SEBI Plans to Restrict Borrowing by AIFs to Prevent Systemic Risk

Swetha Dhinesh

30 May, 2023

The Securities and Exchange Board of India (SEBI), the capital markets regulator, has recommended amending the current regulations regulating Alternative Investment Funds (AIFs) in order to strengthen corporate governance mechanisms. According to the plan, Category I and Category II AIFs shouldn’t use leverage or directly or indirectly borrow money to make investments, SEBI stated in a consultation issued on May 18, 2023. Subject to certain restrictions, these AIFs may borrow to cover any deficit in drawdown while making an investment in an investee firm. The cash borrowed must be used to cover the AIF’s operational needs and not to make investments, SEBI underlined. It is the regulatory aim behind allowing borrowing for Category I and II AIFs.

Alternate Investment Fund (AIF)

AIF stands for Alternate Investment Fund, which is a privately pooled investment vehicle that collects money from domestic and international investors to invest it in line with a specified investment strategy for the benefit of its investors. In India, AIF can be founded or incorporated as a trust, company, limited liability partnership, or other type of body corporate. Funds covered under the SEBI (Mutual Funds) Regulations of 1996, the SEBI (Collective Investment Schemes) Regulations of 1999, or any other Board regulations governing fund management operations are not included in Alternate Investment Fund.

Restrictions on borrowing by Category I and Category II AIFs are found in Regulations 16(1)(c) and 17(c) of the Alternate Investment Fund Regulations. These AIFs are not currently permitted to borrow money for investing. However, SEBI is thinking about enabling Category I and Category II AIFs to borrow money in the event that the amount of money required from investors falls short. 

Key points 

1. The regulator suggested requiring Alternate Investment Funds to solely keep their investments’ instruments or securities in dematerialised form. It has also been suggested that alternate investment funds with a corpus of fewer than 500 crores should also be subject to the necessity of the mandatory appointment of a custodian for the protection of securities.
2. Accredited Large Value Funds (LVFs) should be allowed to extend their term by up to four years with the consent of two-thirds of the LVF’s unit holders, measured by the value of their investment in the LVF. SEBI observed that despite having no fundraising or investment activity in their plans for many years, several AIFs are still clinging to their certificates of registration.
3. In light of this, SEBI advised that an AIF’s manager make sure that the alternate investment fund pays a renewal charge equal to 50% of its applicable registration fee within three months of the expiration of the abovementioned block period for the following block of five years from the date of grant of registration. 
4. In order to increase transparency in costs and prevent miss selling, the markets regulator asked alternate investment funds to provide investors with a “direct plan” alternative last month. They also adopted a trial model for distribution commission.
5. If the Alternate Investment Fund do not pay the renewal fee, a late fee of two per cent of the registration amount will be applied, up to a maximum of double the registration fee, for each day the fee is late. In accordance with the suggested changes, Sebi will also require that custodians be appointed for all AIFs, regardless of the amount of the corpus. Existing alternate Investment funds with a corpus of less than Rs 500 crore will have six months to name a custodian after receiving authorisation.
6. Similar to their responsibilities for foreign portfolio investors (FPIs), the custodians will also be tasked with independently overseeing the investments made by AIFs. The regulator has also suggested dematerialising AIF investments for easier monitoring and more transparency. Sebi had ordered that AIF units be dematerialised at its most recent board meeting.

Borrowings by Category I and II

Additionally, Category II AIFs are defined as follows in Regulation 3(4)(b) of the AIF Regulations: “Category II Alternative Investment Fund which does not fall under Category I or Category III and which does not undertake borrowing or leverage other than to meet day-to-day operational requirements and as permitted in these regulations.”

• Although the regulatory intent behind allowing borrowing for Category I and II AIFs is that the funds borrowed shall be utilised for meeting operational requirements of the AIF and not for the purpose of making investments, it is understood that there may be uncertainty among market participants with regard to the purpose for which AIFs may borrow funds.
• According to feedback from the industry, while Category I and II AIF PPMs generally state that borrowing must be done for temporary funding, it is understood that these AIFs actually borrow money for investment purposes, subject to the conditions outlined in AIF Regulations.
• According to the investment reports that AIFs have provided, the following information relates to the temporary borrowings that AIFs have made over the last three quarters:

Tabular Coloum:

• Borrowings designated as being for “any other purpose” rather than operational expenses could be for making investments. Asset-liability mismatch may result from funds borrowed by Category I and II AIFs for investing in unlisted securities. Given this, it is necessary to make it clear that monies borrowed by Category I and II AIFs may not be used to make investments.
• However, Category I and II AIFs may be allowed to borrow to make up the shortfall in drawdown from an investor(s) while making investments, provided that such borrowing shall not exceed 10% of the investment made in an investee company and shall be subject to other conditions specified for borrowing by Category I and II AIFs, in order to ensure that any AIF does not lose an investment opportunity due to the shortfall in drawdown amount called for from an investor. Only in extreme circumstances and as a last resort will borrowing be allowed to cover such shortfalls; it cannot be used to accommodate differing drawdown schedules or delays in providing funds by certain investors.
• Additionally, Category I and II AIFs that invest primarily in securities that are not publicly traded run a high risk of becoming illiquid. It is believed that a cooling down period may be maintained between two periods of borrowing or leverage in order to prevent such AIFs from engaging in protracted leverage. This is already required for Category I and II AIFs that trade Credit Default Swaps when borrowing. 
• The Alternative Investment Policy Advisory Committee (AIPAC)^[1] met to discuss the matter on May 10, 2023, and the committee recommended the aforementioned suggestions. 

Proposal:

1. Neither Category I nor Category II AIFs may use leverage or borrow money directly or indirectly in order to make investments. 
2. Category I and II AIFs may take out loans to cover any shortfalls in drawdown while making investments in investee companies, provided that the following criteria are met:
   • Such borrowing is only permitted in an emergency and as a last resort.
   • The amount borrowed must not be more than 10% of the intended investment in the investee company.
   • The investor who missed or didn’t make a drawdown payment will be the only one who will be assessed the cost of that borrowing.
3. If the AIF plans to borrow money to cover any drawdown shortfalls, the PPM (Private Placement Memorandum) for the scheme may make that information public. 
4. The manager must inform all AIF/scheme investors about the amount borrowed, the terms of the loan, and the repayment schedule.
5. AIF shall not borrow from the same investor more than once to cover a shortfall related to a drawdown.
6. The borrowing to cover the gap shall not be utilised to set up alternative drawdown schedules for various investors.
7. According to AIF Regulation, Category I and Category II AIFs must maintain a thirty-day cooling-off period between each period of authorised leverage.

Conclusion

This step ensures that Alternate Investment Fund don’t endanger market stability by using excessive leverage or borrowing, which is not allowed as per regulation. Striking a balance between promoting the development and effectiveness of the Alternate Investment Fund and guaranteeing systemic stability and investor protection is the goal.

Read our Article: Proposed Amendment to SEBI (Alternative Investment Funds) Regulations, 2012