Mint Explainer: Why AIFs want to pledge shares of investee companies

livemint.com:

Mint explains Sebi's reservation on such arrangements and why there’s a rethink now. Sebi’s primary concern was regarding losses that investors might suffer should a portfolio company default.

The regulator noted in the consultation paper, “By creating pledge or charge or hypothecation by an AIF on its assets to secure the loans obtained by its investee companies, investors may lose their entire equity in the investee company in case such investee companies default on repayment of their loan/debt." Therefore, creating pledges on assets of the investee companies by the AIF may, at times, not be in the best interest of the investors, the regulator added. Most investments of AIFs are in early-stage ventures, start-ups, small enterprises, social ventures and infrastructure projects, many of which carry a risk of failure.

Its other concern was regarding the systemic risk to the financial services ecosystem posed by large-scale defaults by portfolio companies where AIFs had pledged their shares. Sebi’s existing regulations explicitly bar category I and II AIFs from indirect borrowings or additional leverage.

“Large amounts of such additional leverage, particularly if some of it is also layered and stacked across multiple entities, can become a source of systemic risk to the financial services ecosystem," the consultation paper said. Sebi has noted that global securities markets regulators such as the US Securities and Exchange Commission and UK Financial Conduct Authority as well as the International Organization of Securities Commissions have also flagged the risk of systemic financial sector leverage on the back of private capital investments.