SEBI’s Strategic Blueprint for Hassle-free AIF Liquidation and In-Specie Asset Distribution
- Introduction
The Securities and Exchange Board of India (“SEBI”) kept its eyes peeled over the emergence of Alternative Investment Funds (“AIFs”), and it’s unfolding as a higher-risk private pool of funds. The quicksand, however, was the unliquidated AIFs [1] (investments that are not sold due to lack of liquidity, which may be due to sectoral changes or pending litigation [2]) that pinched hard on the market due to indispensable investors, which in valuation weren’t pocket-sized. Vide Alternative Investment Funds (Second Amendment) Regulations, 2023, introducing Liquidations Scheme provided a procedural framework for working out the outstanding and in-specie distribution of assets, which had its own friction, like industry concerns over market conditions, negative tax implications, and inflexibility in regulatory issues. The need of the hour was a more effectively managed, cost-friendly [3], less intrusive process offering broader horizons for negotiation, which gives heightened returns; ergo, the ‘Dissolution Period’ [4].
SEBI, vide circular dated 9 July 2024, issued a clarification regarding the information to be filed by schemes of AIFs availing dissolution period/additional liquidation period and conditions for in specie distribution of assets of AIFs.
The present Blog seeks to unravel the procedural compliance that has been brought about by the circular, its implications on the regulatory body, and the investors, challenges, and recommendations. It further runs through some global practices on unliquidated AIFs that could be inculcated in India.
- Background
The Dissolution Period is when the same AIF scheme is continued to achieve a full liquidation, inserted as Regulation 29B by the Second Amendment, 2024 to SEBI (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”).
As per Regulation 29B (2) of the AIF Regulations, an information memorandum is to be filed with SEBI through a merchant banker for an AIF scheme that seeks to enter into a dissolution period.
III. Decoding the Circular
- Redefined Information Memorandum Requirements for enhancement
The recent circular enlists the specifications which have to be mentioned in the information memorandum, that has to necessarily be submitted to the Board before the expiration of the liquidation period or, in case of an additional liquidation period, before the expiry of the same. This direction over AIF schemes to submit an information memorandum ensures regulatory oversight, and mandates the inclusion of comprehensive details about the scheme and its unliquidated assets, thereby enhancing transparency and investor protection. There is an additional layer of verification through the requirement of a due diligence certificate from a merchant banker, which strengthens the credibility of the dissolution process.
It also requires the percentage of investors consenting for the dissolution period, the date of intimation to SEBI about the consent and opting for the dissolution period, and the percentage by value of the unliquidated investments for which the bid has been successfully arranged by the AIF or its manager.
- Prioritizing Resolving Investor Complaints
There should not be any pending investor complaint regarding non-receipt of funds or securities against such schemes as on the date of notification of the amendment, i.e., 25th April, 2024, to avail a fresh additional ‘Liquidation Period’. Even if the scheme has successfully resolved any such investor complaint, the fresh ‘Liquidation Period’ shall be available from the date of resolution till the already prescribed date, as previously mentioned. By requiring that all investor complaints be resolved before granting an additional liquidation period, this provision ensures that investors’ rights and interests are preserved. If there is no provision in place, entities managing investment schemes might escape accountability, focusing on speed rather than thoroughness when addressing grievances, potentially creating an atmosphere of neglect regarding investor complaints. Nonetheless, a potential downside of such a provision is that it may leave investors waiting for liquidated returns instead of allowing for the best resolution of their investments during this crucial time. Additionally, there is a possibility that AIFs might be tempted to manipulate the complaint resolution processes, favouring quick settlements over effective management of investor issues, which could pose risks for both investors and regulatory oversight.
- The Power of Collective Voice: Securing Investor Consent for In-Specie Distributions
In terms of in-specie distribution of unliquidated investments, it is further clarified that other than the mandatory in-specie distribution as provided in the SEBI Master Circular for AIFs and the SEBI Circular dated 26th April, 2024, any other in-specie distribution shall be done only after obtaining the consent of at least 75 percent investors by value. This ensures that it is the investors who ultimately retain control over the winding-up process rather than fund managers, which would otherwise make it prone to potential misuse. This implies that there will be increased involvement from investors alongside enhanced protections and minimized legal disputes. Conversely, some may perceive that seeking majority approval instead of considering all possible options and best practices is a limited strategy, leading to potential missed chances for improved asset management and the possibility of additional administration challenges caused by investor disagreements and disputes. AIFs will need to remain vigilant when choosing AIF managers.
- Practical challenges
- Could the Information Memorandum requirements prove to be negatively extensive?
Preparing detailed information memorandums and conducting extensive due diligence can be resource-intensive. Fund managers must now allocate additional resources to ensure full compliance with SEBI’s detailed regulatory framework.
- Is 75% too much of a stretch?
Funds with large and diverse investor bases may face a hurdle in the form of obtaining the requisite 75% investor consent for entering into the dissolution period or opting for in-specie distribution.
Further, the in-specie distribution system has certain drawbacks, such as the process being complex and requiring meticulous tracking of distributed assets and coordination among investors. Additionally, each investor’s receipt of in-specie assets must be managed in compliance with existing regulatory frameworks. Some securities may have transfer restrictions, impacting the effectiveness of in-specie distribution. This can particularly affect foreign or institutional investors bound by specific investment mandates.
- Current Regulatory Gaps in the SEBI Framework and Proposed SEBI Amendments
The existing SEBI framework includes provisions for in-specie payouts and a dissolution time for unliquidated AIF units. However, these systems confront substantial problems, such as tax consequences and inefficiencies in asset liquidation. Furthermore, the limitation on accepting new commitments during the dissolution period complicates capital management by limiting scheme managers’ capacity to raise the necessary money, which is also a straining load. SEBI could consider increasing the liberty to continue asset management after the term to overcome these challenges. This legislative change would enable managers to actively engage in strategic asset management beyond the fund’s lifetime, capitalizing on favourable market conditions to maximize asset value and avoid forced liquidations.
For a better and thorough oversight and policy supervision of unliquidated AIF units, major individual factors that deliver illiquidity in AIF specifically can be unearthed, for which a committee can be constituted. The findings could proceed to SEBI, intimating other regulatory bodies in concerned domains to develop regulations to curb these detrimental facets. Example: One such probable mode that leads to illiquidity is evergreening –– the RBI notification dated 19th December, 2023, has already addressed the issue by tightening the regulations upon SEBI’s intimation. Many such regulated entities were flagged for the same. While the capital market watchdog may find it pertinent to do so, many practitioners in the field warn and alert that such stringency may make it difficult to nurture the nascent AIF market in India. While rigorous compliance measures aim to avert systemic risks in the financial services sector, concerns about the balance between risk mitigation and industry growth remain in dispute. Methods such as phased implementation of new regulations and providing extended timelines for compliance can dilute the immediate burden on regulated entities.
- Global Practices and solutions for managing unliquidated AIF units
In the U.S., a key measurement includes imposing a 15% limit on illiquid investments for open-end funds. This regulatory threshold effectively prevents excessive exposure to illiquid assets. Moreover, U.S. Securities and Exchange Commission Rule 22e-4 mandates investment funds to design and maintain comprehensive liquidity risk management strategies to manage portfolio liquidity risks. This includes continuous assessment, meticulous management, and periodic monitoring. Portfolio investments must be systematically divided into four categories: highly liquid, moderately liquid, less liquid, and illiquid. A Highly Liquid Investment Minimum (“HLIM”) is created to protect liquidity positions. This helps avoid pitfalls at a later stage.
EU: Multiplicity in Approach
The European Securities and Market Authority (“ESMA”), through AIF Managers Directives (“AIFMD”), highlights various methods to handle illiquid or unliquidated AIF units, such as side pockets, redemptions in kind, swing pricing, and subscription/redemption suspensions.[5] Additionally, AIFMD emphasizes scenario analysis and stress testing. These facilitate a proactive rather than reactive approach to liquidity management.
For SEBI, synthesizing the U.S SEC’s direct regulatory investment limits and portfolio classification and the AIFMD’s flexible liquidity management tools, which are also available in several other jurisdictions, would offer a compelling blueprint that aligns with the International Organisation of Securities Commissions (“IOSCO”) standards while addressing local market needs.
VII. Conclusion
Liquidation of unliquidated assets plays a critical role in determining an AIF’s profitability and business success. The recent developments brought in by the Securities and Exchange Board of India embark on a trend to create a nurturing ecosystem for future investment and are thus remarkable. Though with every development, more challenges are making their place along with the ease and incentives around business development, the solution lies in seeking shelter in vigilance toward the shifting Indian AIF landscapes with evolving global practices that may fit in.