Sebi May Allow AIFs To Pledge Shares In Investee Firms
The Securities and Exchange Board of India (Sebi) is reportedly considering a proposal to permit alternative investment funds (AIFs) to pledge their shares in companies that they invest in. This move would allow these investment vehicles to engage in leverage.
According to people familiar with the development, Sebi wants to allow pledging for legitimate purposes, particularly in cases such as infrastructure.
If an infrastructure project's special purpose vehicle (SPV) seeks a loan, the bank will usually require promoters to pledge shares in the SPV as security.
However, if an AIF is the promoter or controlling shareholder of an SPV operating an infrastructure project, it would be difficult to do so unless the fund can pledge the share.
There are currently some restrictions in place that could affect the proposed rule. A person familiar with the matter stated that the rule will be based on certain checks and balances and that Sebi will be engaging with the industry to ensure its implementation.
However, Sebi did not respond to queries regarding the matter.
The regulator is planning to release a consultation paper in the near future to gather public comments on the matter. It's worth noting that under current Sebi rules, only Category 3 funds are permitted to engage in leveraging, with the consent of investors. Category 1 and Category 2 funds are not allowed to do so.
Vinod Joseph, partner of the investment funds practice at ELP, a law firm, suggested that Sebi should amend the AIF regulations to allow funds to pledge the securities of their investee companies. However, this may only be permitted if the private placement memorandum allows it, a super majority of investors approve the proposal to pledge the securities of investee companies and the pledge secures a loan offered to one or more portfolio companies, he added.
A few months ago, Sebi frowned upon the practice of AIFs pledging securities of their portfolio companies with banks. It had pulled up India Infrastructure Fund II for making such pledges.
In its 31 May order, Sebi stated that the fund had jeopardised the investments of its investors. The pledging was not in their best interests, even though the fund's investors had full knowledge of the move and had implied consent.
Joseph said that Sebi's order regarding India Infrastructure Fund II clarifies that if an Alternative Investment Fund (AIF) offers any security or guarantee to a lender who is lending to its portfolio company, it is considered indirect borrowing.
Securities lawyers pointed out that leverage is not defined in the AIF regulations. Siddharth Shah, a partner at Khaitan and Co., said that Sebi's interpretation of the restriction on leverage by Category 1 and 2 AIFs now encompasses borrowing at the investee company level, where the AIF pledges its shares. This created a stir among fund managers who manage infrastructure funds or real estate funds, as effective leverage at the investee level is inherent in these asset classes and offering of shares held by AIFs and guarantees as a significant shareholder is often necessary.
