And such a crisis is now actually brewing in the AIF industry, which includes both venture capital (VC) and private equity (PE) funds in India. Several AIFs, valued at ₹17,500 crore, are set to expire within the next 16 months, but are facing problems winding down. They blame it on the lack of liquidity and legal constraints resulting from a funding winter. AIFs have already exercised one extension but have now sought another. But, this one has a rider—a host of Sebi rules, which experts say are difficult for the funds to comply with.
Exit options
After their term finally comes to an end, AIFs will have two options. The first is a liquidation scheme—a closed-ended scheme that purchases the units of the expiring AIF. Once this scheme is initiated, the AIF cannot accept any additional funds and will revert to its original tenure but will not be eligible for extensions.
The second option is in-specie distribution, wherein the AIF transfers its stake in portfolio companies, such as equity shares, compulsorily convertible preference shares (CCPS), compulsorily convertible debentures (CCD), etc., to investors on a pro-rata basis. For instance, if the AIF holds stakes in 10 startups, investors will be distributed the shares of all 10 startups, which will be deposited in their demat accounts directly. But this can be done only after obtain approval from 75% of investors by value. In case it does not get this approval, the AIF will have to go for a forced in-specie distribution. Herein, the AIF is obligated to transfer its stake to all investors, irrespective of their consent.
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Bids and challenges
One of the challenges posed by Sebi’s new provisions for AIF exits is the requirement for the fund manager to secure bids for 25% of the portfolio before proceeding with either the liquidation scheme or in-specie distribution.
Note that for documenting the performance of the fund manager, the net asset value (NAV) is recorded either at the price when 25% of the bids are arranged, or at a fixed value of ₹1 if no such bids are secured.
In a real world scenario, it may be difficult for the fund manager to attract bids for only 25% of the portfolio at a fair price. In practicality, if the fund manager were able to find buyers for a quarter of the portfolio, it is likely that there would have been interest in acquiring the entire portfolio. This requirement could lead to delays or hinder the exit process, as finding suitable buyers for just a portion of the assets may not be as straightforward as selling the entire portfolio.
Rules and contradiction
Sebi mandates that in order to proceed with the liquidation scheme or in-specie distribution, the fund manager needs to obtain approval from 75% of investors by value. If 90% of investors agree to the liquidation scheme, Sebi rules stipulate that the dissenting shareholders (10%) must be paid off from the 25% bids arranged. This creates a priority distribution waterfall mechanism, where certain investors are given preferential treatment over others. Sebi typically prohibits such preferential treatment, as it can lead to inequitable outcomes and may not align with the principles of fair and equal treatment for all investors. In other words, the two rules seem to contradict one another.
Exit strategies
In the event that the fund manager manages to arrange bids for 25% of the portfolio, investors who had previously given their approval for either the liquidation scheme or in-specie distribution may revoke their consent and opt to liquidate their investments from the 25% bids. This situation can create complexities for the fund manager and disrupt the exit process. The fund manager may face challenges in reconciling the interests of investors who now want to change their exit preferences, leading to potential disputes and delays in finalizing the exit strategy.
Tax liabilities
The swapping of units from the original VC fund ‘A’ to the liquidation scheme ‘B’ can potentially lead to significant tax liabilities for investors, resulting in liquidity and tax payment issues. When 75% of investors agree for the liquidation scheme ‘B’ and 25% portfolio bids are arranged, the swapping of units from ‘A’ to ‘B’ becomes a taxable event.
Furthermore, as per Section 194LBB of the Income Tax Act, the AIF is mandated to effect tax deducted at source (TDS) at a rate of 10%. The combination of TDS deductions by the AIF and the long term capital gains (LTCG) tax payment by investors can create liquidity challenges as investors may need to make tax payments without any cash gains. This situation can potentially strain investor cash flows.
“Sebi’s guidelines are a non-starter,” expressed Deepak Aggarwal, chief financial officer at Singular India Opportunities Fund. He emphasized two critical concerns: First, they fail to address funds whose liquidation period has already ended, leaving them without clear exit strategies. Secondly, while the guidelines aim to protect investors, these cannot stop a firesale by AIFs. Such a scenario could result in substantial losses for both dissenting and remaining investors.
In-specie distribution
When a VC fund holds shares of a portfolio startup (X) and decides to transfer these shares to its investors, the transfer process may be subject to restrictions if mentioned in the Articles of Association (AOA) of the startup. If the AOA explicitly states that transfers of shares are subject to certain conditions or require the approval of the board of directors, the portfolio startup’s board has the right to reject the transfer.
In such a scenario, the board of the startup can exercise its discretion to evaluate the transfer request and may reject it if it believes the transfer does not align with the company’s strategic objectives, existing shareholders’ interests, or if there are any legal or regulatory concerns.
If a VC fund holds stakes in foreign startups and considers an in-specie distribution or transfer of shares to investors, it must navigate potential compliance violations and conflicts among different investor groups.
Individual investors, particularly high net worth individuals (HNIs), may face conflicts due to the limitations of the liberalized remittance scheme (LRS), which restricts resident individuals from remitting more than $250,000 annually for various purposes, including foreign investments. Also, family offices structured as trusts may encounter difficulties accepting in-specie distributions of foreign startup shares, as trusts are often not allowed to hold foreign unlisted securities.
Additionally, institutional investors such as insurance companies and non-banking financial companies (NBFCs) may be prohibited from directly investing in foreign shares or may require the Reserve Bank of India (RBI) approval, which could delay liquidation proceedings.
Foreign investors holding shares in startups located in unfavourable jurisdictions may be hesitant to receive shares through an in-specie distribution due to challenges in remitting the stock overseas to avoid double taxation avoidance agreement (DTAA) complications.
Fair value and Fema violation
As per Foreign Exchange Management Act (Fema) guidelines,the fair market value, or FMV, of unlisted shares (CCPS) should be calculated by two independent merchant bankers in accordance with international valuation methodologies. But this can result in problems as well. Suppose two independent valuers assign a FMV of ₹600 and ₹650, whereas the bids received are at an NAV of ₹300 (50% lower due to firesale), then swapping of shares for the liquidation scheme below the FMV is considered to be in violation of Fema.
Sebi rules also mandate a write off of the investments if an investor does not agree to a liquidation scheme or in-specie distribution, leading to the scheme’s closure. Aggarwal sought to know who would be responsible for effecting TDS in such cases and how the money would be returned to investors.
Risks galore
Startup investing is glamorous and high net worth investors are attracted by high-profile listings. However if the AIF fails to exit its investments within the tenure of the fund , both the AIF and its investors will find themselves dealing with a maze of complex liquidation rules. Unless the rules are amended, investors should be very careful about chasing the startup dream through AIFs.