The Securities & Exchange Board of India recently came out with a consultation paper to give flexibility to Category I and II AIFs to create encumbrance on their holding of equity in infrastructure sector investee companies to facilitate raising funds through debt by them.

Investee company means any company, special purpose vehicle or limited liability partnership or body corporate or real estate investment trust or infrastructure investment trust in which an AIF makes an investment.

Alternative Investment Fund or AIF means any fund established or incorporated in India which is a privately pooled investment vehicle that collects funds from sophisticated investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors.

Venture capital funds (including angel funds), SME funds, social venture funds and Infrastructure funds will come under Category I classification while real estate funds, private equity funds, funds for distressed assets, etc. can be categorised as Category II AIFs.

Current SEBI regulation prohibits Category I and II AIFs from being party to any leverage availed of either by them or by any other entity, mainly to protect investors.

However, according to the consultation paper, there is merit in allowing AIFs to pledge equity investments in infrastructure sector investee companies.

“Debt funding of infrastructure projects is provided through Project Finance. In project finance, the protection provided to the lenders is the pledge of equity of the project (i.e. equity held in the infrastructure Special Purpose Vehicle holding the project). Currently, this pledge is crucial requirement for lenders, as it provides lenders the right to step into the project in case the SPV defaults on its payment obligation. It can be said that, in the absence of such equity pledge, project finance is severely hampered,” the SEBI consultation paper said.

So, allowing AIFs to create encumbrance on their equity holdings is essential for infrastructure development, particularly in project financing, it feels.

To allow pledging of equity investments, SEBI has proposed that AIFs that have already on-boarded investors must explicitly disclose any plans for pledging or encumbering equity investments in their Private Placement Memorandum. For schemes without on-boarded investors, AIFs must obtain consent from either all investors or at least 75 per cent of them for such encumbrances. In cases requiring 75 per cent investor consent, dissenting investors will be bound by the majority decision, the paper said.

This is a welcome move as the funds raised through pledging will help infrastructure investee company to complete the project. This will not only hlep the investee company but the larger society as well. Besides, completed project, especially on time, will act as a double dhamaka for AIFs, which can reap benefit of capital appreciation on completed project and earn income through pledged shares.

Key risks

However, according to SEBI paper, by creating pledge on its assets to secure the loans obtained by its investee companies, investors may lose their entire equity in the investee company in case of default on repayment of their loan/debt. This may be the case if equity of the investee company post default has some value. Thus, creating pledge on assets of the investee companies by the AIF may, at times, not be in the best interest of the investors.

Moreover, investee companies obtaining loans against AIF equity holdings as collateral can result in indirect and additional leverage. Large amounts of such additional leverage, particularly if some of it is also layered and stacked across multiple entities, can become a source of systemic risk to the financial services ecosystem, it further said.

Apart from this, AIF may be forced to pledge more shares in case of fall in stock prices. So, AIFs should assess the risk involved before allowing the shares to be pledged.

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