Infrastructure funds are in a real quandary. The recent SEBI order in the case of an infrastructure fund (click here to read more) says that the funds cannot pledge shares to facilitate borrowings by its portfolio companies. The context and impact of the order is as intriguing as the possible solutions that the funds industry would seek to tackle this issue.
Violation of AIF regulations: Pledged shares and loans
The fund in question registered as a Category I AIF and raised money a few years back. SEBI, during its inspection, noticed that the fund investing primarily in infrastructure projects had pledged shares and debentures of its portfolio companies. Based on this pledge some of the investee companies obtained loans. The fund documents had made adequate disclosures for investors. SEBI inspection was almost towards the fag end of the tenure of the fund, and likely, the fund would have initiated the process of exiting its investments and distributing to investors.
Regulations bar Category I AIFs from borrowing directly or indirectly or engaging in any leverage except for meeting temporary funding requirements. This clearly means no borrowing at AIF level for investment purposes. Erstwhile venture capital fund regulations did not contain such restrictions. Category III AIFs are allowed to borrow, apparently because they invest primarily in listed securities which are liquid, and their market price or value is certain and known.
SEBI's focus on investor protection
One may ponder whether the logic behind the bar on borrowing by Category I AIFs is to protect the banking system from lending for the purpose of investment in illiquid (unlisted), long-gestation investments or whether it is to protect AIF investors. Clearly, SEBI is concerned more with the latter. This is also amply demonstrated in the provisions under which the SEBI order is passed. Sections 11(1), 11B (1) and 11B (2) of SEBI Act, 1992 under which the order is passed all deal with investor protection.
SEBI seems to have taken note of how AIF regulations have been understood by the industry and observed that no loss has been caused to the investors and hence has taken a lenient approach towards levying financial penalty and restricted its order to warning the fund to be careful in future and amend legal contracts. Since by the time SEBI inspection and the process of passing the order was completed, the fund had got the pledge on its securities released, there were no further directions.
SEBI's indirect borrowing classification: Implications for the fund industry
SEBI has considered pledging shares for investee companies borrowing as indirect borrowing. In the light of the above, it would be worthwhile to compare the impact of direct borrowing in the fund and the borrowing by investment companies against a pledge of shares of (other) investee companies.
In the case of borrowing by the fund where the investee companies do well and generate more than the ‘normal’ return, investors would obviously benefit and their returns after paying normal returns to the lenders, would be above normal. Where investee companies don’t generate desired cash flows, the secured lenders would eventually make some recoveries and the investors may lose.
On the other hand, where the investee company borrows and not the fund, if the investee company does generate adequate cash flows and repays the loans, the pledged securities get released and investors benefit from appreciation of investee company’s value. In the event of inadequate cash flows, if it cannot repay the loan, the lenders seize pledged securities and recover their loan and the investors lose or get the residual value.
In either case, so long as both the investee companies and the borrowing entities are under the same beneficial owners, that is, the investors, the impact of borrowing by the fund and by the investee companies appears to be quite similar.
While all this may be obvious, it’s important to appreciate that the effect of the SEBI action is fair from the investor protection perspective, which is probably why SEBI did not buy the argument that the regulations bar only the borrowing by the fund.
This gives rise to a related question. Why do infrastructure companies like the ones covered by the SEBI order borrow or borrow against pledge of assets owned by another legal entity?
Typically, a toll road company would construct a project and collect toll revenues for a term as agreed with the owner of the project, generally a government body or agency. Hence, they don’t own significant assets which can be offered as security for taking loans. This is where a fund as a shareholder would offer in the interest of its investee company, its other assets (its investments) as collateral to the lender bank.
Borrowing by the project company is essential and unavoidable to fund the project because the entire funding through equity is not always possible due to long gestation and unpredictability of revenues and hence high risk, as compared to a lender who is fine with a bank return on a secured loan. Hence, the practice of fund industry pledging its shares has evolved as a financing solution.
However, after the SEBI order, will it imply for the rest of the fund industry to get the pledge of their investments released where similar arrangements are in place? No doubt, the industry would be expected to amend all legal documents and not to engage in this mode of ‘indirect’ borrowing.
The way forward: Seeking clarity
The industry players would need to deliberate on the way forward on two aspects. The first move is to hold discussions with the regulator regarding solutions for existing arrangements. Since the order is for a specific fund and in the context of a specific fact pattern, it’s important that the industry seeks ‘informal guidance’ under the SEBI-provided mechanism to seek either grandfathering of existing arrangements or clarity on timeframe for unwinding the same.
Secondly, in the absence of any explicit grandfathering of past transactions, industry players will have to make alternative arrangements to substitute existing loans through any other acceptable collateral so that the pledged securities can be released.
Further, it’s important that regulators in consultation with the industry come up with alternative ways of raising debt capital for the projects if the currently prevalent mode is plugged. Otherwise, one is likely to see fund structures moving from domestic AIFs to offshore funds or to GIFT City where International Financial Services Centres Authority regulations are relaxed and allow leveraging.
Sunil Gidwani is Partner at business advisory firm Nangia Andersen LLP and Jaspreet Bedi is Partner at Nangia & Co LLP. Views are personal.