Regulatory Update: Second Amendment to Alternative Investment Fund Regulations

Recently, the Securities and Exchange Board of India (SEBI) has notified the SEBI (Alternative Investment Funds) (Second Amendment) Regulations, 2024 (AIF Second Amendment Regulations), amending the SEBI (Alternative Investment Funds) Regulations, 2012 (AIF Regulations). The amendments aims to provide: (a) ease of doing business and flexibility to category I and II alternative investment funds (AIFs) to create encumbrance on their holdings in investee companies engaged in the infrastructure sector; and (b) flexibility to AIFs and its investors to deal with the unliquidated investments, in line with the decisions taken at the 204^th meeting of the SEBI board. The key changes are as follows:

1. Encumbrance by category I and II AIFs:Through the AIF Second Amendment Regulations, category I and II AIFs may create encumbrances on the equity of their investee companies, which are engaged in the business of development, operation, or management of projects in any of the infrastructure sub-sectors listed in the Harmonised Master List of Infrastructure issued by the Central Government. However, such encumbrance can only be created for the purpose of borrowing by such investee company and subject to any other conditions, as may be specified by the board from time to time. SEBI, through a circular dated 26 April 2024 (please click here to read the circular), has laid down the framework for category I and II AIFs to create encumbrance on their holding of equity of their investee companies:
   • Existing schemes of category I or category II AIFs who have not on-boarded any investors prior to 25 April 2024, can create encumbrance as mentioned above, subject to explicit disclosure in relation to creation of such encumbrance and disclosure of associated risks in their Private Placement Memorandums (PPMs).
   • Encumbrances created prior to 25 April 2024 can continue if such encumbrances were created after making an explicit disclosure in the PPM. In the event such encumbrances are created without an explicit disclosure in the PPM, consent from all investors in the AIF is required to be obtained by 24 October 2024. If not received, the encumbrances must be removed by 24 January 2025. Also, any encumbrances created otherwise than as stated above must be removed by 24 October 2024.
   • Any borrowings against encumbrances must be utilized only for the purpose of development, operation, or management of the investee company, and must not be utilized otherwise, including to invest in another company, and such terms must be incorporated in the investment agreements entered between the AIFs and the investee company.
   • Any category I and II AIFs with more than 50% foreign investment or with foreign sponsor / manager or with persons other than resident Indian citizens as external members in its investment committee which is set up to approve its decisions must comply with the Reserve Bank of India’s master direction on ‘Foreign Investments in India’ dated 04 January 2018 (please click here to read the master direction), as though the AIF is a person resident outside India.
   • In case of default by the borrower investee company, category I or II AIFs shall ensure that the fund or its investors are not liable beyond the encumbered equity by the AIF of such investee company.
   • AIFs are barred from extending any form of guarantee for investee companies.
   • Category I or II AIFs are prohibited from creating encumbrance on their investments in foreign investee companies.
2. Flexibility to AIFs and their investors in managing unliquidated investments: AIF Second Amendment Regulations provides that during the liquidation period of a scheme, AIFs may distribute investments of a scheme which are not sold due to lack of liquidity, in-specie to the investors or enter into the dissolution period, after obtaining approval of at least 75% of the investors by value of their investment in the AIF, in the manner and subject to conditions as may be specified by SEBI from time to time. In the absence of consent, such investments of the AIF are to be dealt in a manner as may be specified by SEBI from time to time. SEBI, through a circular dated 26 April 2024 (please click here to read the circular), has laid down certain conditions in relation to unliquidated investments:
   • Introduction of Dissolution Period: The AIF Second Amendment Regulations introduces a dissolution period following the expiry of the liquidation period, allowing the AIFs to liquidate its unliquidated investments. Prior to seeking the required investor consent, the AIF must arrange a bid for a minimum of 25% of the value of its unliquidated investments. Details pertaining to the proposed tenure of the dissolution period, details of unliquidated investments, value recognition of the unliquidated investments, for reporting to performance benchmarking agencies, etc., and an indicative range of bid value, along with the valuation of the unliquidated investments carried out by 2 independent valuers are required to be disclosed to investors prior to seeking their consent. Further, the AIF must intimate SEBI regarding the investor consent and decision to enter into the dissolution period, prior to the expiry of the liquidation period. If the AIF fails to sell its unliquidated investments during the dissolution period, such investments must be mandatorily distributed in-specie to the investors, and no further extension or liquidation period will be provided after the expiry of the dissolution period.
   • Mandatory in-specie distribution: If AIF fails to obtain required investor consent for entering into dissolution period or in-specie distribution, then the unliquidated investments must be mandatorily distributed to investors in-specie, without the requirement of obtaining consent of 75% of the investors by value of their investments.
   • One-time flexibility for expired liquidation period: AIFs whose liquidation period has expired or shall expire on or before 24 July 2024, shall be granted a fresh liquidation period till 24 April 2025. It is pertinent to note that in cases of AIFs with pending investor complaints in relation to non-receipt of funds / securities, must resolve them before availing this one-time flexibility. However, it shall be available from the date of resolution of the investor complaints till 24 April 2025.
   • Discontinuation of the option of launching liquidation scheme: Any liquidation scheme launched by an AIF prior to 25 April 2024 shall continue to be governed by the SEBI circular dated 21 June 2023 on ‘Modalities for launching Liquidation Scheme and for distributing the investments of AIFs in-specie’, till such schemes are wound up.
3. Due diligence obligations regarding circumvention of laws: Through the AIF Second Amendment Regulations, SEBI has enhanced the due diligence obligations, wherein it requires AIFs, their investment managers and key management personnel to conduct specific due diligence, as SEBI may prescribe, concerning their investors and investments to prevent any attempts to circumvent pertinent laws (including Acts, Rules, Regulations, Guidelines or circulars administered by financial sector regulators, including SEBI).

Please click here to read the AIF Second Amendment Regulations.

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