[Tirth is a student at Gujarat National Law University.]
The Securities and Exchange Board of India (SEBI), in its May 2023 order in the matter of India Infrastructure Fund II, Global Infrastructure Partners India Private Limited and IDBI Trusteeship Services Limited, seemed to have questioned the commercial wisdom of fund managers and trustees of India Infrastructure Fund, Category I Alternative Investment Funds (AIFs). In its order, SEBI held that encumbering equity of the investee entities by AIFs for facilitating investee entities in raising capital is contrary to the provisions of SEBI (AIF) Regulations 2012 (AIF Regulations), which restricts funds to engage in any kind of leverage.
This has since enabled discussions among stakeholders and SEBI on whether AIFs be allowed to create encumbrances on their equity holding in investee entities as such a mechanism has conceivable merits. This has led to SEBI issuing a circular titled ‘Framework for Category I and II Alternative Investment Funds (AIFs) to Create Encumbrance on Their Holding of Equity of Investee Companies’ which at present permits such encumbrance on equity of investee entities solely engaged in the business of development, operation or management of projects in the infrastructure sector.
This post aims to delve into the deeper aspects of the matter by decoding the SEBI order, contextualizing the SEBI circular taking into account its emphasis on infrastructure sector followed by analyzing and delineating the impact of allowing such considerations across all sectors.
Navigating the SEBI Order
SEBI, acting on the quarterly report submitted by India Infrastructure Fund (IIF) disclosing the pledging of securities held by the fund in its portfolio companies, issued show cause notices (SCN) to its manager and trustee alleging violations of AIF Regulations. IIF had allegedly pledged approximately 24% of the assets under management (AUM) of various portfolio companies with lenders as collateral for loan taken by the portfolio companies thereby violating Regulation 16(1)(c) which prohibits category I AIFs from borrowing or engaging in any leverage except for meeting temporary funding requirements.
The fund argued that its founding aim was to engage in infrastructure projects in India while making sure that significant stakes were secured for involvement in the management and control of the underlying business. Further, it argued that the borrowings for which equity has been encumbered were availed of by the portfolio companies and not by the AIF fund and both the fund and portfolio company were distinct entities and the restrictions in the regulations were limited to leverage availed by the fund. Interestingly, the private placement memorandum (PPM) entered into by the fund was in approval of the investors allowing such encumbrance. Rejecting the view, SEBI held that contrasting any leverage under Regulation 16 with leverage against encumbrance of equity will subject investors with probable financial risk on account of default by portfolio investee companies and the AIF Regulations had overriding effect over PPM.
Even though SEBI acted by construing inclusive interpretation of the regulations, the arguments of the fund were not devoid of merits. Though engaging in leverage by encumbrance carry financial risk to investors, at times not engaging in such leverages may lead to opportunity losses to the investee companies inevitably impacting investor investments. Not allowing such engagements may also lead to default of their existing obligations thereby pushing investee companies to the path of insolvency. Moreover, investment entities have been routinely engaging in management buyouts where they acquire considerable stakes in the entity thereby identifying as their promoters where they could pledge their holdings for facilitating borrowings of the company in an effort to turnaround the prospects of the company.
Further, it could also be argued that AIFs are professionally managed funds engaging sophisticated strategies where investors are HNIs willing to take huge amount of risks. With adequate disclosures and investor concurrence, disallowing such a mechanism would be super-imposing regulatory perception in the garb of investor protection.
SEBI Circular: Encumbrance Allowed in Infrastructure Sector
In light of the IIF order, SEBI had issued a consultation paper dated 2 February 2024 soliciting public comments and thereafter the circular on 26 April 2024.
The circular states that for facilitating borrowing by the investee company, existing schemes of Category I or Category II AIFs that have not onboarded any investors before 25 April 2024, may place an encumbrance on the equity of the investee company subject to relevant disclosures in the PPM. The existing encumbrances may be continued with only by obtaining the consent of all AIF investors by 24 October 2024. Moreover, the circular restricts the borrowing company to utilize the proceeds on encumbered equity for purposes other than development, operation or management of projects in Infrastructure sub-sectors listed in the Harmonised Master List issued by Central Government. Additionally, the circular limits the encumbrance until the tenure of the scheme and prohibits encumbrances in favour of foreign investee entities.
In prudence, equity encumbrance by AIF becomes vital in case of infrastructure sub-sector as there is minimal alternative means of project financing as in the sector, particularly in cases of road concessions, lenders have little or no recourse to the underlying assets since the government, government-owned entities, or other appropriate authorities want to retain the ultimate control to prevent an abuse of monopoly power on the underlying assets, not the borrower. Thus, in the event that the borrower defaults, the lenders are unable to seize control of the underlying asset or infrastructure project. Hence, promoter’s equity pledging becomes a common practice. However, this may not be the case for all investee entities. Although, some of the investee companies of social venture capital (SVC) faces a similar situation where funding for social projects lacking economic motivation may not interest lenders for traditional sources of capital. Lack of financial records and security obsessed lending by banks make the situation similar for SME borrowers too.
Considerations
In light of the above developments, it becomes imperative to deconstruct whether such a mechanism would be feasible across sectors. With additional prospects of raising capital through encumbrance, there are certain vital considerations along with potential investor risks that require attention.
First, concerns of stock price manipulation, where AIFs engage in large amount of equity investments of investee entities resulting in increase in stock price, at which price the loans are availed by investee entities. It results in additional disbursement by lender purely due to price increase from such investment rather than through justified means of business development or cash flow. It exposes other category investors and even lenders to financial risks. Additionally, in case where pledged amount goes down below margin, lender may require AIFs to pledge additional shares to make up the margin call.
Second, allowing large scale encumbrances leads to cascading in financial networks. It results in considerable risks as AIF and investments are stacked across multiple entities, where one project fails performance, it fuels the decline of other entities having interest in such failing entity. It happens as when borrower defaults, lender resort to selling the pledged equity which further fuels stock price decline. With allowing large scale practice and stacking of multiple layers of entities, considerable risks exist of cascading downfall of financial market.
Conclusion
Allowing encumbrance of equity by AIFs may prove to be beneficial for investees in enabling a new means of finance. However, macro-economic considerations needs to be kept in view for large scale allowance of the mechanism resulting in potential risks of margin calls and negative market sentiment causing stock price fluctuations. The following pointers may help mitigate these concerns:
First, equity pledging by AIFs may be allowed to all investee entities which does not hold large public stake such as start-ups/ventures incorporated as private limited companies or unlisted public companies having less exposure to large public stake with mandatory majority or super-majority investor approval. For companies involving large public stake such as listed entities, a threshold for pledging may be worked out. Further in such entities, margin call pledging and post-pledging secondary market equity acquisition of investee companies may be restricted or subject to approvals and disclosures.
Second, layers of investors in the particular scheme may be restricted or investments till the point of natural persons/beneficial owners before encumbrance may be tracked and publicly disclosed. Moreover, such borrowings may be restricted to be utilized for core business purposes only. In any case, AIF’s equity pledging may create a new avenue for capital financing subject to appropriate regulation where risks to stakeholders or markets are in question.
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