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The authors are Arihant Sethia, a second year student at Gujarat National Law University, and Keshav Kulshrestha, a third year student at Institute of Law, Nirma University
Introduction
Alternative Investment Funds (“AIFs”), as defined by Regulation 2(b) of the AIF Regulations, represent privately pooled investment vehicles that gather funds from investors for deployment according to a specified investment policy. In a bid to enhance the ease of business for AIFs, SEBI issued a consultation paper on February 2. The focus of this consultation paper is to explore the feasibility of permitting Category I and II AIFs to encumber their equity holdings in infrastructure sector investee companies, facilitating these entities in raising debt.
This post delves into the implications of such a proposal, emphasising the risks associated with leveraging AIF assets in the infrastructure sector and scrutinising the potential trade-offs between fostering investments and ensuring robust investor protection. The discussion unfolds by outlining SEBI's regulatory stance, addressing industry representations, evaluating risks tied to infrastructure investments, and advocating for a balanced approach considering investor welfare and financial stability.
What are the Current Prohibitions on Category I and Category II AIFs?
SEBI's AIFs, under Regulation 16(1)(c) and Regulation 17(c) of the AIF regulation, impose an explicit bar on Category I and II AIFs against any form of direct or indirect borrowing. Category I AIFs invest majorly in Startups, SMEs and projects which are socially and economically viable while Category II AIFs majorly invest in Equity and Debt securities of companies. As clarified through the consultation paper, the usage of the terminology “directly or indirectly” indicates a wide ambit, proscribing AIFs from involvement in any kind of leverage- not solely borrowings by the fund itself but also extending to asset encumbrance in the form of securities pledged to secure debt for portfolio companies. By deterring even indirect exposure to leverage, the intent is to insulate investor capital from potential erosion resulting from enforced transfers or disposal of equity assets held by the AIFs consequent to defaults on loans backed by securities belonging to the fund’s investee firms.
What are the Issues for Consideration Before SEBI?
SEBI’s consultation paper takes cognisance of representations from industry bodies and AIFs seeking regulatory reliefs for pledging equity stakes in infrastructure sector investee enterprises to facilitate requisite project financing towards the promotion of infrastructure growth. It notes that for capital-intensive infrastructure ventures, especially those implemented via Special Purpose Vehicles (“SPVs”), lenders invariably seek leverage in the form of pledges over promoter equity as a mitigant against defaults. By providing robust security to lenders, such pledges enable easier asset takeovers and recovery management upon non-performing loans. The consultation paper recognises that more than leveraging fund corpus, enabling equity encumbrance aims to engender greater lending confidence towards infrastructure projects and SPVs. It cautions that curtailing the flexibility of AIFs in financing infrastructure assets may risk shrinking the overall pool of capital flows to such projects from banking and NBFC channels, thereby impeding national infrastructure goals.
The SEBI proposal could expose AIF investors to significant risks by allowing them to pledge their equity holdings in infrastructure companies. This opens the possibility of loss of control over their investments if defaults occur, as lenders could seize the pledged shares. Additionally, the proposal increases the exposure of AIF investors to project-specific risks inherent in infrastructure investments, such as long gestation periods and susceptibility to external shocks. This contradicts SEBI's core objective of ensuring investor protection and a fair market, as it introduces uncertainties and potential financial losses for investors.
To strike a balance between facilitating infrastructure financing and mitigating potential systemic risks, the proposal suggests allowing AIFs to pledge equity only in investee companies engaged in infrastructure development. This limitation is proposed to minimise the impact on financial stability, considering the systemic risk associated with AIFs pledging equity across sectors.
The consultation paper further deliberates upon the prospect of permitting a broader universe of AIFs to pledge portfolio equity assets beyond merely infrastructure sector investments, subject to well-defined checks and balances. It considers that given sophisticated investor constituencies in Category I and II AIFs, and with adequate risk disclosures and unit holder consent requirements, funds may be allowed flexibility in encumbering equity assets within disclosed thresholds as collateral support for borrowers to stimulate lending flows.
However, this flexibility would be circumscribed by strict conditions such as clear articulation of pledging possibilities in the Private Placement Memorandum (PPM), binding consent requirements from all investors for creating pledged positions, quantitative ceilings on leverage against fund assets, and prohibiting unconditional guarantees by AIFs. The consultation paper also reveals due regulatory coordination, soliciting the Reserve Bank of India's views to assess potential financial stability ramifications of the suggested framework.
Risks Associated with Infrastructure Companies
Infrastructure companies form the backbone of any economy. But investing in infrastructure companies carries inherent risks for investors, particularly concerning inflation, interest rate sensitivity, leverage, and ESG (Environmental, Social, and Governance) considerations. While infrastructure is often presented as an inflation hedge, this is only partially true.
Infrastructure investments are also sensitive to changes in interest rates, and their fair market value is highly correlated with interest rate movements. According to EDHE Cinfra data, a 1% increase in the discount rate can lead to a 10% reduction in the fair value of infrastructure equity investments. This exposes investors to inflation risk through interest rate fluctuations, as changes in market discount rates can have a more significant impact on valuations than expected cash flow changes.
The Companies Act, 2013 also incorporates certain exemptions designed specifically to accommodate the distinctive risks and imperatives of infrastructure enterprises. Section 55(2) enables issuance of preference shares by infrastructure companies for durations beyond the twenty-year threshold under the general law, subject to the redeemable percentages stipulated under Rule 10 of the Companies (Share Capital and Debentures) Rules. This allows tailored redemption schedules for preference capital raised by infrastructure firms over periods up to thirty years.
Additionally, Section 186(11)(a) creates exemptions from prohibitions on loan and guarantee provisions for companies engaged in financing activity towards infrastructure facilities. By incorporating such exemptions attuned to the nature of infrastructure funding, the regulatory regime displays cognisance of the sector’s distinct capital needs and the role of enabling companies in bridging infrastructure deficits through financial and risk participation. The accommodations thereby attempt to facilitate infrastructure growth in a compliance-oriented framework, factoring in the specific challenges such companies face.
Analysis
SEBI's primary duty is to secure the welfare of investors, and it must prioritise measures that safeguard their interests. The proposed amendment to allow Category I and II AIFs to create an encumbrance on their equity holdings in infrastructure companies for facilitating debt raises significant concerns regarding investor protection. As highlighted in the risks associated with infrastructure investments, the potential exposure to large risks requires stringent regulatory scrutiny.
Infrastructure companies, with their long gestation periods and susceptibility to external shocks like the COVID-19 pandemic, pose inherent risks. For example, during the COVID-19 pandemic, the S&P BSE India Infrastructure index experienced a substantial decline, losing nearly 35% of its value between January and March 2020. This sharp decrease reflected the challenges and uncertainties faced by the infrastructure sector in India during the lockdown.
So, allowing these companies to leverage AIFs' shares introduces a substantial risk of default on loans, especially during unforeseen events. In such situations, AIF investors may face severe losses as their equity holdings could be at stake due to the pledged shares. This presents a direct threat to investor welfare and contradicts SEBI's core objective of ensuring a fair and secure market for investors.
Further, SPVs which tend to serve as investee companies inherently carry more elevated risks for investors due to their project-specific nature. Unlike diversified companies that can absorb the failure of one project, an SPV is designed for a particular undertaking. If the supported project encounters challenges or fails, the entire SPV is at risk, making it a precarious investment. Pledging shares for a single SPV implies that the fate of the investment is solely tied to the success of that specific venture, amplifying the financial vulnerability for investors. This concentrated risk factor underscores the high stakes associated with pledging shares for singular projects within the infrastructure sector.
Considering the cost-benefit analysis of the proposed amendment, the potential benefits of increased funding for infrastructure companies through the pledge of shares should be weighed against the significant costs and risks involved for AIF investors. While increased funding may seem beneficial in the short term, the long-term repercussions of potential defaults and loss of ownership rights must not be overlooked.
The cost to AIF investors involves a loss of control over their equity holdings in the infrastructure companies. In the event of defaults, lenders could seize the pledged shares, resulting in a loss of ownership and potentially substantial financial losses for AIF investors. This undermines the very essence of investor protection and contradicts SEBI's duty to ensure a fair, transparent, and secure investment environment.
From a broader economic perspective, the proposed amendment may have cascading effects on the financial stability of AIFs, which play a crucial role in channelling funds to various sectors, including infrastructure. Economic stability relies on the integrity and robustness of the financial system, and any compromise in investor protection could lead to a loss of confidence in the market.
Conclusion
In conclusion, while infrastructure development is vital for economic growth, SEBI's proposed amendment to allow AIFs to pledge equity introduces substantial risks for investors. The potential benefits of increased funding should be weighed against the significant costs, including investors’ loss of control over equity holdings and heightened exposure to project-specific risks. Prioritising investor protection aligns with SEBI's core mandate, ensuring a fair and secure market. Striking a balance between encouraging investments and safeguarding investors is crucial for long-term financial stability and market integrity.
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