Mint Explainer: Why AIFs want to pledge shares of investee companies

Sebi currently considers pledging securities of portfolio companies by AIFs to enable investee businesses to avail bank finance as indirect borrowing and prohibits category I and II AIFs from entering into such arrangements. The AIF industry and corporate lobbies have been seeking a change to this regulation for some time now as they felt such arrangements would benefit both investors as well as investee companies. These restrictions on such pledging were put in place when Sebi replaced venture capital regulations with AIF regulations.

Mint explains Sebi's reservation on such arrangements and why there’s a rethink now.

What are Sebi’s concerns?

Sebi’s primary concern was regarding losses that investors might suffer should a portfolio company default. The regulator noted in the consultation paper, “By creating pledge or charge or hypothecation by an AIF on its assets to secure the loans obtained by its investee companies, investors may lose their entire equity in the investee company in case such investee companies default on repayment of their loan/debt." Therefore, creating pledges on assets of the investee companies by the AIF may, at times, not be in the best interest of the investors, the regulator added. Most investments of AIFs are in early-stage ventures, start-ups, small enterprises, social ventures and infrastructure projects, many of which carry a risk of failure.

Its other concern was regarding the systemic risk to the financial services ecosystem posed by large-scale defaults by portfolio companies where AIFs had pledged their shares. Sebi’s existing regulations explicitly bar category I and II AIFs from indirect borrowings or 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," the consultation paper said. Sebi has noted that global securities markets regulators such as the US Securities and Exchange Commission and UK Financial Conduct Authority as well as the International Organization of Securities Commissions have also flagged the risk of systemic financial sector leverage on the back of private capital investments.

What is the current regulation on borrowings and pledging of shares by AIFs?

Sebi says that pledging of securities held by category I and II AIFs in investee companies for loans availed of by the latter violates provisions of the AIF regulations. Category III AIFs such as hedge funds and private investment in public equity (PIPE) funds are exempted from this rule. However, their leverage cannot exceed 2x of the NAV of the fund and they need to obtain the contest of their investors. Category I and II funds are not allowed to borrow either directly or indirectly or engage in any leverage except for meeting temporary funding requirements.

Category I AIFs include venture capital funds, SME funds, social venture funds and infrastructure funds. Any AIF that cannot be classified as category I or III are classified as category II and these include real estate funds, private equity funds and funds for distressed assets.

How does pledging by AIFs help infrastructure companies?

Pledging of equity investments by AIFs helps investee infrastructure companies secure financing, particularly larger ticket loans required for project execution.

It is commonplace for promoters and significant shareholders of businesses to offer their holdings to the company to use as collateral to raise funds, and AIFs tend to be significant stakeholders in many projects in which they invest. Infrastructure building entities, in particular, require large borrowings to execute projects as equity alone will not suffice. Most of the infrastructure projects have long gestation and the inability to raise funding can affect timely execution and lead to cost overruns, which will then hurt the interest of investors. Lack of adequate funding can sometimes result in the shelving of the project. Lenders will not disburse large loans unless they are given some comfort in the form of shares held by promoters and others as collateral. Such collateral allows lenders to intervene in a project if the borrower (usually a special purpose vehicle implementing the project) defaults on repayments.

How will it help investors of AIFs to allow their shares to be pledged?

It’s all about risks and rewards. Investors in AIFs include high-networth individuals from the country and overseas besides institutional money. Fundraising by an AIF is done through private placement and an investor is required to bring a minimum of ₹1 crore as investment. It is expected that most investors have a fairly high-risk appetite and the ability to stay invested for a few years. AIFs are required to invest at least 51% of their corpus in unlisted entities and they can invest up to 25% of their corpus in a single entity.

Allowing AIF to pledge shares to help a portfolio company carries risks and rewards. If the project fails to repay loans, the lenders can take control of the pledged shares and that will lead to losses for investors of an AIF. On the other hand, if the project is successful and the pledge is released, the AIF would be able to exit the project at a good valuation and offer its investors a good return.