Guidelines for Category I and II AIFs on borrowing and creation of encumbrance on equity of investee companies
Chapter 14 - Guidelines for Category I and II AIFs on borrowing and creation of encumbrance on equity of investee companies
14.1. Borrowing by Category I and II AIFs
14.1.1.
Category I and Category II AIFs are generally not allowed to borrow funds or use leverage for making investments or for other purposes.
However, they may borrow funds for:
Temporary funding requirements.
Day-to-day operational requirements.
Such borrowing is allowed only if all the following limits are followed:
The borrowing is for a maximum of 30 days.
Borrowing can be done on not more than 4 occasions in a year.
The borrowing must not exceed 10% of the investable funds.
Example:
An AIF has investable funds of ₹100 crore.
It may temporarily borrow up to ₹10 crore for operational or temporary funding requirements.
Each borrowing can last for a maximum of 30 days.
Such borrowing can be undertaken on a maximum of 4 occasions in a year.
14.1.3.
Category I and Category II AIFs may borrow funds to meet a temporary shortfall in the drawdown amount.
(a).
However, if the AIF intends to use such borrowing, this must be clearly disclosed in the PPM of the scheme.
Investors should therefore be informed through the PPM that the scheme may borrow funds to bridge a temporary shortfall in investor contributions.
(b)
Borrowing to meet a drawdown shortfall should be used only in an emergency and as a last resort.
The AIF may borrow only when:
The investment opportunity is imminent and needs to be closed;
The required drawdown amount has not been received from one or more investors before the investment date; and
The Manager has made best efforts to obtain the pending drawdown amount from the delaying investor(s).
Therefore, the AIF cannot routinely borrow simply because an investor has delayed payment.
Example:
An AIF has to invest ₹10 crore in Company X by 15 September.
Investor A has been asked to contribute ₹3 crore but has not paid by the investment date.
The Manager has made repeated efforts to obtain the ₹3 crore from Investor A.
The investment opportunity is about to close and waiting for Investor A would cause the AIF to miss the opportunity.
In this emergency situation, the AIF may temporarily borrow the ₹3 crore as a last resort.
(c)
The amount that a Category I or Category II AIF can borrow to meet a drawdown shortfall is subject to a maximum limit.
The borrowing cannot exceed the lowest of the following three amounts:
20% of the investment proposed to be made in the investee company.
10% of the investable funds of the AIF scheme.
The commitment still pending to be drawn down from investors other than the investor(s) who failed to provide the drawdown amount.
Therefore, the AIF must calculate all three limits and take the lowest amount as the maximum borrowing permitted.
Example:
Proposed investment in Company X = ₹20 crore
20% = ₹4 crore
Investable funds of the scheme = ₹30 crore
10% = ₹3 crorePending commitment from other investors = ₹2 crore
The three limits are:
₹4 crore
₹3 crore
₹2 crore
The lowest amount is ₹2 crore.
Therefore, the AIF can borrow maximum ₹2 crore to meet the drawdown shortfall.
(d)
The cost of borrowing taken to meet the drawdown shortfall shall be charged only to the investor(s) who failed to provide the required drawdown amount.
Other investors who have provided their drawdown amounts on time cannot be made to bear this borrowing cost.
The borrowing cost may include the interest or other costs associated with the temporary borrowing.
Example:
An AIF requires ₹10 crore for an investment.
Investor A fails to provide a required ₹2 crore drawdown on time.
The AIF temporarily borrows ₹2 crore to complete the investment.
The interest/cost of this borrowing must be charged only to Investor A.
Investors B and C, who paid their drawdown amounts on time, will not bear any part of this borrowing cost.
(e)
The borrowing facility cannot be used to give investors different timelines for paying their drawdown amounts.
All investors must continue to follow the drawdown timelines applicable to them under the fund documents.
Borrowing is only meant to deal with a temporary delay or shortfall, not to intentionally give certain investors extra time to make their contribution.
(f)
The Manager must disclose details of any borrowing used to meet a drawdown shortfall to all investors of the AIF/scheme.
The disclosure must include:
Amount borrowed.
Terms of the borrowing.
Repayment details.
This information must be provided to investors periodically, in accordance with the terms agreed with the investors in the relevant fund documents.
Example:
An AIF temporarily borrows ₹2 crore because an investor fails to meet a drawdown.
The Manager must disclose to all investors:
₹2 crore was borrowed.
The terms on which the ₹2 crore was borrowed.
How and when the ₹2 crore will be repaid.
The disclosure must be made at the frequency agreed with investors under the relevant agreement.
14.1.4.
Category I and Category II AIFs must maintain a 30-day cooling-off period between two separate periods of borrowing.
The 30-day cooling-off period starts from the date on which the previous borrowing is repaid.
Therefore, an AIF cannot immediately undertake another borrowing after repaying the previous borrowing.
Example:
An AIF repays its previous borrowing on 1 September 2026.
The 30-day cooling-off period will run from 1 September 2026.
The AIF can undertake the next borrowing only after completing the required 30-day cooling-off period.
14.2. Framework for Category I and II AIFs to create encumbrance on their holding of equity of investee companies
14.2.1.
Category I and Category II AIFs may create an encumbrance on the equity of an investee company, but only in limited circumstances.
The investee company must be engaged in:
The development, operation or management of infrastructure projects covered under the Harmonised Master List of Infrastructure Sub-sectors issued by the Central Government.
The encumbrance can be created only to enable the investee company to borrow funds.
Therefore, the AIF cannot create such an encumbrance for its own borrowing or for any unrelated purpose.
Example:
A Category II AIF holds equity in Company X.
Company X is developing an infrastructure project covered under the Harmonised Master List of Infrastructure Sub-sectors.
Company X wants to borrow money from a bank for the project.
The AIF may create an encumbrance over its equity in Company X to facilitate Company X's borrowing.
14.2.2.
In this regard, the following conditions are specified:
(a).
A Category I or Category II AIF scheme may create an encumbrance on the equity of an investee company to facilitate borrowing by the investee company.
However, the PPM must clearly disclose:
That such an encumbrance may be created; and
The risks associated with creating the encumbrance.
Therefore, investors must be made aware of both the possibility of the encumbrance and the risks involved before investing in the scheme.
Example:
A Category II AIF invests in the equity of an infrastructure company.
The company wants to borrow money for its infrastructure project.
The AIF may create an encumbrance over its equity to facilitate the company's borrowing.
The PPM must clearly tell investors that:
The AIF may create such an encumbrance &
Investors may face risks associated with the encumbered equity.
(b).
Category I and Category II AIFs must ensure that the borrowed funds raised by the investee company against the encumbered equity are used only for the investee company's:
Development.
Operation.
Management
of the infrastructure projects referred to in Para 14.2.1.
The borrowed funds cannot be used for any other purpose.
In particular, the investee company cannot use these borrowed funds to make investments in another company.
This restriction must be expressly included as a term of the investment agreement between the AIF and the investee company.
Example:
A Category II AIF encumbers its equity in Company X to help Company X borrow ₹50 crore.
Company X must use the ₹50 crore for its own infrastructure project, such as developing or operating the project.
Company X cannot use the ₹50 crore to invest in Company Y.
The investment agreement between the AIF and Company X must clearly state this restriction.
(c)
The encumbrance created over the AIF's equity investment cannot continue beyond the remaining tenure of the AIF scheme.
Therefore, the period for which the equity remains encumbered must be equal to or shorter than the residual tenure of the Category I or Category II AIF scheme.
Example:
A Category II AIF has 3 years remaining in its scheme tenure.
The AIF creates an encumbrance over its equity investment in an infrastructure company.
The encumbrance can remain in place for a maximum of 3 years.
It cannot continue beyond the date on which the AIF scheme's tenure ends.
(d).
A Category I or Category II AIF must comply with Para 7.11.2 of the RBI Master Direction dated 4 January 2018 on Foreign Investment in India.
It must comply as if the AIF were a person resident outside India, if any of the following applies:
More than 50% of the AIF's investment is foreign investment.
The AIF has a foreign Sponsor or Manager.
The AIF's Investment Committee has external members who are not resident Indian citizens.
This requirement applies where the Investment Committee is set up to approve the investment decisions of the AIF.
(e).
If the borrower investee company defaults on its borrowing:
The Category I or Category II AIF must ensure that the AIF or its investors do not face liability beyond the equity of the investee company that was encumbered.
So, the AIF's exposure is limited to the encumbered equity.
The lender cannot impose any additional liability on the AIF or the investors of the AIF beyond that encumbered equity.
Example:
An AIF holds equity worth ₹20 crore in an infrastructure company.
The AIF encumbers this equity to help the company borrow funds.
The company later defaults on the loan.
The AIF and its investors should not be required to pay any amount beyond the ₹20 crore worth of encumbered equity.
(f).
The permission to create an encumbrance on equity investments does not mean that Category I or Category II AIFs are allowed to provide a guarantee for the borrowings of an investee company.
In other words, an AIF may encumber its equity in the permitted circumstances, but it cannot use this flexibility to guarantee the investee company's obligations.
Example:
A Category II AIF holds equity in Company X.
Company X wants to borrow ₹50 crore for its infrastructure project.
The AIF may encumber its equity in Company X, subject to the applicable conditions.
However, the AIF cannot give a guarantee to the lender stating that it will repay Company X's ₹50 crore loan if Company X defaults.
(g).
Category I and Category II AIFs cannot create an encumbrance on their investments in foreign investee companies.
The flexibility to create an encumbrance is therefore limited to eligible investments in Indian investee companies.
Example:
A Category II AIF holds equity in an Indian infrastructure company.
Subject to the prescribed conditions, the AIF may create an encumbrance on that equity.
However, if the AIF holds equity in a foreign company, it cannot create an encumbrance over that investment.
14.2.3.
The SFA, in consultation with SEBI, shall formulate implementation standards to ensure that:
The encumbrance created by Category I or Category II AIFs over the equity of an investee company is used only to facilitate debt raising by the eligible infrastructure-sector investee company.
Managers of Category I and Category II AIFs must adopt and comply with these implementation standards.
The standards will provide the practical framework for ensuring that the encumbered equity is used only for the permitted purpose.
These standards shall be published on the websites of the SFA industry associations:
Indian Venture and Alternate Capital Association (IVCA).
PE VC CFO Association.
Trustee Association of India.
Example:
A Category II AIF encumbers its equity in an infrastructure company to help the company raise debt.
The Manager must ensure that the arrangement follows the implementation standards formulated by the SFA in consultation with SEBI.
The Manager cannot use the encumbrance arrangement for a purpose outside the permitted infrastructure-sector debt raising.
