[Shreya is a student at National Law University Odisha.]
Over the past decade, the alternative investment funds (AIFs) regime in India has experienced substantial growth. AIF is commonly understood as a regulatory term encompassing venture capital and private equity funds, which pool investor funds for investment purposes. Private equity investments in India reached a total of $44 billion between 2015 and 2020, with an upward trend in average deal size from $40 million to $65 million. Consequently, the Securities and Exchange Board of India (SEBI), responsible for overseeing AIFs, has prioritized making regular revisions to the SEBI (Alternative Investment Funds) Regulations 2012 (AIF Regulations) with an aim to foster transparency and enhance various other aspects of the regulations. Most recently, on 18 May 2023, the SEBI published a consultation paper outlining several proposed amendments to the regulations to further strengthen the existing governance mechanism of the AIFs.
What the Consultation Paper Entails
Borrowing for Category I and Category II AIFs
Currently, Category I and Category II AIFs are allowed to borrow funds solely for their day-to-day operational needs. They can leverage up to 4 times a year, at most 10% of the available funds for investments in the AIF. However, each borrowing instance should not exceed 30 days.
SEBI’s proposal to establish a regulatory umbrella on borrowing for investments is a positive development for the AIF industry. It emphasizes that such borrowing should be considered a last resort, prompted only by delays or defaults in investor drawdowns. The proposal also highlights the importance of promptly disclosing the terms of such borrowing to investors, ensuring transparency and accountability in the borrowing practices of Category I and Category II AIFs. This step will contribute significantly to establishing a transparent and responsible borrowing framework for these AIF categories.
However, SEBI’s proposed borrowing modalities may present implementation challenges and hinder the acceptance and utilization of the proposed flexibility. For example, charging the cost of borrowing only to investors who delay or default on drawdown notices, and limiting borrowed funds to a maximum of 10% of the investment opportunity, may not be operationally efficient. This threshold could restrict the ability of an AIF to raise sufficient funds for specific investment opportunities, particularly if an investor has committed more than 10% of the total corpus but cannot fulfil the drawdown notice.
In such a situation, even if the AIF has the capacity to borrow 10% of the total investment amount for a specific opportunity, it might still face difficulties in gathering sufficient funds to seize that opportunity. Consequently, the AIF may be compelled to forego such investment prospects. It becomes crucial for the managers of Category I and Category II AIFs to explore alternative approaches to address these limitations and bridge the gaps effectively. Additionally, Category I and Category II AIFs, which primarily invest in unlisted securities, carry high illiquidity risks. To prevent excessive and frequent leverage, SEBI proposed to implement a cooling-off period between borrowing periods for such AIFs, similar to the requirement for AIFs dealing with credit default swaps.
Dematerialization of assets / investments of AIFs
After considering the suggestions put forth by the Alternative Investment Policy Advisory Committee (AIPAC) and taking into account the public feedback received on the consultation paper regarding the “Dematerialization of Units of AIFs” issued by SEBI on 3 February 2023, the SEBI, during its meeting on 29 March 2023, approved the proposal to make it compulsory for AIFs to issue units in dematerialized form. This decision aims to facilitate easier monitoring and administration by stakeholders and provide investor protection against operational and fraud risks. Additionally, recognizing that the AIF industry is an advanced and rapidly expanding sector, it is deemed appropriate to introduce the mandatory dematerialization requirement for AIF assets. SEBI is proposing that all AIFs maintain their investments in a digital format unless a specific type of investment cannot be converted into a digital form. The objective is to create a more efficient and secure process. In cases where an AIF has a controlling stake in a company for existing investments, they may be granted a grace period of 6 months to transition to digital holdings. This approach aims to streamline operations and enhance the overall security of AIF investments.
SEBI, on 21 June 2023 via a circular titled “Issuance of Units of AIFs in Dematerialized Form” introduced this amendment to the Regulation 10(aa) of the AIF Regulations, stating that AIFs shall issue units in dematerialized form subject to the conditions specified by SEBI, in the specified time frame. All the units already issued must be dematerialized for the schemes of AIF with corpus less than or equal to INR 500 crore by 31 October 2023 and for schemes of AIF with corpus more than INR 500 crore by 30 April 2024. Additionally, units are to be issued only in dematerialized form from 1 November 2023 and 1 May 2024 onwards, respectively.
Mandating the appointment of custodian for AIFs
As per Regulation 20(11) of the AIF Regulations, only Category I and Category II AIFs with a corpus of less than INR 500 crore and not engaged in credit default swaps are not obligated to appoint a custodian. According to data provided by AIFs to SEBI as of March 31 2023, approximately 90% of the total investments made by all AIFs are held by AIFs that have a custodian. It is worth noting that the SEBI (Portfolio Managers) Regulations 2020 also require portfolio managers to appoint a custodian for the securities they manage or administer.
To ensure independent oversight of AIF investments, SEBI has proposed that custodians of AIFs should assume similar responsibilities to those applicable to custodians of foreign venture capital undertakings and foreign portfolio investors.
Maximum extension of tenure by large value fund for accredited investors
In 2021, SEBI introduced the concept of 'Accredited Investors', who are well-informed or well-advised about investment products, in the Indian securities market. SEBI also established the concept of large venture fund (LVF), an AIF scheme where each investor is an accredited investor who at least invests INR 70 crore. Certain flexibilities were also granted to accredited investors and LVFs. Currently, LVFs can extend their investment tenure for up to 2 years with the approval of at least 2/3rd of the unit holders. Additionally, LVFs can further extend their tenure beyond 2 years if they meet the conditions specified by SEBI and comply with the terms of the contribution agreement and other fund documents. However, upon the expiration of the tenure or extended tenure, the AIF scheme must be fully liquidated within one year, following the AIF Regulations.
Furthermore, SEBI recently introduced a framework that allows AIFs to address unliquidated investments by either selling them to a new scheme of the same AIF, called the liquidation scheme, or distributing the unliquidated investments in-kind, subject to approval from 75% of the investors by value and in the prescribed manner. SEBI has proposed to provide the option of a liquidation scheme to all AIF schemes, including LVFs, and therefore, it was deemed necessary to align the tenure extension of LVFs with that provided for other AIF schemes.
Mandating the renewal of registration of AIFs
According to Regulation 3(7) of the AIF Regulations, the certificate of registration granted to an AIF is valid indefinitely as long as the AIF remains operational and does not surrender the certificate. Presently, there is no obligation to pay a renewal fee to maintain the validity of the registration certificate. However, it has been observed that certain AIFs continue to hold their registration certificate despite not engaging in any fundraising or investment activities in their schemes for an extended period of time. The existence of inactive registration certificates has raised specific concerns and issues.
SEBI suggests the introduction of renewal fees, which is equivalent to 50% of its applicable registration fee, for AIFs to promote transparency in the market. The proposal stems from the observation that certain AIFs possess licenses without engaging in any activity or raising capital in their schemes. According to the proposal, all AIFs would be obligated to pay a renewal fee for a period of 5 years, commencing within 3 months of the notification being issued.
The aforementioned proposed amendments are designed to reinforce the governance mechanism of AIFs. These proposals aim to establish consistency among all categories of AIFs and improve the overall operation, monitoring, and functioning of AIFs. SEBI has taken proactive measures to update the AIF Regulations and is in the process of suggesting several more changes. The proposals represent a combination of necessary updates to create a more efficient and improved AIF framework. As the AIF Regulations have been in place for over a decade, these ongoing enhancements demonstrate SEBI’s commitment to transforming the AIF regime into a highly efficient and globally competitive one.