[By Siddhi Bhosale]
The author is a student of Maharashtra National Law University, Mumbai.
I. Introduction:
Under the Alternative Investment Funds (‘AIF’) Regulations, 2012, AIFs can be classified into Category I, II and Category III AIFs. This categorisation is essentially based on the investment objectives and the overall impact a specific Category of AIF has on the broader economy at large. In this regard, Category III AIFs occupy a unique position as it employs diverse and complex trading strategies for investing in listed as well as unlisted securities. Moreover, Category III AIFs can use leverage and trade in derivatives, distinguishing them from Category I and II AIFs.
Pre-IPO (‘Initial Public Offerings’) placements have increasingly become a familiar investment strategy for Category III AIFs, wherein the subscription monies are often placed in the escrow pending the allotment of shares. In a pre-IPO transaction, the subscription monies acquired from AIF are transferred to and blocked in an escrow account before the underlying shares are allotted, thereby the funds remain locked pending IPO completion, with the securities passing only upon the allotment. This lacuna vis-à-vis timing raises an important compliance question: does the breach of Regulation 15(1)(d), i.e., of ten per cent concentration limit crystallise on the date the subscription funds are committed and blocked in escrow, or on the date the shares are actually allotted to the AIF?
This article examines the semantics revolving pre-IPO escrow arrangement by taking into account Regulation 15(1)(d), and the manner in which the concentration limit breach effectuate in such transactions. The timing of the breach is relevant as the concentration limit is calculated as a proportion of an AIF’s scheme, particularly the scheme’s investable funds, as stipulated in the proviso to Regulation 15(1)(d) and Regulation 2(1)(p) that defines what are “investable funds”. The investable funds might fluctuate between the commitment of funds and the allotment of securities. Determining the timing is significant for open-ended schemes, where redemptions may reduce the investable funds during this intervening period that lies in between.
For instance, a scheme with investable funds of ₹ 100 crores that commits ₹9.5 crores to a pre-IPO placement, it would initially remain within the prescribed ten percent threshold. However, if redemptions of ₹10 crores occur before allotment, the same commitment would represent approximately 10.56 per cent of the reduced investable funds of ₹90 crores. Consequently, the scheme would remain complaint if the concentration limit were assessed on the date of escrow funding, but would exceed the prescribed threshold if assessed on the date of allotment. The determination of the relevant date is therefore critical, as it directly affects the assessment of compliance under Regulation 15(1)(d) and the extent to which fund managers must anticipate and manage concentration risk before the securities are allotted.
II. Regulatory Framework:
Under Regulation 15(1)(d) of the AIF Regulations, 2012, Category III AIFs are subjected to a concentration limit which mandates that they are prohibited from investing more than ten per cent of their investable funds in a single Investee Company, directly or through investment in units of other AIFs. The ‘proviso’ to Regulation 15(1)(d) further allows Category III AIFs to calculate the concentration limit for investments in listed equity on the basis of either investable funds or the net asset value (“NAV”) of the scheme. This becomes relevant while assessing the applicable concentration limit and the timing of a potential breach in pre-IPO placements. This regulation is thereby intended in order to regulate the concentration of an AIF’s investments in a single company and prevent excessive exposure to one Investee Company. When a large value fund for accredited investors is set up, an exception has been provided as the concentration limit is capped at twenty per cent.
Herein, an “Investee Company” is essentially the company in which the AIF makes or proposes to make an investment, either directly or through units of another AIF and “investable funds” entails the corpus of the scheme of AIF net of the expenditure for administration and management of the fund. Thereby, the ten per cent threshold consequently requires the amount invested in a particular Investee Company to be assessed against the investable funds of AIF.
The Regulation also gives rise to a distinction between an active breach and a passive breach of the concentration limit. An active breach arises where the AIF makes an investment which exceeds the prescribed limit at the time of investment. Whereas, a passive breach, on the other hand, may arise where an investment that was initially within the prescribed limit subsequently exceeds it owing to the changes in the value or composition of the underlying investment that was made.
This distinction assumes significance in determining the point at which the obligation under Regulation 15(1)(d) is triggered. The concentration limits serve as an important measure for the protection of Limited Partners (‘LP’), and thereby compliance with the prescribed threshold forms an integral component of the regulatory framework for fund managers governing Category III AIF investments.
III. Pre-IPO Escrow Mechanics:
A pre-IPO placement generally begins with the execution of a subscription agreement between the AIF and the issuing company. Pursuant to the subscription, the escrow arrangements are undertaken wherein the AIF transfers the subscription monies to the escrow account, and the amount remains blocked pending completion of the conditions for allotment. The funds are therefore contractually committed towards the proposed investment and remain unavailable for other purposes, while also not being immediately released to the issuer.
The subsequent steps involve the issuer completing the necessary corporate and regulatory formalities, allotting the underlying securities to the AIF and crediting them to demat account of the AIF as directed under the SEBI circular. Upon the allotment, the subscription monies are released to the issuer. Until that point, the AIF possesses a contractual right to subscribe to the securities, however, it does not hold legal title to the securities. As a result, there is a distinction between a contractual commitment to invest and the legal acquisition of the underlying securities.
The SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (‘ICDR Regulations’) also use allotment as a relevant point in time for the commencement of the general lock-in applicable to specified pre-issue capital. The ICDR Regulations separately refer to the date of purchase for specified categories, including Category I and Category II AIFs. Regulation 17(c) uses of ICDR Regulations use the date of purchase to determine the minimum holding period applicable to specified pre-issue equity shares held by venture capital funds, Category I and Category II AIFs, and foreign venture capital investors. However, Regulation 17(c) concerns the holding period of shares already acquired, rather than the treatment of funds committed towards a proposed investment. It therefore does not determine the relevant date under Regulation 15(1)(d) of the AIF Regulations. Instead, it exposes that the relevant temporal reference point depends on the regulatory obligation in question. Resultantly, the timing of a concentration-limit breach in a pre-IPO escrow arrangement must be determined primarily by examining the comport of language used in Regulation 15(1)(d), including whether the placement of funds in escrow constitutes an investment before the underlying securities are allotted..
IV. What Does ‘Invest’ Mean:
Regulation 15(1)(d) uses the expression “invest”, rather than “commit”, “subscribe”, “agree to invest”, or “block” funds for investment. This distinction is relevant where subscription monies have been placed in escrow, but the underlying securities have not yet been allotted. Although “invest” is not specifically defined under the AIF Regulations, the definition of “Investee Company” refers to a company in which the AIF “makes or proposes to make an investment”. Thereby, the distinction between an investment that is proposed and one that is made indicates that a contractual commitment towards acquiring securities need not, by itself, constitute an investment for the purposes of Regulation 15(1)(d).
The transfer of subscription monies into escrow creates a contractual commitment and may prevent the AIF from deploying those funds elsewhere. However, it does not confer legal title to the shares, shareholder rights or an existing holding in the investee company. Until allotment, the AIF possesses a contractual entitlement to receive the securities themselves. The concentration limit is intended to restrict a scheme under AIF or AIF’s exposure to a single Investee Company and manage the concentration risk for investors. Treating funds placed in escrow as an investment before the securities are acquired would extend the restriction to a contractual commitment that has not yet become part of the AIF’s investment portfolio.
Moreover, the framework stipulated by SEBI permits the concentration limit for listed equity to be calculated using the Net Asset Value (‘NAV’) immediately preceding the date on which the AIF “makes such investment”. This formulation contemplates an identifiable investment date and does not refer to the earlier date on which funds were placed in the escrow.
A passive breach presupposes that an investment exists before its value changes. Resultantly, applying the same logic to an active breach, the relevant point to be taken into account should be when the securities are actually acquired upon the allotment, rather than when funds are merely committed towards their acquisition. Thus, in a pre-IPO escrow arrangement, ‘allotment’ establishes a stronger basis for determining the trigger for Category III AIFs under Regulation 15(1)(d).
Conclusion:
The question of whether a Category III AIF breaches the ten per cent concentration limit at the time of escrow funding or at the time of allotment hinges on the meaning of “invest” in Regulation 15(1)(d). It indicates that the relevant event in determining the trigger event is the acquisition of the securities upon the allotment, rather than the earlier contractual commitment of funds. This interpretation is further supported by the distinction between an active and passive breach, as a passive breach can arise only in respect of an investment that already exists.
Accordingly, in a pre-IPO escrow arrangement, the active breach of Regulation 15(1)(d) crystallises only upon allotment of the underlying securities to the AIF. Nevertheless, the fund managers should ensure that the post-allotment exposure remains within the prescribed threshold at the time funds are committed. To avoid uncertainty in the landscape of application of the concentration limit, SEBI should consider issuing a clarification, perhaps through a regulatory Frequently Asked Question (FAQ) or via an informal guidance as authorised under Section 11(1) of the SEBI Act, 1992 and SEBI (Informal Guidance) Scheme, 2025, clarifying the relevant date for examining compliance in pre-IPO escrow arrangements. This would augur well by providing enhanced certainty to fund managers and ensure a consistent approach to ensure compliance with Regulation 15(1)(d).