SEBI Revises AIF Regulations to Address Investment Challenges

Recasting the Investment Framework: A Comprehensive Analysis of SEBI’s 2025 Amendment to Regulation 17(a) of the AIF Regulations

Introduction

In a significant regulatory development, the Securities and Exchange Board of India (“SEBI”) notified the Alternative Investment Funds (Amendment) Regulations, 2025 on 21^st May 2025 revising the investment framework under Regulation 17(a) of the SEBI AIF Regulations 2012 (“AIF Regulations”). The amendment specifically pertains to Category II AIFs and their investment eligibility criteria. In light of broader capital market reforms and changing debt market, this move is aimed at addressing structural inconsistencies and enhancing capital flexibility. This article shall discuss the original framework concerning Regulation 17(a) of the AIF Regulations. The frictions caused between AIF Regulations and the 2023 amendment to the SEBI (Listing Obligations and Disclosure Requirements), 2015 (“LODR Regulations”), and SEBI’s response in form of a consulation paper followed by a board meeting ultimately leading to the 2025 amendment. The author shall discuss the relevant provisions of the amendment and assess implications of such amendment.

The Original Framework: Regulation 17(a) and Interpretation

Category II AIFs comprises of private equity funds, debt funds and real estate funds that do not undertake leverage or trading other than for hedging. They operate under a mandate focused on unlisted securities. Prior to the amendment, Regulation 17(a) provided that:

“Category II AIF shall invest in investee companies or in the units of Category I or other Category II AIF as maybe disclosed in the placement memorandum”.

This was followed by an explanation stating:

“Category II AIF shall invest primarily in unlisted companies directly or through investment in units of other AIFs”.

While indicative of investment focus, the word ‘primarily’ left an ambiguous room for interpretation.

To address this, SEBI issued a Master Circular for AIF dated 31^st July 2023 clarifying that the term ‘primarily’ means that more than 50 percent of the investible funds of a Category II AIF must be used in unlisted securities. This clarification by the SEBI effectively formalised a minimum threshold for unlisted investments under Regulation 17(a) of AIF Regulations.

Regulatory Friction: LODR Amendments & Listing Mandates

In move to push further for transparency and market integrity particularly in debt markets, SEBI introduced an amendment to LODR Regulations on 20^th September 2023. The amendment resulted in the insertion of Regulation 62A. It mandated that all the listed entities that have outstanding listed non-convertible debt securities (“NCD”) or propose to list NCDs on or after 1^st January 2024 must necessarily list all the subsequent NCD issuances on recognised stock exchanges.

While this change was progressive in intent, it had unintended consequences for Category II AIFs. Owing to the 2023 LODR amendment, the companies must now list their debt securities. This can result in a situation where fewer unlisted debt securities are available in the market. Since Category II AIF are meant to invest in private/unlisted assets, they will be left with fewer suitable options. With a shrinking pool of unlisted debt instruments, these funds began facing compliance hurdles in meeting their 50 percent minimum investment requirement under Regulation 17(a) of AIF Regulations.

SEBI’s Response

The conflict between regulatory frameworks could be identified as on one hand promoting listing of debt instruments and on the other, restricting Category II AIFs to ‘primarily’ unlisted securities. Recognising this conflict, SEBI, on 7^th February 2025, released a consultation paper proposing a review of Regulation 17(b) to align with the AIFRegulations with market practicalities. Following public comments and internal deliberation through its board meeting dated 24^th March 2025, SEBI resolved to ‘reclassify’ listed debt instruments.

It was decided that listed securities rated ‘A’ or below by SEBI registered credit rating agencies shall be treated as equivalent to unlisted securities for the purpose of compliance with the minimum investment requirement under Regulation 17(a). This clarification not only provided certainty but also widened the investable universe for AIFs.

The Current Amendment

The 21^st May 2025 amendment notification of AIF Regulations formally incorporates the above decision of minimum investment requirements. It amends the explanation to Regulation 17(a) to read that as follows:

“Category II AIF shall invest primarily in unlisted securities and/or listed debt securities (including securitised debt instruments) which are rated ‘A’ or below by a credit rating agency registered with the Board, directly or through investment in units of other AIFs, in the manner as may be specified by the Board”

While allowing SEBI to further specify conditions to ensure risk control, this brings about important changes. First, it includes ‘listed debt securities’ rated A or below within the permitted investment scope of Category II AIFs. Second, it equates such listed debt instruments to ‘unlisted securities’ for the purposes of regulatory compliance with the requirement to invest primarily in unlisted securities under Regulation 17(a).

Implications and Way forward

By allowing listed debt securities rated ‘A’ or below to count as ‘unlisted’ for compliance, the amendment widens the scope of investments for Category II AIFs. While the amendment opens new avenues, it will also expose investors to lower rated debt securities. The continued emphasis on disclosure in the Placement Memorandum serves as a safeguard ensuring that the investors make informed decisions. However, it is to be seen that issuance of lower rated debt instruments enhances to what extent since AIFs now have regulatory incentive to include them. The amendment harmonises the AIF Regulations with LODR Regulations whilst avoiding a scenario where compliance with one SEBI regulation would have created difficulties in complying with the other. This creates predictabililty and confidence for fund managers & investors. SEBI’s 2025 amendment through consultation highlights responsive & consultative policymaking.