AIF debt funds may be the next game changer in terms of debt investments in India
Foreign investors have been in a tizzy for some time. The stock indices have risen substantially, even as non-performing assets are at their highest. Banks and non-banking finance companies (NBFCs) have been facing troubled times, with liquidity getting trapped in such non-performing assets. But, as with all gloomy clouds, there is always a silver lining. Amidst the volatility in the market, many foreign investors have evinced interest in investing in Indian debt as an asset class.
One popular mode through which they make this possible is the foreign portfolio investment (FPI) route. As of date, publicly available data shows investment by FPIs in corporate debt to be over Rs 193 lakh crore. Taking into account government securities as well as special schemes, more than doubles this figure to about Rs 443 lakh crore as total FPI investment. However, foreign investors are always keen to consider alternative investment routes and, in this regard, alternative investment funds (AIFs) registered under the SEBI (Alternative Investment Funds) Regulations, 2012 (AIF Regulations) might have the potential to become an attractive platform for foreign investors to pool their money for taking part in the Indian debt asset class.
This article looks at some of the key beneficial aspects of an AIF debt fund that fund managers as well as foreign investors may consider vis-à-vis the more traditional FPI route, on a few relevant parameters.
Of the three categories of AIFs, a ‘debt fund’ would fall under Category II AIF that invests primarily in debt or debt securities of listed or unlisted investee companies according to the stated objectives of the fund. The markets regulator, Securities and Exchange Board of India (SEBI), has clarified under an informal guidance that the term ‘primarily’ is indicative of where the main thrust of a Category II AIF ought to be. Further, the investment portfolio of a Category II AIF needs to be more in unlisted securities.
One point to note is that although the AIF Regulations permit AIFs to invest in ‘debt,’ which may include loans, the frequently asked questions on the AIF Regulations by SEBI give conflicting views. While the minimum investment from an investor in an AIF is Rs 1 crore – meant to attract sophisticated investors – the returns are not guaranteed and hence investors looking for comfortable fixed returns should stay away from such investments.
Some of the key differentiators between the FPI and AIF routes are discussed below in brief.
Regulatory regime and compliance
FPIs are governed by SEBI (Foreign Portfolio Investors) Regulations, 2019 and AIFs are by the AIF Regulations – both being regulated by the common regulator SEBI. AIF Regulations are fairly straight-forward and SEBI has laid down a simplified process for their set-up and registration. The registration of FPIs is slightly more onerous and is outsourced so to speak by SEBI to designated approved depository participants.
Further, the periodical reporting and compliances are less onerous for AIFs compared to those for FPIs as they are required to, inter alia, make reporting of beneficial ownership, percentage holding of securities in portfolio entities as well as issuance of overseas derivative instruments.
While there are no minimum corpus/capitalization requirements for FPIs, a Category II AIF is required to have a minimum corpus of Rs 20 crores to operate. This would provide a wider pool of capital for the AIF to make debt investments.
While AIFs are permitted to invest in all forms of debt securities, including non-convertible debentures (both listed and unlisted), optionally convertible instruments, security receipts issued by asset reconstruction companies, etc., FPIs are restricted from investing in optionally convertible instruments and partly paid instruments.
Accordingly, AIFs can be used to make plain-vanilla debt investment transactions as well as structured debt transactions with a combination of debt and equity as well.
Credit concentration and maturity norms
Pursuant to the circular issued by the Reserve Bank of India (RBI) last year, an FPI are not be allotted more than 50 per cent of the securities in a single debt issuance of a portfolio company. Further, FPIs cannot make fresh investments in corporate bonds having a minimum residual maturity of less than one year. Also, no investment in a single corporate bond could exceed 20 per cent of an FPI’s aggregate corporate debt portfolio. While these conditions were somewhat relaxed under the Voluntary Retention Route scheme introduced by the RBI this year, one key condition of requiring the amount of investment to be retained in India for a minimum period of three years remains.
The AIF Regulations only provide for credit concentration limit of not investing more than 25 per cent of an AIF’s investable funds in a single portfolio entity and no minimum residual maturity requirements. With these conditions, AIFs are a clear winner for debt investments.
Security creation and enforcement
While there are nuances to security creation and enforcement by various types of entities in India, in general, security is required to be created in favour of a security trustee in India that would hold it for the benefit of the FPIs while AIFs can hold security on their own.
However, it must be noted that neither AIFs nor FPIs have protection under The Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 and accordingly, security cannot be enforced without the intervention of the court. That said, AIFs would be in a position to appropriate the security towards the outstanding debt, whereas FPIs will necessarily have to enforce the security through a security trustee in India with the realization proceeds then remitted to them.
In conclusion, we foresee a repeat of 2008-09, with the fund managers once again looking to make structured debt or debt investments to safeguard capital.
Given the relaxed regulatory environment and the clarity offered by SEBI under the AIF Regulations, ease of security creation and enforcement and flexibility in terms of investment instruments, AIFs are certainly being considered. Further, since AIFs can also provide the much-needed liquidity to Indian businesses in the current scenario, the market is witnessing an interest in AIFs being set-up as debt funds in the real estate, infrastructure and education sectors. In fact, the Government of India has also recently approved the setting up of a Rs 25,000 crore AIF, which is likely to be a debt fund, to address the liquidity issues faced in the real estate sector. Accordingly, AIF debt funds may be the next game changer in terms of debt investments in India.(The writers are respectively, Partner and Principal Associate at J. Sagar Associates. Views expressed in this article are personal.)LIVE NOW... Video series on How to Double Your Monthly Income... where Rahul Shah, Ex-Swiss Investment Banker and one of India's leading experts on wealth building, reveals his secret strategies for the first time ever. Register here to watch it for FREE.