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The Securities and Exchange Board of India (SEBI) is amending Alternative Investment Fund (AIF) rules to enhance investor parity and market integrity. New guidelines mandate pro-rata rights for investments and distributions, restricting differential rights unless specific conditions apply. The regulator also proposes investment flexibility for Category II AIFs and has heightened due diligence requirements to curb misuse like "evergreening" stressed loans and money laundering, following concerns from RBI and investigations into billions in questionable AIF investments. These changes aim for greater transparency and accountability in India's AIF market.
The Securities and Exchange Board of India (SEBI) is currently undertaking a review and amendment of its Alternative Investment Fund (AIF) regulations. Through a series of circulars and proposals over recent months, impacting the capital markets in India, SEBI aims to enhance investor protection and ensure fair treatment within privately pooled funds by clarifying rules on investor rights, investment flexibility, and due diligence requirements. Advertisement
SEBI has mandated pro-rata rights for investors in AIFs. This means investors must receive returns and losses proportional to their commitment in both investments and distribution of proceeds. The regulator has clarified that differential or special rights for one class of investors cannot be granted at the expense of others, though exceptions apply if an investor is excused from or defaults on a contribution. Permitted differential rights, provided there are full disclosures, include waivers or reductions in fund expenses for select investors, varied management fee structures based on investor size or tenure, and additional reporting rights.
Certain entities, such as AIF managers or sponsors, government-owned or controlled entities, multilateral or bilateral development financial institutions, and State Industrial Development Corporations, may accept lesser returns or greater losses through junior or subordinate units if explicitly disclosed. This exemption also applies to Large Value Funds (LVF), defined as those where each investor commits a minimum of INR 70 crore, if each investor expressly waives pari-passu rights.
AIFs with priority distribution models established before December 13, 2024, are generally barred from accepting new commitments or making new investments unless specific exemptions apply. SEBI has also prohibited differential distribution models that affect the pooling nature of AIFs.
SEBI has instructed AIF managers to conduct stricter due diligence on investors to prevent circumvention of rules, including "evergreening" or masking of stressed loans. Both the Reserve Bank of India (RBI) and SEBI have expressed concerns about AIFs being used for "evergreening" bad loans, a practice where new loans are given to stressed borrowers to repay existing ones.
Investigations initiated in October 2023 reportedly looked into cases involving INR 15,000-20,000 crore (USD 1.8-2.4 billion) where AIFs were allegedly misused. Additionally, a SEBI official noted that around INR 1 trillion (one-fifth) of AIF investments are reportedly "questionable in terms of intent" and are under scrutiny for bypassing regulations. The RBI also tightened rules for banks and non-banking financial companies investing in AIFs in December 2023, with amendments made in March 2024.
For Category II AIFs, SEBI has proposed allowing greater flexibility to meet their mandate of investing predominantly in unlisted securities. This involves including listed debt securities with a credit rating of 'A' or below. This proposal addresses concerns where amendments to listing regulations reduced the availability of unlisted debt, making compliance challenging for these funds.
The aim is to preserve Category II AIFs' role in funding higher-risk businesses that often lack access to traditional financing options, while balancing flexibility with market stability.
Category I and II AIFs are now allowed to borrow for up to 30 days, capped at four times a year and up to 10% of investable funds, for operational or temporary needs. They are also permitted to create encumbrances on equity holdings, with disclosures, to facilitate debt for their investee companies.
Investments by AIFs made on or after July 1, 2025, must be held in dematerialized form. For cases where an AIF exercises control over the investee company, dematerialization must occur by October 31, 2025. Some exemptions apply for short-tenure schemes. Investor consent is now required for fund dissolution, with an exit option for dissenting investors.
Mandatory in-specie distribution (distribution of assets directly, rather than cash) is required if 75% consent for dissolution fails. The regulations aim to promote the growth of the AIF industry while ensuring adequate regulatory oversight. These changes are part of broader efforts to maintain fairness, transparency, and stability in India's capital markets.
Source - PTI
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