Alternative investment fund managers face a slew of new regulations designed to protect investors in India’s burgeoning AIF sector.
Last week the Securities and Exchange Board of India (SEBI) introduced a new framework for the governance of alternative investment funds (AIFs), clarifying the borrowing rules for these funds to enhance transparency, protect investors and ensuring the financial stability of the rapidly growing – but sometimes inherently risky – AIF sector.
The new regulations, announced on 19 August, are one pillar of SEBI’s ongoing efforts to refine the investment landscape in India, particularly for high-net-worth individuals and institutional investors who constitute the primary clientele for AIFs. The AIF industry in India has seen robust growth in recent years, with a November 2023 report from the Indian Association of Alternative Investment Funds (IAAIF) estimating the size of the market at more than USD 84 billion, a five-fold increase since 2024.
KEY PROVISIONS
The rules outline updated and more stringent conditions under which AIFs can engage in borrowing, with fundamental implications for their operational strategies, with the rules stipulating that AIFs can now borrow only up to 25% of their investible funds, a hefty reduction from the hitherto higher, often unregulated thresholds. The cap is applicable across all categories of AIFs, including Category I (social ventures, infrastructure, etc), Category II (private equity funds, debt funds, etc), and Category III (hedge funds).
Funds are also required to ensure that any borrowing is aligned with their investment strategy and objectives as disclosed to investors, a provision clearly aimed at preventing excessive risk-taking that may arise from leveraging, particularly in the more aggressive Category III AIFs.
Disclosure requirements are also tightened, with AIFs now mandated to provide detailed information on their borrowing levels and terms in their quarterly reports to SEBI as well as in communications with investors. SEBI has stipulated that any deviation from funds’ disclosed borrowing strategy must be communicated to investors and the regulator promptly so that funds are not misused and investors are not exposed to unforeseen risks.
KEEPING AN EYE ON RISK
With some AIFs by their very nature carrying more risk than other more conventional investments, SEBI has introduced mandatory risk management practices, including the stress testing of portfolios. Funds will now be required to conduct regular stress tests to evaluate the potential impact of market volatility, liquidity shortages and other adverse conditions on their portfolios and these tests must take into account the effects of leverage and be reported to SEBI on an annual basis. AIFs must also now establish a comprehensive risk management framework that addresses liquidity risk, credit risk and operational risk.
The board has placed restrictions on borrowing from foreign entities. While foreign investments in AIFs are allowed, overseas sources will now be subject to stricter scrutiny and regulatory approval.
IMPLICATIONS
The new rules are likely to have a profound impact on the AIF industry in India. Fund managers, particularly those operating Category III AIFs, which are more reliant on leverage for generating returns, may need to reassess their strategies. The borrowing cap and the strict disclosure requirements could limit their ability to engage in high-risk, high-reward investments but this could also lead to a more disciplined approach to investment, potentially reducing the likelihood of large-scale defaults and market disruptions. On the other hand, investors are likely to benefit from the enhanced transparency and risk management practices mandated by the new rules.
By imposing borrowing caps, enhancing disclosure requirements and introducing robust risk management practices, it is clear that SEBI is setting out to strike a balance between promoting the growth of the increasingly valuable AIF industry and safeguarding the interests of investors. As the industry adjusts to these changes, the long-term impact on India’s financial markets remains to be seen, but the emphasis on stability and transparency should provide some benefit to the broader economy.
