On 18th May 2023, the Securities Exchange Board of India ("SEBI") released a Consultation Paper on the proposed amendment to SEBI (Alternative Investment Funds) Regulations, 2012 ("AIF Regulations") with the following proposals:

1. Borrowing for Category I and Category II AIFs

Regulations 16(1)(c) and 17(c) of AIF Regulations currently place a restriction on borrowing or engaging in any leverage except for meeting temporary funding requirements by Category I and II AIFs. It implies that Category I and Category II AIFs can be used only in exceptional circumstances to meet day-to-day operational requirements or temporary funding. It also implies that they are not allowed to borrow money for the purpose of investing.

Proposal:

However, SEBI is considering allowing Category I and Category II AIFs to borrow funds in case there is a shortfall in the amount of money called for from investors, this borrowing will have some conditions such as:

a. Category I and Category II AIFs shall not borrow funds directly or indirectly or engage in leverage for the purpose of making investments.

b. Category I and II AIFs may borrow for the purpose of meeting shortfall in drawdown while making investment in an investee company, subject to the following conditions:

i. borrowing shall not exceed 10% of the proposed investment and shall be done only in case of emergencies and as a last recourse.

ii. The cost of such borrowing shall be charged only to such investor who delayed/ defaulted on the drawdown payment.

iii. AIF shall not borrow more than once for meeting shortfall with respect to drawdown from the same investor.

iv. If the AIF intends to borrow funds for meeting shortfall in drawdown, the same may be disclosed in the PPM of the scheme and the manager shall disclose the details regarding amount borrowed, terms of borrowing and repayment to all the investors of the AIF/scheme.

c. Category I and Category II AIFs shall maintain thirty days cooling off period between two periods of permissible leverage as provided in AIF Regulations.

2. Dematerialisation of Assets/ Investments of AIFs

Considering the recommendations of AIPAC and public comments received on the consultation paper on 'Dematerialisation of units of AIFs' issued by SEBI on February 03, 2023, Board in its meeting held on March 29, 2023, approved the proposal to mandate issuance of units of AIFs in demat form for ease of monitoring and administration by stakeholders and for investor protection against operational and fraud risk. Further considering that AIF industry is a sophisticated space which is rapidly growing, it is now appropriate to introduce the requirement of mandatory dematerialization of assets of AIFs.

SEBI is suggesting that all AIFs should hold their investments in a digital form unless a particular type of investment cannot be dematerialized. This is to make the process more streamlined and secure. For existing investments where the AIF has a controlling stake in a company, they may be given a grace period of 6 months to make the transition to digital holdings.

Proposal:

a. It is proposed to mandate that AIF shall hold the instruments/ securities of their investments only in dematerialized form. The aforesaid requirement shall not be applicable in case of investment in such types of instruments/securities for which dematerialization is not available.

b. As regard the existing investments are concerned, a period of 6 months will be provided to dematerialize investments made by AIF in such investee companies.

3. Mandating appointment of custodian for AIFs

As per Regulation 20(11) of the AIF Regulations, a custodian was mandated to be appointed if the corpus in Category I AIF & Category II AIF exceeded INR 500 crore. However, in the case of Category III AIF, a custodian is appointed irrespective of the corpus of the AIF. Appointment of custodian is done, when the sponsor or manager of Category I & II AIFs is transacting in credit default swaps, as per the terms and conditions specified by SEBI.

It may be noted that SEBI (Portfolio Managers) Regulations, 2020 and SEBI (Mutual Funds) Regulations, 1996 also provides for appointment of a custodian in respect of securities managed or administered by portfolio managers or mutual fund houses and provide such other custodial services as may be authorized by SEBI.

Proposal:

a. SEBI is proposing to make it mandatory for all AIFs to have a custodian with an aim to bring parity across all categories of AIFs.

b. Existing Category I and Category II AIFs will be given 6 months to appoint an independent custodian.

c. The manager of the AIF shall ensure that the custodian appointed by AIF is not an associate of manager/ sponsor/ trustee of the AIF. Existing AIFs who have appointed custodians that are associates of their manager / sponsor / trustee, shall be given a time period of 6 months to comply with the aforesaid requirement.

d. Custodians shall also be responsible for monitoring investments of AIFs regarding investment conditions and other related requirements under AIF Regulations.

4. Maximum extension of tenure by Large Value Fund ("LVF") for Accredited Investors

SEBI, in 2021, introduced the framework for 'Accredited Investors' in the Indian securities market as a class of investors who are well-informed or well-advised about investment products. SEBI also introduced the concept of LVF, which is a scheme of an AIF in which each investor is an Accredited Investor and invests at least INR 70 crore. Certain flexibilities were also given to Accredited Investors and LVF. LVFs are currently allowed to extend their investment tenure up to 2 years with approval from the 2/3rd of the unit holders. Further, LVFs are permitted to extend their tenure for more than 2 years if the terms of the contribution agreement, other fund documents, and conditions specified by SEBI are fulfilled. On the expiry of the tenure or extended tenure, the AIF scheme is required to fully liquidate within 1 year in accordance with the AIF Regulations.

It is also pertinent to note that, SEBI has recently enabled a framework to allow AIFs to deal with unliquidated investments by either selling such investments to a new scheme of the same AIF i.e., Liquidation Scheme or distributing such unliquidated investments in-specie, subject to approval of 75% investors by value and in the prescribed manner. Considering that the aforesaid option of liquidation scheme is proposed to be provided to all schemes of AIFs, including LVFs, it was felt that the extension of tenure of LVFs may be aligned with that provided for other schemes of AIFs.

Proposal:

LVFs may be permitted to extend their tenure up to four years, subject to approval of 2/3rd of the unit holders by value of their investment in the LVF.

5. Renewal of Registration of AIFs

As per Regulation 3(7) of the SEBI (AIF) Regulations, a certificate of registration granted to an AIF is perpetual and is valid till the AIF is not wound up or the certificate of registration is not surrendered. At present, there is no requirement to pay a renewal fee to keep the certificate of registration in force.

It was also observed that AIFs are still holding the certificate of registration despite having no fund raising or any investment activity in their schemes for several years. Certain issues were raised when a certificate of registration was held with no activity.

Proposal:

a. AIF's manager should ensure that AIF pays a renewal fee equivalent to 50% of its applicable registration fee within 3 months after the expiry of 5 years from the date of grant of registration.

b. Those AIFs that have completed 5 years from the date of grant of the certificate will also be liable to pay a renewal fee equal to 50% of its applicable registration fee.

c. Where an AIF fails to ensure the payment of the renewal fee then a late fee of an amount of 2% of its registration fee shall be charged for each day of delay subject to a maximum of two times of the registration fee.

d. After this, the certificate of registration of the AIF shall be canceled or suspended.

e. In addition to this, the AIFs shall not accept any fresh commitment or make any investment in a new investee company or launch new schemes unless the renewal fee is paid. It is the responsibility of the custodian of AIF to monitor the compliance of the aforesaid provisions by AIF or the Manager.

The aforesaid proposed amendments seek to strengthen the governance mechanism of AIF. These proposals further aim to bring parity across all categories of the AIFs and enhance the operation, monitoring and functioning of the AIFs.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.