Ananya SonthaliaPartner
Shubham SoniSenior Associate
Shubhangi AgrawalAssociate
Key Developments
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SEBI approves proposals empowering alternative investment funds with ability to create encumbrance on holdings, extend tenure for unliquidated assets and conduct enhanced due diligence
In its board meeting held on 15 March 2024 (Board Meeting), the Securities and Exchange Board of India (SEBI) made some key decisions to empower Alternative Investment Funds (AIF). Here are the key decisions:
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Category I and Category II AIFs will have the flexibility to create encumbrance on holdings in infrastructure sector companies
Category I and Category II AIFs will now be able to facilitate raising of debt/loan by their investee companies in infrastructure sector, by creating encumbrance on the equity held by them in such companies. These companies are those involved in infrastructure sub-sectors listed in the ‘Harmonised Master List of Infrastructure Sub-sectors’ issued by the Department of Economic Affairs.
With the ability to create encumberance, AIFs can participate in debt based project financing for their investee companies’ capital intensive infrastructure projects. This will promote ease of business by unlocking efficient capital utilisation by such companies, and makes AIFs more appealing as a source of capital.
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AIFs will have additional flexibility to deal with unliquidated investments
AIFs will now be able to hold unliquidated investments for longer than their original term in the same scheme, instead of starting a new liquidation scheme, subject to certain conditions. Also, if an AIF's one-year liquidation period post the original term or extended term has ended (or will end within three months from this proposal’s official notification), it may get an additional year for any unliquidated assets held by it, subject to certain conditions.
This development will enable the fund managers to potentially generate better returns on unliquidated assets held by the AIF, without the operational hassle of launching a new scheme. This also reduces the pressure on investment managers to quickly sell or write down assets if they could not liquidate them within the liquidation period.
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AIFs will have to conduct enhanced due diligence on investors and investments
AIFs, their managers, and key personnel will have to perform specific due diligence on their investors and investments. This is to prevent circumvention of financial sector regulations by AIFs and avoid issues like evergreening of loans by regulated lenders, sidestepping of exchange control norms, etc.
The pilot industry standards forum for AIFs has been tasked with formulating implementation standards, in consultation with SEBI, to ensure that the due diligence requirements are not open-ended or subject to interpretation.
The enhanced obligation is anticipated to lead to increased operational costs. Nonetheless, it will serve as a safeguard against the misuse of AIFs as a means to bypass financial sector regulations, bolstering confidence in the financial ecosystem.
Subsequently, on 25 April 2024, SEBI has notified amendments to the AIF Regulations, giving effect to the above decisions.
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Guidelines for alternative investments funds for holding investments in dematerialised form
SEBI has introduced new guidelines requiring AIFs to hold their investments in dematerialised (Demat) form. Accordingly, all new investments made by AIFs on or after 1 October 2024 must be in Demat form, barring specific exemptions. Existing investments also need to be in Demat form if the AIF controls its investee company along with other SEBI registered intermediaries. This requirement does not apply to any AIF whose tenure ends on 31 January 2025 or which is in extended tenure as on 12 January 2024.
The new requirements are expected to increase cost and regulatory compliance burden on the investment manager and the investee companies, including early stage private companies, to ensure that the investment instruments being subscribed by AIFs are in Demat form, except in specified conditions. However, this will lead to increased transparency in the ecosystem, and enhanced confidence among potential investors in AIFs.
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Alternative investment funds mandated to appoint a custodian with the obligation to report the investments under custody
All AIFs must now appoint a custodian before the date of the first investment, who will in turn be obligated to report investments under their custody to SEBI. Existing Category I and Category II AIFs who have not appointed a custodian will have to mandatorily appoint them by 31 January 2025. An associate of the AIF's sponsor or manager can function as a custodian only upon fulfilment of certain specified criteria.
The pilot industry standards forum for AIFs will formulate the standards for reporting of data on investments by AIFs, in consultation with SEBI. These standards will specify the format and frequency of reporting of data by the manager of AIF to the custodian, and subsequently by the custodian to SEBI.
This development is intended to bring greater transparency and standardisation of reporting norms for all AIFs.
