Introduction
The Securities and Exchange Board of India (“SEBI”), as part of its ongoing regulatory reforms, released a consultation paper on February 7, 2025, seeking public comments to review Regulation 17(a) of the SEBI (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”). The objective is to enhance investment flexibility for Alternative Investment Funds (“AIFs”), particularly in debt securities, while addressing concerns arising from recent regulatory changes by way of allowing Category II AIFs to make up to 100% of their investment in certain listed debt securities as explained in detail below. As of now, Category II AIFs are allowed to make less than 50% of their investments in listed securities.
A key development influencing this proposal is Regulation 62A of SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (LODR Regulations), which mandated listing of unlisted debt securities of listed entities. Market participants argue that these restrictions have limited investment opportunities for AIFs, particularly in structured finance and private credit markets. By revisiting Regulation 17(a), SEBI aims to strike a balance between investment flexibility and market stability.
This blog delves into the existing legal framework, the challenges posed by Regulation 62A, SEBI’s proposed reforms, and their potential impact on the investment ecosystem.
Existing Framework of Regulation 17(a) of AIF Regulations
Regulation 17(a) of the AIF Regulations governs the investment restrictions for Category II AIFs. The Regulation states:
“Category II Alternative Investment Funds shall invest in investee companies or in the units of Category I or other Category II Alternative Investment Funds as may be disclosed in the placement memorandum;
Explanation. – Category II Alternative Investment Fund shall invest primarily in unlisted companies directly or through investment in units of other Alternative Investment Funds.”
Further to Regulation 17(a) above, the SEBI, vide clause 11.1.5 of SEBI Master Circular, dated July 31, 2023, for AIFs, issued a clarification in relation to the term ‘primarily’ in Regulation 17(a). The SEBI clarified that the investment portfolio of a Category II AIF ought to be more in unlisted securities, as against the aggregate of other investments. Accordingly, Category II AIFs are required to invest more than 50% of the investible funds in unlisted securities.
Impact of Regulation 62A of SEBI (LODR) Regulations, 2015
SEBI introduced Regulation 62A under the LODR Regulations to improve transparency and disclosure standards for investments in unlisted debt securities. While well-intended, this regulation has had a significant impact on AIFs, as it, inter alia, imposes the following constraints:
- Compulsory Listing for NCDs: This provision mandates that any listed entity planning to issue NCDs after January 1, 2024, must unequivocally list these securities on stock exchanges. The objective is clear — to subject all future NCDs issuances to market scrutiny, eliminating the shadows of opacity.
- Listing of Outstanding Unlisted NCDs: If a listed entity intends to list NCDs after January 1, 2024, it must also undertake to list all outstanding unlisted NCDs issued on or after that date within three months.
While these restrictions are aimed at enhancing transparency, they have inadvertently reduced liquidity in the private credit market and hindered AIFs’ ability to deploy capital effectively to unlisted debt securities. SEBI’s proposed amendment seeks to address this unintended consequence of its amendment, while maintaining its stance on investor protection.
SEBI’s Proposed Amendments to Regulation 17(a)
With the aforementioned LODR amendment and considering that investment opportunities in unlisted debt securities market might be shrinking, SEBI is of the view that the scope of category II AIFs to invest ‘primarily’ in unlisted securities (i.e. >50%) may be expanded to include some listed debt securities as well. However, the same may be enabled in a manner that category II AIFs continue to assume the due credit risk in the ecosystem.
SEBI’s consultation paper proposes a flexible investment framework for Category II AIFs, 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.
Thus, SEBI has proposed permitting AIFs to invest in lower-rated debt instruments, subject to enhanced risk management practices. This move is expected to expand investment opportunities for debt focussed AIFs in private credit markets.
Potential Implications of the Proposed Changes
SEBI’s proposed reforms are likely to extensively impact India’s alternative investment landscape:
- Greater Investment Flexibility: AIFs will have the freedom to explore structured credit transactions, mezzanine financing, and high-yield investments, enhancing portfolio diversification.
- Improved Market Liquidity: Relaxing investment restrictions can increase liquidity in India’s corporate bond market, enabling more efficient capital allocation.
- Higher Returns for Investors: AIFs will be able to tap into new high-yield debt opportunities, potentially offering better risk-adjusted returns.
- Boost to Economic Growth: By facilitating funding options in listed debt securities having credit rating ‘A’ or below, the proposed changes can strengthen India’s private credit market and drive economic expansion.
- Need for Enhanced Risk Controls: While increased investment flexibility is beneficial, it also necessitates stronger risk management frameworks to prevent excessive credit exposure.
Conclusion
SEBI’s proposal to relax Regulation 17(a) of AIF Regulations, 2012, is a testament to its commitment towards improving ease of doing business as an adaptive and active regulator. By removing constraints on debt investments, the revised framework seeks to enhance investment flexibility, deepen market liquidity, and boost economic growth. However, the success of these reforms will depend on ensuring adequate risk controls and maintaining investor confidence.
As the consultation process unfolds, industry stakeholders must actively engage with SEBI to refine the final regulatory framework, ensuring that it balances investment opportunities with financial stability. If executed as intended, these changes can position India as a more attractive destination for alternative debt investments in the coming years.