SEBI Proposes Allowing AIF Investments In Lower-Rated Listed Debt

Posted On - 20 February, 2025 • By - Pooja Chatterjee

Introduction

SEBI’s recent consultation paper seeks public feedback on proposed changes to Regulation 17(a) of the SEBI (AIF) Regulations, 2012.[1] The proposal aims to ease investment restrictions for Category II AIFs, which would allow them to allocate more funds to listed debt securities rated ‘A’ or below. This is in light of the shrinking availability of unlisted debt securities due to recent amendments under Regulation 62A of the SEBI (LODR) Regulations, 2015. Public comments are invited until February 28, 2025.

Background: Impact of SEBI’s LODR Amendments on Category II AIFs Investing in Debt Securities

Regulation Governing Category II AIFs

  • Regulation 17(a) of SEBI (Alternative Investment Funds) Regulations, 2012:
    • Category II AIFs can invest in investee companies or units of Category I or other Category II AIFs as disclosed in the placement memorandum.
    • The primary investment focus of Category II AIFs should be in unlisted companies, either directly or through other AIFs.
  • Clarification by SEBI (Master Circular dated July 31, 2023):
    • The term ‘primarily’ in Regulation 17(a) indicates that Category II AIFs should allocate a majority of their investments to unlisted securities over other investment avenues.
    • As per this, Category II AIFs are required to invest more than 50% of their investible funds in unlisted securities.
  • Definition of “Debt Fund” under Regulation 2(1)(i) of AIF Regulations, 2012:
    • A Debt Fund is an AIF that primarily invests in debt securities of listed or unlisted investee companies or in securitized debt instruments.
    • This provides AIFs with the regulatory flexibility to invest primarily in debt securities.

Introduction of SEBI’s LODR Amendments (Regulation 62A, SEBI (LODR) Regulations, 2015)

Mandatory Listing of Subsequent Issuances of Non-Convertible Debt Securities (NCDs):

  1. Any listed entity with non-convertible debt securities (NCDs) already listed must list all subsequent NCDs issued on or after January 1, 2024.
  2. The listed entities that issued unlisted NCDs on or before December 31, 2023, may list those securities voluntarily.
  3. If a listed entity chooses to list NCDs after January 1, 2024, it must also list all its outstanding unlisted NCDs within three months of listing the newly issued NCDs.

Concerns Raised by AIF Industry Associations & Debt-Focused Funds

The AIF sector, particularly debt-focused funds, has raised some valid concerns about the interplay of SEBI’s regulations. There is a potential conflict: SEBI mandates that Category II AIFs prioritize unlisted securities, a reasonable objective in itself. However, the recent LODR amendments are significantly reducing the availability of unlisted debt, a key asset class for these funds. By restricting the issuance of unlisted Non-Convertible Debentures (NCDs), these amendments are shrinking the very investment pool AIFs are expected to draw from. Essentially, the regulations seem to be pulling in opposite directions.  

The situation is further complicated by the fact that even if an AIF manages to identify a suitable unlisted debt investment, its unlisted status is not guaranteed. The LODR rules stipulate that any unlisted debt issued after January 1, 2024, can be compelled to become listed if the issuing company subsequently decides to list any of its debt instruments. This introduces a significant degree of uncertainty for AIFs, which makes long-term investment strategy and portfolio management exceedingly challenging.

Category II Debt Funds are especially vulnerable. Their investment thesis hinges on access to unlisted debt. These regulatory changes, particularly rule 62A(3), pose a serious threat to their operational model. The risk of unlisted debt investments being reclassified as listed could severely disrupt their intended strategy.

Impact of LODR Amendments on Category II AIFs

  • Limited Issuance of Unlisted Debt Securities:
    • Listed entities with outstanding listed NCDs can only issue listed debt securities from January 1, 2024, onward.
    • The availability of unlisted debt securities for AIF investments is likely to decrease.
  • Mandatory Future Listing of Currently Unlisted NCDs:
  • Any unlisted debt security issued after January 1, 2024, may be required to be listed later if the issuer decides to list any other debt security in the future.
    • This forces Category II AIFs into compliance with LODR amendments, despite their regulatory requirement to focus on unlisted securities.
  • Shrinking Investment Universe for AIFs:
    • The overall availability of unlisted debt securities for investment may shrink due to compliance constraints.
    • Category II AIFs focusing on unlisted debt may struggle to maintain their portfolio composition as mandated under Regulation 17(a).

Analysis of Periodic Data on AIF Investments in Debt Securities (as of September 2024)

  • Total Category II AIF Schemes: 1,383
  • Schemes investing in debt securities: 330
  • Schemes investing more than 90% in unlisted debt securities: 147
  • Schemes investing more than 75% in unlisted debt securities: 165
  • Schemes investing more than 50% in unlisted debt securities: 192

Issues under Consideration

Industry Concerns and Regulatory Deliberations

The concerns raised by industry stakeholders regarding investment restrictions on Category II AIFs were reviewed and deemed valid after internal deliberations.

Risk Assumption and Market Role of Category II AIFs

  • Category II AIFs, being closed-ended funds with a mandate to invest primarily in unlisted securities, inherently assume both liquidity risk and credit risk.
  • By taking on these risks, they provide crucial funding to companies that may not have access to traditional financing options, including those not yet ready for a public offering.

Impact of LODR Amendments on Investment Scope

  • The recent LODR amendments could shrink the universe of unlisted debt securities available for investment.
  • Given this, it is worth considering whether the requirement for Category II AIFs to invest primarily (>50%) in unlisted securities should be broadened to include listed debt securities as well.
  • However, this expansion must ensure that Category II AIFs continue to bear credit risk, aligning with their role in the financial ecosystem.

Credit Rating as a Parameter for Risk Evaluation

  • To maintain the intended risk exposure of Category II AIFs, credit rating has been suggested as a key metric for investment decisions.
  • Specifically, it is recommended that Category II AIFs be encouraged to invest in listed debt securities rated ‘A’ or below, which aligns with their higher risk appetite.

Proposed Regulatory Adjustment

  • To mitigate the impact of shrinking unlisted debt investment opportunities, the requirement for Category II AIFs to allocate more than 50% of their investible funds to designated securities (currently unlisted securities) may be adjusted.
  • Investments in listed debt securities with a credit rating of ‘A’ or below could also count toward this requirement.

Deliberations by the Alternative Investment Policy Advisory Committee (AIPAC)

  • AIPAC examined the matter and recommended that SEBI consider using both credit rating-based criteria and privately placed listed debt securities as parameters for investment by Category II AIFs.
  • However, since private placement of listed debt does not fully align with the intended role of Category II AIFs (as outlined in Point 2), it is not recommended as a valid parameter for regulatory criteria.

Proposal for Consideration

Based on AIPAC recommendations and internal discussions, SEBI is seeking public feedback on the following proposal:

  • Investment Flexibility for Category II AIFs: Category II AIFs should be allowed to invest more than 50% of their total investible funds in a combination of:
    • Unlisted securities, and/or
    • Listed debt securities with a credit rating of ‘A’ or below.
  • Investment Modes: These investments can be made directly or through investments in units of other AIFs.

Conclusion

The proposed adjustment to Regulation 17(a) is a pragmatic response to the evolving debt market landscape, balancing regulatory consistency with market flexibility. By allowing Category II AIFs to count investments in lower-rated listed debt securities toward their mandated allocation, SEBI acknowledges both the shrinking universe of unlisted debt and the critical role of AIFs in financing riskier ventures. However, the shift also raises questions about credit risk concentration and investor protection, making it essential for stakeholders to weigh in.

[1] https://www.sebi.gov.in/reports-and-statistics/reports/feb-2025/consultation-paper-on-review-of-regulation-17-a-of-sebi-aif-regulations-2012-with-the-objective-of-ease-of-doing-business_91737.html.

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