[By Paavanta & Samriddhi Mishra]
The authors are students at National Law University Odisha.
INTRODUCTION
Securities and Exchange Board of India (SEBI) recently amended the SEBI (Alternative Investment Funds) Regulations 2012 (AIF Regulations) regulation to enhance ease of doing business. To provide more flexibility to Category I and II Alternative Investment Funds (AIFs), SEBI has allowed to create encumbrance on their holding in certain infrastructure companies. This was done to facilitate the raising of debt in the infrastructure companies as it acts as a backbone for all other sectors. The Budget Announcement for financial year 2023-24 identifies “Infrastructure & Investment” as one of seven priorities, and emphasizes the need for private money in supporting infrastructure investment. Thus, a resilient and inclusive infrastructure is necessary for growth in a developing economy and therefore it is necessary to find multiple sources of funding including private investment for infrastructure. This significant amendment can allow infrastructure companies to raise debt against equity which is a common industry practice to raise funds for companies in the infrastructure sector. This can both amplify returns and losses for the investor. Thus, the amendment brings along itself potential risks for both the investor and investee companies. This article thus, analyses the implications and effectiveness of the amendment from the perspective of the investor and investee company while considering the potential to expand the amendment’s scope to other business sectors.
SEBI GREENLIGHTS EQUITY ENCUMBRANC BY AIFs
In a bold stride towards improving transparency and ease of doing business for Category I and II AIFs, SEBI amended AIF Regulations to allow the creation of encumbrance on the holding of equity in investee companies. The term “encumbrance” is broadly defined in Regulation 28(3) of the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 2011 as “any restriction on the free and marketable title to shares, by whatever name called, whether executed directly or indirectly; pledge, lien, negative lien, non-disposal undertaking; or any covenant, transaction, condition or arrangement in the nature of encumbrance, by whatever name called, whether executed directly or indirectly.” Accordingly, the encumbrance can be created on the equity of the investee company which operates in the infrastructure sub-sectors listed in the Harmonised Master List of Infrastructure (HMLI) issued by the Central Government.
Additionally, a disclosure in the Private Placement Memorandum (PPM) is mandatory to continue an encumbrance created before 25 April 2024. SEBI discourages all encumbrances that were created for the investee companies other than those mentioned in the HMLI that too without the appropriate disclosure in the PPM. However, the regulatory watchdog allows the creation of encumbrance that was not disclosed in the PPM but created for the companies mentioned in HMLI with a condition of obtaining mandatory consent of all the investors in the scheme of the AIF.
Moreover, the encumbrance on equity is permitted solely for borrowing by the investee company of which duration shall not be greater than the residual tenure of the scheme. Thus, the funds raised through this borrowing can only be used for the specific purpose for which they were borrowed.
It is important to note that the creation of encumbrance is prohibited for investments in foreign investee companies. Additionally, SEBI mandates Category I and II AIFs with significant foreign involvement (with more than 50% investment) to comply with the Reserve Bank of India’s master direction related to foreign investments for pledging shares of Indian investee companies by non-residents.
CRITICAL ANALYSIS
Investor perspective
This change has been done to give a boost to the financing of infrastructure companies in India. While this can help raise debt for the infrastructure company, it can also increase risk for the investor. In case of default of the company, the investor can lose all of their equity resulting in the investor’s loss. Furthermore, availing loans by investee companies on the pledge of the AIF’s equity holdings might result in indirect and extra leverage. To mitigate these concerns there is a strong emphasis on the twin pillars of consent and disclosure.
Large quantities of extra leverage, especially if it is layered and piled across several firms, can pose a systemic danger to the financial services industry. Global securities market authorities (such as the SEC and FCA in the United States and the United Kingdom, respectively), as well as IOSCO, have warned of the potential of systemic financial sector leverage resulting from private capital investments.
Infrastructure is a wide expression that umbrellas various kinds of businesses, including power, roads, trains, ports, airports, telecommunications, and urban development allowing investors to have diversified portfolios. But infrastructure is a high-risk high-return investment, with low liquidity. There is a higher risk of loss in the case of infrastructure companies owing to the long gestation period and its vulnerability to external factors like changes in policies, cost overruns, and long delays.
Investee Company Perspective
Infrastructure companies’ dynamic and vulnerable nature to external as well as internal changes such as policy changes, delays in clearance, inflation, interest rate sensitivity, leverage, and environmental, social, and governance considerations make it difficult to raise funds via traditional methods. Therefore, infrastructure industries raise the majority of funds through “project finance” to share the potential risk associated with other stakeholders. Project financing offers a strategic advantage by keeping debt off- companies’ balance sheets, safeguarding credit capacity for diverse purposes. This off-balance sheet approach is particularly advantageous for firms seeking financial agility. Since infrastructure funds deal with long-term finance, with a significant gap in the creation of the project’s assets, it thus becomes difficult for the lenders to source the collateral or mortgage for the loans at the time of investment. Therefore, it is an industry practice where via project finance infrastructure sector or funds pledge their equity in exchange for the cash. This is also done via the creation of a Special Purpose Vehicle (SPV) by the company for the execution of the project and pledging the SPV’s shares to the lender. This technique firstly provides a security cushion to the lender in the case of default by the company and secondly, it improves the borrowing capacity of the company as there is no debt creation in the balance sheet of the company with an icing of cash flow which further boosts its credit rating to raise additional funds.
SEBI now requires that the duration of encumbrance on an AIF’s portfolio equity securities is equivalent remaining tenure of the AIF’s scheme. However, generally, when a charge is established for the lender’s benefit, it typically remains in effect until the loan is fully repaid. Lenders are unlikely to accept AIF security that must be released on a fixed date even if the loan is still outstanding. Even in cases where a portfolio company secures a loan that must be repaid before the AIF’s tenure concludes, lenders are unlikely to agree in the loan agreement to release the security prematurely if the loan isn’t repaid upon maturity. Thus, this double-edged sword regulation of SEBI will make it difficult for investee companies to raise funds via the creation of encumbrance on the equity as these are the company that operates in long-term projects and thus need long-term capital whereas AIF-I and II are close-ended funds.
Conclusion
Allowing the AIF I and II categories to create an encumbrance on their holdings will allow companies to raise debt successfully and use the additional debts to increase their growth without diluting ownership. However, as every rose has its thorn, this amendment also raises some concerns, this introduces risks for investors, such as potential loss of their equity from loan defaults in a volatile industry. The mismatch between encumbrance tenure and debt repayment periods complicates lenders’ ability to extend credit, challenging the very objective of the amendment.
However, in its consultation paper, SEBI considered widening the scope of the recent amendment but didn’t make any further comment on this consideration. As per the authors, SEBI can consider broadening the amendment’s scope. Many sectors need to evolve hand in hand with the infrastructure and SEBI can allow similar flexibility for those sectors too. If the investors are well informed and are ready to provide risk capital in a bid to achieve high returns then there is no reason because of which classification should be made between infrastructure and other sectors. SEBI can allow similar flexibility in sectors like real estate, healthcare, and renewable energy. While implementing this amendment SEBI has to consider all of these aspects and make the requisite changes so that the intention behind the amendment is fully realized.