[By Biraj Kuanar]
The author is a student of National Law University Odisha.
Introduction
The recent amendments to the SEBI (Alternative Investment Funds) Regulations 2012, introduced by SEBI on 25 April 2024, when read along with the circular issued by the Securities and Exchange Board of India (SEBI) on 26 April 2024, aim to create a tectonic shift in the alternative investment landscape in India. The goal of these amendments is to provide flexibility to Alternate Investment Funds (AIFs) and their investors while concurrently addressing regulatory arbitrage and circumvention of law concerns.
Before discussing the changes incorporated by the recent amendments, it is important to understand how AIF exits operate. These funds usually have a fixed tenure, after which they enter a liquidation phase. During this phase, fund managers are tasked with selling off the remaining investments and returning capital to the investors. However, fund managers face numerous hurdles when dealing with illiquid assets that can’t be easily divested within the stipulated timeline. This challenge thereby sets the stage for the recent amendments.
At the core of the changes lies the introduction of a “dissolution period” for AIFs, which promises to revolutionise the handling of unliquidated investments. Prior to the amendment, AIFs were presented with limited options while dealing with unsold assets due to a lack of liquidity at the end of their tenures. The first option is the distribution of assets taking place in-specie, which is the practice of distributing an AIF’s assets to investors in their current form instead of conducting the sale of assets and distributing cash so acquired. While such distribution allows for the fund’s closure on time, it creates difficulties for investors who may not be equipped to manage these assets on their own.
The second option for dealing with unsold assets is to set up liquidation schemes for holding or acquiring such assets. The amendments, by providing greater flexibility in handling such situations, ensure investor protection to a great extent.
The new dissolution period offers a more nuanced alternative aimed at streamlining the process under which, post-expiry of the traditional one-year liquidation period, AIFs can enter into the dissolution period after garnering approval from at least 75% of their investors. Meanwhile, the AIFs can sell the unliquidated investments or continue distributing them in-specie to the investors.
This flexibility, however, comes with strings attached. AIFs going down this route must first arrange bids for the remaining 25% of unliquidated investments to provide dissenting investors an option to exit. If, upon the exit of the dissenting investors, any portions of the bids remain, they are to be provided to non-dissenting investors for pro-rata exit, in case they choose to do so. What is important to note is that the dissolution period can’t exceed the AIF’s original tenure, nor are extensions permitted. In addition to this, neither fresh commitments from investors nor new investments by the AIFs are permitted to ensure that the liquidation of remaining assets is not hindered.
The launch of new liquidation schemes from 25 April 2024, has also been prohibited by SEBI. As in previous times, AIFs would set up separate liquidation schemes in order to acquire and hold the unliquidated investments of AIF schemes that were on the verge of expiring. This has been done to counter the notoriety of the mechanism, which plagued the commercial viability of the schemes.
Encumbrances on AIFs Equity: A Boost for Infrastructure Investments
The amendments have also ushered in changes to ‘encumbrances’ on equity holdings of AIFs. Category I and II AIFs have been permitted to create encumbrances on the equity of their investee companies. However, permission has only been provided for companies delving into projects in the infrastructure subsectors as listed in the “Harmonised Master List of Infrastructure” and for the sole purpose of borrowing by the investee company. And such encumbrances are to be explicitly disclosed in the AIF scheme’s private placement memorandum.
SEBI’s firm stance in addressing regulatory arbitrage and circumvention of law concerns
SEBI has taken a firm stance by imposing obligations on the AIFs, their managers, and Key Management Personnel (KMPs), to exercise caution while conducting due diligence concerning their investors and investments in particular on foreign investments. KMPs include senior executives such as the fund manager, chief investment officer, and other key decision-makers responsible for the fund’s operation and investment strategies, while also ensuring compliance with regulatory requirements. The inclusion of KMPs in the new due diligence obligations underscores SEBI’s emphasis on personal accountability for regulatory compliance at all levels of AIF management. All of which is aimed at preventing any attempted circumvention of regulations or laws administered by SEBI and other financial regulators.
Temporary reprieve to select AIFs by SEBI
In addressing concerns, SEBI has provided much-needed reprieve by allowing one-time flexibility for select AIFs. This flexibility is provided for schemes that have already expired or are expiring by 24 July 2024, and do not have any investor complaints pending concerning the non-receipt of funds as of 25 April 2024, wherein, upon meeting such conditions, an additional liquidation period until 24 April 2025 will be granted.
All of this is carried out to make sure that AIFs can fully liquidate their investments, carry out in-specie distribution, or opt for the dissolution period that has been brought into the picture via the recent amendments. Further, the circular, which was issued by SEBI on 26 April 2024, also acts as a guiding light in implementing the various changes that SEBI has brought in through the amendments.
Balancing Flexibility and Oversight: Implications and Analysis
The recent amendment represents how the landscape of alternate investments is evolving in India by showcasing the steps taken in the right direction to address the challenges faced by AIFs and their investors in trying to balance flexibility provided to AIFs and investors with the regulatory oversight over them by regulators. The newly brought-in dissolution period acts as a pragmatic and streamlined approach to the problem of unliquidated investments and the handling of unsold assets at the end of the tenure of an AIF. This focused period will aid the AIFs in liquidating or distributing their investments and counter the complexities inherent in establishing separate liquidation schemes.
But, the new obligations, imposed on the AIFs, their managers, and KMPS in conducting due diligence while aimed at preventing any attempted circumvention of regulations or laws administered by SEBI and other financial regulators are shrouded in ambiguity. This is because the new obligations seem to be overriding the settled rules under schedule VIII of “Foreign Exchange Management (Non-debt Instruments) Rules 2019 (the FEM NDI Rules)”.
The FEM NDI Rules state that investments that are made by AIFs, having Indian-owned and controlled (IOCC) managers: the managers being resident Indian citizens for the purpose of downstream investments, are considered domestic investments and not foreign investments, even in the presence of foreign investors. The idea behind such nomenclature was a policy decision to promote the growth of asset management industries in India.
However, the new obligations treat the AIFs with IOCC managers as “persons resident outside India,” despite the precise rules under the Foreign Exchange and Management Act 1999 (FEMA). And also gives regulators like SEBI the ability to decide whether an AIF with IOCC managers is being used to circumvent laws or regulations. Such regulatory discretion in earlier times only used to come into play when investments were made in sectors prohibited for foreign investments.
But now the obligations by widening the scope of SEBI’s intervention by giving it powers to treat AIFs with IOCC managers as “persons resident outside India,” thereby invoking the ambiguous due diligence obligations, are effectively overriding the FEM NDI rules, in treating the investments as foreign.
Such ambiguity will give rise to potential conflict regarding the classification of foreign investments and lead to inconsistent interpretations, which will affect the objective of promoting the growth of asset management industries. Therefore, SEBI must provide clarity in order to harmonise the provisions with FEMA and ensure consistency.
Conclusion
While these amendments represent a significant milestone in the evolution of AIFs in India, in testing these new waters, the regulators need to engage in constructive dialogue with AIFs and investors. Which in turn will help in fostering an ecosystem that promotes innovation and attracts investments while also upholding the highest standards of transparency. That being said, one cannot lose sight of ensuring that a robust regulatory system should be in place, which will help in maintaining consistency and instil confidence among all the stakeholders involved along with providing pertinent legal compliance mechanisms. Feedback loops, which will help in the identification of emerging challenges, will also help in aligning with global best practices. All in all, by striking the right balance between flexibility and oversight, India can establish itself as a market leader for alternative investments.