Funding winter, illiquid startups and Sebi guidelines hamper AIF exits

And such a disaster is now really brewing within the AIF business, which incorporates each enterprise capital (VC) and personal fairness (PE) funds in India. Several AIFs, valued at ₹17,500 crore, are set to run out inside the subsequent 16 months, however are dealing with issues winding down. They blame it on the dearth of liquidity and authorized constraints ensuing from a funding winter. AIFs have already exercised one extension however have now sought one other. But, this one has a rider—a bunch of Sebi guidelines, which consultants say are tough for the funds to adjust to.

Exit choices

After their time period lastly involves an finish, AIFs could have two choices. The first is a liquidation scheme—a closed-ended scheme that purchases the models of the expiring AIF. Once this scheme is initiated, the AIF can’t settle for any further funds and can revert to its unique tenure however won’t be eligible for extensions.

The second choice is in-specie distribution, whereby the AIF transfers its stake in portfolio firms, reminiscent of fairness shares, compulsorily convertible choice shares (CCPS), compulsorily convertible debentures (CCD), and many others., to buyers on a pro-rata foundation. For occasion, if the AIF holds stakes in 10 startups, buyers can be distributed the shares of all 10 startups, which can be deposited of their demat accounts instantly. But this may be accomplished solely after acquire approval from 75% of buyers by worth. In case it doesn’t get this approval, the AIF should go for a pressured in-specie distribution. Herein, the AIF is obligated to switch its stake to all buyers, regardless 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 supervisor to safe bids for 25% of the portfolio earlier than continuing with both the liquidation scheme or in-specie distribution.

Note that for documenting the efficiency of the fund supervisor, the web asset worth (NAV) is recorded both on the value when 25% of the bids are organized, or at a set worth of ₹1 if no such bids are secured.

In an actual world state of affairs, it might be tough for the fund supervisor to draw bids for under 25% of the portfolio at a good value. In practicality, if the fund supervisor have been capable of finding patrons for 1 / 4 of the portfolio, it’s probably that there would have been curiosity in buying the complete portfolio. This requirement might result in delays or hinder the exit course of, as discovering appropriate patrons for only a portion of the belongings is probably not as simple as promoting the complete portfolio.

Rules and contradiction

Sebi mandates that so as to proceed with the liquidation scheme or in-specie distribution, the fund supervisor must acquire approval from 75% of buyers by worth. If 90% of buyers comply with the liquidation scheme, Sebi guidelines stipulate that the dissenting shareholders (10%) have to be paid off from the 25% bids organized. This creates a precedence distribution waterfall mechanism, the place sure buyers are given preferential remedy over others. Sebi sometimes prohibits such preferential remedy, as it may result in inequitable outcomes and should not align with the ideas of honest and equal remedy for all buyers. In different phrases, the 2 guidelines appear to contradict each other.

Exit methods

In the occasion that the fund supervisor manages to rearrange bids for 25% of the portfolio, buyers who had beforehand given their approval for both the liquidation scheme or in-specie distribution might revoke their consent and choose to liquidate their investments from the 25% bids. This state of affairs can create complexities for the fund supervisor and disrupt the exit course of. The fund supervisor might face challenges in reconciling the pursuits of buyers who now need to change their exit preferences, resulting in potential disputes and delays in finalizing the exit technique.

Tax liabilities

The swapping of models from the unique VC fund ‘A’ to the liquidation scheme ‘B’ can doubtlessly result in vital tax liabilities for buyers, leading to liquidity and tax fee points. When 75% of buyers agree for the liquidation scheme ‘B’ and 25% portfolio bids are organized, the swapping of models from ‘A’ to ‘B’ turns into a taxable occasion.

Furthermore, as per Section 194LBB of the Income Tax Act, the AIF is remitted to impact tax deducted at supply (TDS) at a charge of 10%. The mixture of TDS deductions by the AIF and the long run capital positive aspects (LTCG) tax fee by buyers can create liquidity challenges as buyers might have to make tax funds with none money positive aspects. This state of affairs can doubtlessly pressure investor money flows.

“Sebi’s pointers are a non-starter,” expressed Deepak Aggarwal, chief monetary officer at Singular India Opportunities Fund. He emphasised two crucial considerations: First, they fail to deal with funds whose liquidation interval has already ended, leaving them with out clear exit methods. Secondly, whereas the rules purpose to guard buyers, these can’t cease a firesale by AIFs. Such a state of affairs might lead to substantial losses for each dissenting and remaining buyers.

In-specie distribution

When a VC fund holds shares of a portfolio startup (X) and decides to switch these shares to its buyers, the switch course of could also be topic to restrictions if talked about within the Articles of Association (AOA) of the startup. If the AOA explicitly states that transfers of shares are topic to sure circumstances or require the approval of the board of administrators, the portfolio startup’s board has the best to reject the switch.

In such a state of affairs, the board of the startup can train its discretion to guage the switch request and should reject it if it believes the switch doesn’t align with the corporate’s strategic goals, current shareholders’ pursuits, or if there are any authorized or regulatory considerations.

If a VC fund holds stakes in international startups and considers an in-specie distribution or switch of shares to buyers, it should navigate potential compliance violations and conflicts amongst totally different investor teams.

Individual buyers, notably excessive internet price people (HNIs), might face conflicts because of the limitations of the liberalized remittance scheme (LRS), which restricts resident people from remitting greater than $250,000 yearly for varied functions, together with international investments. Also, household places of work structured as trusts might encounter difficulties accepting in-specie distributions of international startup shares, as trusts are sometimes not allowed to carry international unlisted securities.

Additionally, institutional buyers reminiscent of insurance coverage firms and non-banking monetary firms (NBFCs) could also be prohibited from instantly investing in international shares or might require the Reserve Bank of India (RBI) approval, which might delay liquidation proceedings.

Foreign buyers holding shares in startups positioned in unfavourable jurisdictions could also be hesitant to obtain shares by way of an in-specie distribution attributable to challenges in remitting the inventory abroad to keep away from double taxation avoidance settlement (DTAA) problems.

Fair worth and Fema violation

As per Foreign Exchange Management Act (Fema) pointers,the honest market worth, or FMV, of unlisted shares (CCPS) needs to be calculated by two impartial service provider bankers in accordance with worldwide valuation methodologies. But this can lead to issues as properly. Suppose two impartial valuers assign a FMV of ₹600 and ₹650, whereas the bids acquired are at an NAV of ₹300 (50% decrease attributable to firesale), then swapping of shares for the liquidation scheme beneath the FMV is taken into account to be in violation of Fema.

Sebi guidelines additionally mandate a write off of the investments if an investor doesn’t comply with a liquidation scheme or in-specie distribution, resulting in the scheme’s closure. Aggarwal sought to know who could be chargeable for effecting TDS in such instances and the way the cash could be returned to buyers.

Risks galore

Startup investing is glamorous and excessive internet price buyers are attracted by high-profile listings. However if the AIF fails to exit its investments inside the tenure of the fund , each the AIF and its buyers will discover themselves coping with a maze of advanced liquidation guidelines. Unless the principles are amended, buyers needs to be very cautious about chasing the startup dream by way of AIFs.