In its recent board meeting on June 27, 2024 (“Board Meeting“), the Securities and Exchange Board of India (“SEBI”) approved a number of proposals, including, in particular, approving Category I and Category II Alternate Investment Funds (“AIFs”) to borrow funds for up to 30 days in order to temporarily cover a deficit in investor drawdown when such drawdown was necessary in order to make investments in portfolio firms.
Background – Proposals on Borrowing by Category I And Category II AIF
Category I and II AIFs are not permitted to borrow money directly or indirectly or use leverage except for meeting temporary funding requirements as per Regulations 16(1)(c) and 17(c) of the SEBI (AIFs) Regulations, 2012 (the “AIF Regulations“). Certain limitations are put in place to make sure that Category I and II AIFs only borrowed money to cover their operating needs and not to make investments that would worsen the asset-liability mismatch. AIFs are not permitted to enter into such arrangements even when borrowing or leveraging to satisfy short-term financial needs: (i) for longer than thirty days; (ii) more than four times a year; or (iii) if the amount borrowed exceeds 10% of the investable funds.
While the regulatory intent behind permitting borrowing for Category I and II AIFs is that the funds borrowed should be utilized for meeting operational requirements of the AIF, and not for the purpose of making investment. Through its consultation paper released by SEBI on May 18, 2023 (“Consultation Paper“), SEBI had taken note of the fact that there is ambiguity amongst market participants with respect to the purpose for which AIFs can indeed borrow funds. In fact, the private placement memorandums of several AIFs state that they may borrow funds for temporary funding. SEBI has also noted that several AIFs have been engaged in borrowing funds to make investments.
One of the main recommendations made by SEBI in the Consultation Paper was to make sure that, unless there are dire circumstances, borrowing should only be used as a last resort for investments made by Category I and II AIFs. SEBI suggested that borrowing be allowed for Category I and II AIFs only in emergency cases when an investor fails to make a drawdown payment on time or at all. Additionally, (a) the borrowing should not be greater than 10% of the anticipated investment in the investee company and should be restricted to covering the shortfall from that particular investor; and (b) AIF refrain from borrowing from the same investor more than once in order to cover a deficiency; and (c) Mandated cooling-off period to avoid extended indebtedness and make sure that Category I and Category II AIFs don’t continuously borrow money without a break.
By way of the Consultation Paper, SEBI had solicited comments from the public on the afore-mentioned proposals.
Minutes of the Board Meeting
More than a year after the Consultation Paper was released and feedback was taken from the market, in the Board Meeting, SEBI has approved the proposal to allow Category I and Category II AIFs to borrow money for a 30-day period in order to cover a shortfall in investor drawdown while making investments. Although the specific framework for borrowing by Category I and II AIFs has not yet been announced, SEBI is anticipated to implement the recommendations presented in the Consultation Paper.
The Board Meeting minutes state that AIF borrowing will only be permitted in the event that an investor fails to pay the drawdown amount by the deadline, in which case the defaulting investor will be responsible for the borrowing expenses.
Recently, SEBI has also issued a guideline in this regard, which highlighted that in order to ensure that the investment opportunity is not lost by any AIF due to any shortfall and to provide ease of doing business and operational flexibility to the AIFs, such measure is important to be adopted. However, it shall be utilized as a last resort and not to facilitate different drawdown schedules or to provide preferential treatment to any particular investor.
A Step in the Right Direction?
SEBI’s decision is certainly a positive step as Category I and II AIFs can now specifically borrow money to cover the deficit in drawdown needed to fund investments in portfolio firms. Earlier, the funds were forced to pass up investment opportunities, which affected the total returns of the AIF. However, by guaranteeing the flexibility of borrowing, the AIFs can now execute investments on schedule. This should improve liquidity management for AIFs by averting missed opportunities.
Nevertheless, there are certain implementation-related difficulties with the plan as it is presented in the Consultation Paper and the guidelines. In particular, if it is implemented, the borrowing cap of up to 10% of the anticipated investment would be onerous. Even if an AIF budgets a large amount and encounters a deficit above this ceiling, it may still find it difficult to close the sale. Further, the limitation on taking out multiple loans from the same investor to cover a shortfall might have a big impact on risk management, investor relations, and fund operations. However, these measures are also required to ensure that the interests of all the stakeholders are kept in mind and is not a common practice among the AIFs.
Author: Ankit Bhasin
Co-Author: Aastha Agarwalla
