainty
According to the amendment, investors who do not wish to continue transferring unliquidated investments to the new scheme must be given an exit option. To provide an exit, the investment manager or AIFs must arrange a bid for a minimum of 25% of the value of the unliquidated investment. The bid will represent the consolidated value of each unliquidated investment in the initial scheme portfolio. Even before obtaining 75% consent on the proposal to transfer to the new scheme, the AIFs' primary goal will be to obtain bids for at least 25% of the unliquidated investments. This is because, before agreeing to approve a proposal, investors need to know the value of the bids they have received, or the IBBI valuation. Further, the circular states that the liquidation value established by the IBBI (Insolvency Resolution Process for Corporate Person) Regulations 2016 or other relevant IBC norms will be the basis for the scheme's closing valuation if bids for the unliquidated investment cannot be arranged.
While this move is laudable in that it allows the investor to discontinue the investment, the amendment lacks clarity on certain aspects. It does not specify how the disinterested investors will be treated if the investing manager or AIFs fails to achieve a minimum 25% bid on the unliquidated investment. The SEBI needs to consider the helplessness of the investment manager in the scenario where the investments do not have buyers. The forced sale of unliquidated investments will negatively affect the investors and the fund, primarily benefiting the buyer.
In-Specie Distribution Hurdles: Practical Concerns Impacting Investor Asset Transfer
If the required consent is not obtained for the transfer to the new scheme, the amendment mandates the in-specie distribution of unliquidated investments to the investors. Further, if the investors are not inclined towards such in-specie distribution, the AIF must write off the investment. However, the mandatory in-specie distribution disregards the practical challenges beneath it.
Such distribution could pose a significant problem for AIFs with foreign or restricted investors. Before making in-specie distributions, AIFs must follow international foreign exchange and investment regulations. AIFs owned and controlled by foreign entities engage in portfolio investment, considered "indirect foreign investment," and should follow FDI investment conditionality and pricing guidelines. Each of these factors increases AIFs' administrative compliance burden.
Additionally, foreign investors may not be allowed to hold AIF securities. Certain limitations and restrictions in the charter document of the previous AIFs portfolio may hinder the in-specie distribution. These factors make AIF's due diligence more difficult. The challenges can lead to quick sales of unliquidated investments, limiting AIFs' investment management flexibility.
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Weighing on Investor's Interest
The amendment of transferring the unliquidated investments to a liquidation scheme was implemented to give an alternative solution to AIFs. Its purpose was to prevent the distressed sale of assets and provide greater flexibility in holding onto investments until the market conditions were favourable. However, the amendment regulations prohibit a liquidation scheme from accepting new investments. This could increase the difficulty for investment managers in raising capital while paying dissenting investors. Here, the investor's interest lies with the incoming capital that could be utilised to acquire the existing shares of dissenting investors.
Further, the industry requested that the existing AIFs continue instead of being required to transfer to the new scheme. The mandatory nature of the amendment presents numerous obstacles, including tax consequences, the right of first offer obligations, revaluation expenses, and other compliances that led to additional burdens on AIFs. Extending the tenure will be much easier than going with a whole transfer to a new scheme.
Even after the transfer to the liquidation scheme, SEBI has said that the payment will be made in the form of units of the liquidation scheme. Ultimately, the investors will gain their capital until AIF sells the investments. All the factors raise essential questions, such as whether the amendments truly provide tangible benefits to investors.
Way Forward and Conclusion
While the steps taken by SEBI are in the right direction towards safeguarding autonomy and the interests of investors, some of the aspects need to be reconsidered in light of the realities of managing AIFs. By extending the tenure of AIFs by one or two years, the potential tax implications and challenges associated with the transfer to a new scheme and in-specie distribution could have been solved. As in the case of Urban Infrastructure, the SEBI has maintained its previous position of not extending the tenure beyond what is permissible under the law. It asserts that it would not only be inappropriate but also against the law to extend the term period of the scheme, promising to have a definite life-span.
SEBI should consider extending the tenure, subject to specific conditions. These conditions include obtaining unanimous approval of all the investors and other such restrictions, ensuring that the extension provision would not easily be used to undermine the established position of the law. The amendments have undoubtedly positively impacted corporate governance and boosted investors' confidence. However, particular areas need to be revisited in terms of clarity, such as the benefits provided to the schemes that have already surpassed their tenure and payouts to the investors if AIFs fail to secure funds. Doing so will not only address the tax implications and other administrative-related issues but also better serve the needs of investors.