On February 7, 2025, the Securities and Exchange Board of India (“SEBI”) has published a consultation paper (“Consultation Paper”) proposing to expand the requirement for Category II Alternative Investment Funds (“Category II AIF(s)”) to invest ‘primarily’ in unlisted securities, to also include listed debt securities having credit rating ‘A’ or below. The above proposal has been made in view of the introduction of Regulation 62A of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“LODR Regulations”). Following is a brief overview of the Consultation Paper.

1. Background

1.1. Regulation 62A, which was inserted in the LODR Regulations with effect from September 20, 2023, provides that a listed entity:

(a) which has issued listed non-convertible debt securities (“NCDs”) is required to list all NCDs proposed to be issued on or after January 1, 2024;

(b) whose subsequent issuances of unlisted NCDs made on or before December 31, 2023, are outstanding on the said date, may list such NCDs; and

(c) that proposes to list NCDs on the stock exchanges on or after January 1, 2024 shall list all outstanding unlisted NCDs previously issued, within 3 (three) months from the date of the listing of the NCDs proposed to be listed.

1.2. Due to the abovementioned regulations, any entity that had issued listed NCDs on or before January 1, 2024, which continued to be listed, is not permitted to issue unlisted NCDs. Additionally, in case an entity proposes to issue any listed NCDs on or after January 1, 2024, then its unlisted NCDs which were previously issued, are mandatorily required to be listed.

1.3. In respect of the above, following representations were received by the SEBI:

(a) adherence to the abovementioned regulation will adversely impact availability of unlisted debt securities for Category II AIFs; and

(b) unlisted debt securities in which Category II AIFs have invested will be required to be listed if the issuer entity proposes to issue any listed debt securities in future.

2. Requirement under the AIF Regulations

2.1. As per regulation 17(a) of the SEBI (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”), a Category II AIF is required to invest ‘primarily’ in unlisted companies.

2.2. SEBI vide Master Circular for Alternative Investment Funds, Master Circular no. SEBI/HO/AFD/PoD1/P/CIR/2023/130 dated July 31, 2023 (superseded by Master Circular no. SEBI/HO/AFD-1/AFD-1-PoD/P/CIR/2024/39 dated May 7, 2024) has clarified that the:

(a) term ‘primarily’ is indicative of where the main thrust of investment by a Category II AIF should be; and

(b) investment portfolio of a Category II AIF ought to be more in unlisted securities as against the aggregate of other investments.

2.3. In this regard, it has been noted in the Consultation Paper that out of total 1,383 (one thousand three hundred eighty three) schemes of Category II AIFs, 192 (one hundred ninety two) have 50% (fifty percent) or more of their total investment in unlisted debt securities. It was further noted that prospective investments of debt fund schemes which significantly invest in unlisted debt securities, may be impacted due to a possible shrinking of universe of investment opportunities in unlisted debt securities in future due to compliance with the LODR Regulations as mentioned above.

3. Issues under consideration

3.1. Category II AIFs, by virtue of being closed ended funds and with the mandate of primarily investing in unlisted securities, assume both liquidity and credit risk. The AIFs by assuming such risk, play a crucial role in providing capital infusion to industries that may not have access to traditional source of funding or at a stage to make a public offering.

3.2. In order to counter any shrinkage of investment opportunities in unlisted debt securities, the scope of primarily investing in unlisted securities may be expanded to include listed debt securities. However, the same may be enabled in such a manner that Category II AIFs still assume the due credit risk.

3.3. It was considered that credit rating of securities would be the appropriate parameter to ascertain credit risk profile. Further, the issue was also deliberated upon by the Alternative Investment Policy Advisory Committee (“AIPAC”). AIPAC recommended that along with the parameter based on credit rating, SEBI may consider exploring a parameter based on privately placed listed debt securities. However, since a parameter based on private placement of listed debt securities does not necessarily align with the role envisaged for Category II AIFs, it was observed that such a parameter may not be considered for devising the criteria for investment by Category II AIFs.

4. Proposal

The following proposal has been made under the Consultation Paper and public comments have been sought by February 28, 2025:

“Category II Alternative Investment Fund to invest more than 50% of their total investible funds in unlisted securities, and/or listed debt securities having credit rating ‘A’ or below, directly or through investment in units of other AIFs.”

5. Our views

The proposal to expand Category II AIFs’ investment mandate represents SEBI’s pragmatic response to evolving market dynamics, particularly in light of the recent amendments to the LODR Regulations. While maintaining AIFs’ fundamental role in assuming credit risk and providing capital to entities with limited funding access, the proposal to include listed debt securities rated ‘A’ or below offers a balanced solution to the potential shrinkage of the unlisted debt securities universe.

Furthermore, listed debt securities also offer the benefit of enforcement under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, which would otherwise not be available to AIFs. This proposed change could therefore offer welcome flexibility to Category II AIFs, while ensuring they continue to serve their intended market function.

A copy of the Consultation Paper can be accessed here.

This update has been contributed by Aastha (Partner) and Aditi Singh Kashyap (Senior Associate).

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