The role of leverage in asset-intensive industries is undeniable—borrowed funds expand the asset base, magnifying potential returns. However, the recent interpretation by the Securities and Exchange Board of India (SEBI) has raised critical questions about the balance between prudent financial management and regulatory compliance.
The controversy: Global Infrastructure Partners and SEBI
The crux of the matter lies in SEBI's recent ruling on the case of Global Infrastructure Partners (GIP), a Category I Alternative Investment Fund (AIF). GIP was found to have pledged securities of its portfolio companies to lenders, which per SEBI contravened Regulation 16(1)(c) of the SEBI (Alternative Investment Funds) Regulations, 2012 (AIF Regulations). Regulation 16(1)(c) limits AIFs' ability to directly or indirectly borrow or engage in leverage.
Prior to SEBI's order, it was widely accepted that this restriction did not hinder AIFs from supporting portfolio companies, provided the AIF did not bear any financial liability due to potential defaults by these companies.
SEBI's interpretation of this regulation now appears to apply to AIFs as well as entities they promote or in which they hold majority shares.
SEBI's stance and its implications
Despite GIP's contentions that the restriction on borrowing and leverage was aimed at AIFs and did not prevent AIFs from supporting their portfolio companies, SEBI held that an AIF's pledge of portfolio company securities for loans constituted indirect borrowing. As regards leverage, SEBI held that the phrase "any leverage" was not limited to leverage taken by the Category I AIF itself and forbade the AIF from being part of any leverage availed either by the AIF or by another entity.
SEBI's interpretation could significantly impact both AIFs and their portfolio companies. It may restrict these entities' ability to secure debt, hindering their growth and operational sustainability, particularly in capital-intensive sectors like infrastructure which inherently rely on leverage for operational sustainability and revenue generation. Without such pledges, lenders may be reluctant to assume unsecured exposure for AIF-backed portfolio companies. This reluctance could stifle the growth of the AIF industry in India.
Revisiting the original intent
SEBI's interpretation seems to deviate from the original intent of the AIF Regulations, as outlined in the 2011 Concept Paper on AIFs. This paper referenced global regulatory practices, including the European Parliament and Council's directive proposal for Alternative Investment Fund Managers. This directive suggested that leverage is considered at the investment fund level and does not include leverage at the portfolio company level. Therefore, if a shareholder pledges securities to reassure lenders, it should not be misinterpreted as a misuse of leverage, as long as it doesn't lead to further downstream investments or acquisitions.
The AIF Regulations were primarily designed to prevent AIFs from engaging in leverage practices that could pose systemic risks to the banking system by avoiding equity risk.
Private equity investors globally commonly invest in special purpose vehicles that hold assets slated for development. However, SEBI's present interpretation could considerably restrict buyout funds' ability to provide such pledges, potentially hindering the growth of India's AIF industry. This becomes more critical in capital-intensive sectors like infrastructure that inherently depend on leverage for operational sustainability and revenue generation.
In the role of majority shareholders or promoters, AIFs often need to secure loans for their portfolio companies. Without such pledges, lenders may hesitate to overlook their internal security creation guidelines, largely dictated by regulatory guidance, leading to reluctance in assuming unsecured exposure for AIF-backed portfolio companies.
The argument that pledges aid to portfolio companies in securing larger loans is fundamentally flawed, given that the underlying asset, upon which loan exposure is calculated, remains constant. Even in insolvency situations, where equity holders are last in the claim line, using shares as collateral to secure portfolio company borrowings doesn't alter the AIF's exposure.
Importantly, leverage forms an integral part of a company's capital structure. Restricting a company's debt financing avenues could lead to inefficient equity capital management.
A way forward
SEBI's consultation paper recently proposed allowing AIFs to borrow in case of an investor drawdown default, acknowledging the need for timely capital injections. The need for majority stakeholders or promoters, such as AIFs, to support portfolio companies in securing debt should be recognized in the same vein. As a safeguard, SEBI could introduce norms to limit AIF exposure to leverage and enforce strict disclosure norms.
SEBI's proactive approach to enhancing AIF governance and disclosure standards is commendable. However, considering the critical role of AIFs in corporate capital raising, SEBI should reassess the operational and regulatory framework governing AIFs. This would ensure harmonious alignment between AIF investment activities and strategies that meet investor comfort and expectations.
In conclusion, it is crucial for SEBI to consider the practical necessities of majority stakeholders or promoters in assisting portfolio companies in securing debt. This should not be misconstrued as professional misjudgment but recognized as practical financial management within the complex dynamics of business operations.
Siddharth Shah is Partner, Shikhar Kacker is Counsel and Samarth Chopra is Associate at law firm Khaitan & Co. Views are personal.
