[Shalin is a student at Maharashtra National Law University, Mumbai.]
Witnessing an impressive compound annual growth rate of 50% in the last 5 years, alternative investment funds (AIFs) have quickly emerged as a lucrative asset class for the Indian investor. However, inherent in this buoyant growth story is liquidity risk, an aspect that has troubled many stakeholders over the years. AIFs engaged in sectors such as real estate, healthcare, and technology have long faced liquidity issues, jeopardizing investor returns as investments remained unsold due to lack of liquidity during the winding up process.
On 15 June 2023, the Securities and Exchange Board of India (SEBI) introduced the SEBI (Alternative Investment Funds) (Second Amendment) Regulations 2023 (Amendment Regulations) which amended the SEBI (Alternative Investment Fund) Regulations 2012 (AIF Regulations). The amendment would now allow AIFs to launch liquidation schemes to sell illiquid investments or distribute them in-specie after receiving the required investor approval to aid the funds in maximizing asset value.
This article presents the pre-amendment context and regulatory concerns and provides a brief overview of the key changes advanced by SEBI. It subsequently discusses some positive impacts of the Amendment Regulations while also examining the potential implementational challenges and their impact on the larger AIF industry.
Context and Regulatory Intent
Regulation 13(5) of the AIF Regulations states that AIFs can only increase the tenure of a scheme only up to 2 years, provided two-thirds of the investors (in terms of the value of their investment in the AIF) approve of such an extension. This restriction does not apply to Large Value Funds for Accredited Investors which can extend the scheme’s tenure beyond 2 years, subject to the relevant clauses stipulated in the fund documents. Regulation 29(8) provides that at the end of an AIF’s tenure (inclusive of any extension), it may distribute the illiquid investments in-specie after receiving the approval of 75% of the investors by value. In case such in-specie distribution fails, AIFs shall fully liquidate the scheme within one year after the expiry of their tenure.
In a consultation paper floated in February 2023, SEBI stated that it received applications from many AIFs seeking an extension of their scheme tenure due to regulatory and legal obstacles and lack of liquidity. The sample data collected by SEBI revealed that the 2-year extension period for 24 schemes worth INR 3,037 crores would end in FY 2023-24, while the extension of another 43 schemes worth INR 13,450 crores would expire in FY 2024-25. Considering these findings, the consultation paper suggested that AIFs and investors be provided with the option of carrying forward unliquidated investments beyond the 2-year period mandated by law.
Arguably, the policy change could also be influenced by instances such as the recent cases of 360 ONE Private Equity Fund (formerly, IIFL Private Equity Fund) shuttering its real estate AIF thereby impacting investor returns and ICICI Prudential closing its real estate AIF while 6 underlying investments remained stuck with the fund even after its expiry in March. In view of the lack of liquidity options for AIFs nearing the end of their tenure, SEBI’s intent appears to be providing greater flexibility to such AIFs to efficiently deal with unsold and illiquid residual assets.
Overview of the Amendment Regulations
Put briefly, the amendments effectively provide 3 additional methods to the AIFs approaching the end of their term in handling illiquid and unsold investments. An AIF may either choose to transfer the unliquidated investments to a new liquidation scheme at the time of winding up or distribute the investments in-specie in a prescribed manner upon receiving the approval of 75% of the investors (in terms of the value of their investment in the AIF) while also arranging bids for a minimum of 25% of the unliquidated investments. A liquidation scheme can neither accept fresh commitments from investors nor make new investments. However, if the requisite investor consent is not obtained for the transfer of unliquidated assets to a liquidation scheme or for an in-specie distribution, then such unliquidated assets shall be mandatorily distributed to the investors in-specie. In case an investor refuses to an in-specie distribution, the amount will be written off. Additionally, SEBI has also stipulated that an AIF manager shall report the amount transferred to a liquidation scheme or distributed in-specie to benchmarking agencies and adequately disclose it under the private placement memorandum (PPM).
The problem of private equity being an asset class with considerable unknowns is particularly accentuated in case of unlisted and illiquid securities. This makes it difficult for a fund to liquidate such assets despite the end of its tenure, putting fund managers at the risk of regulatory default if a timely liquidation does not materialize. Transferring the unliquidated securities to a liquidation scheme could provide an alternative solution by preventing a distressed sale of assets, allowing funds to avoid a forced liquidation based on time and instead providing flexibility to sell when market conditions are favourable, benefiting investors. Requiring AIF managers to report the value regarding sale of unliquidated investments for benchmarking and disclosing it in scheme PPMs is also a positive development. Given that unliquidated investments are a significant component of AIF portfolios, their inclusion in performance benchmarking aligns with the AIF manager’s fiduciary duties towards the fund while also encouraging greater attention to exit strategies during investment.
Drawbacks and Challenges
While the policy intent of the Amendment Regulations is laudable, the implementation of the above-discussed changes is beset with challenges. First, the execution of the mandatory in-specie distribution could be problematic on multiple fronts. It may create a conflicting situation for investors as to whether they should vote in favour of or against a liquidation scheme. For instance, while the investors voting in the scheme’s favour will not get the bid amount available to the dissenting investors, if there are too many investors dissenting, the 75% investor approval threshold would not be met and consequently all the investors would end up receiving in-specie distributions.
A striking concern regarding mandatory in-specie distribution is that such distributions to foreign investors are not yet recognised under Indian exchange control laws, thereby necessitating RBI’s approval and increasing the compliance burden. Mandatory in-specie distribution may also be illegal if the AIF in question has invested in companies dealing in sensitive sectors, due to the limitations on foreign investors on holding those securities. This would also go against Regulation 20(5) of the AIF Regulations which casts an obligation on the fund manager to ensure that no decision of an AIF contravenes applicable laws.
Second, the policy also suffers from a lack of clarity on certain aspects. The Amendment Regulations do not specify how dissenting investors would be treated in cases where the fund manager fails to achieve the minimum bid of 25% of the unliquidated investments. SEBI’s circular also does not clearly delineate the scope of the Amendment Regulations insofar as liquidation schemes are concerned. The policy is silent as to whether it extends to AIFs that have already exceeded their tenure and those that are in the middle of the one-year extension of their terms. Moreover, there is no clarity as to whether venture capital funds set up under the erstwhile SEBI (Venture Capital Funds) Regulations 1996 would also come under the policy’s remit.
Third, the transfer of unliquidated investments from the AIF in exchange of units of the liquidation scheme could result in capital gains in the hands of the unit holders which would eventually be liable for taxation. SEBI also seems to have overlooked frequently occurring obstacles such as investigative orders, prolonged litigation, and ongoing insolvency resolution, among other factors, that may altogether prevent the transfer of unliquidated investments from an AIF to a liquidation scheme.
Fourth, it is a global trend that at the end of an AIF’s tenure, fund managers seek fresh commitments from new investors to facilitate the exit of dissenting investors. The incoming capital is used to buy out some or all of the shares held by the exiting investors who wish to cash out. However, the Amendment Regulations do not allow a liquidation scheme to accept fresh commitments from investors. This could create challenges for fund managers in raising capital when there are dissenting investors choosing to exit.
Fifth, the amendment reflects SEBI’s continuing unwillingness to deter close ended funds from extending their tenure beyond the stipulated time in the PPM. A fund, as in the case of Urban Infrastructure Venture Capital Fund, might want to extend its tenure as the exit provided to unitholders may not be profitable due to the influence of several extraneous circumstances such as economic slowdown, high interest rates, inadequate developer funding, and high construction costs, among others. Often, an AIF’s investments remain unliquidated due to lack of buyers at acceptable prices. In-specie distribution may not always be commercially sound as investors would then receive small stakes of the investee company which would be difficult to sell.
While the Amendment Regulations are introduced with the noble objective of boosting investor confidence, SEBI must assess the evident challenges and loopholes. For instance, the potential tax implications and the issues concerning the transfer of unliquidated investments could be solved if the original scheme holding such investments acts as a liquidation vehicle rather than transferring the investments to another scheme. Similar fine-tuning and clarity on aspects such as the scope of the amendments’ applicability would be a step towards augmenting the growth of AIFs in India.