Amidst the challenging circumstances caused by the COVID-19 pandemic, numerous funds find themselves confronted with various issues regarding the duration of their operations, encompassing possibilities such as extension, early conclusion, and dissolution.

In this edition of our monthly compilation, we delve into the realm of Category I and Category II Alternative Investment Fund/s ("AIF" or "fund"), closed-end funds that are registered with the Securities and Exchange Board of India ("SEBI") in accordance with the SEBI (Alternative Investment Funds) Regulations of 2012 (referred to as the "AIF Regulations").

As per Regulation 13(1) of the AIF Regulations, the term of a Category I and Category II Alternative Investment Fund must be established at the time of application submission. Nevertheless, extensions to the fund's tenure, for a maximum duration of two years, can be granted with the consent of at least two-thirds of investors based on their investment value.

Typically, an AIF is designed to terminate automatically upon the expiration of its predetermined tenure as outlined in the pertinent fund documents. However, the governing documents of AIFs also include provisions for "early termination," which detail the circumstances under which an AIF may be dissolved prior to its intended automatic conclusion. The AIF Regulations also address the possibility of early termination.

Fund managers and investors usually strive to sustain the fund until its originally envisioned tenure, particularly in long-term funds where investments are expected to appreciate over time. The primary objective is to maximize portfolio value and align the timing of the AIF's tenure accordingly. The AIF should be able to achieve an "orderly exit" from the portfolio, enabling it to realize the anticipated exit value that corresponds to the risk-return profile of the asset class.

The AIF Regulations draw a distinction between the winding-up (or termination) and liquidation of an AIF, with the latter anticipated to occur within one year following the former, as we will explore further. This differentiation becomes significant in the context of investor giveback provisions.

Winding Up of AIFs- Legal Provisions

Regulation 29 of the AIF states that:

  • On expiry of term
  • 75% of investors by value of their investment pass a resolution for winding up
  • On direction of SEBI
  • On expiry of term
  • 75% of investors by value of their investment pass a resolution for winding up
  • On direction of SEBI
  • As per the provisions of Companies Act 2013
  • Winding up as per the provisions of act under which that body corporate is incorporated

Furthermore, the winding-up process of an AIF must also adhere to the applicable laws under which it is incorporated. For instance, the Limited Liability Partnerships Act of 2008 states that an LLP (Limited Liability Partnership) should be compulsorily wound up if it operates with fewer than two partners for a period exceeding six months. Hence, if an AIF is established as an LLP and operates with less than two partners for a duration exceeding six months, it may be subject to winding up.

Additionally, the AIF Regulations grant authority to the trustee of an AIF structured as a trust to initiate the winding-up process without requiring investor consent. The trustee must determine that such winding up is in the best interests of the AIF's investors.

Once the winding-up process commences, the trustee, board of directors, or designated partners (depending on the structure) are obligated to inform both SEBI and the investors about the circumstances leading to the winding up. Furthermore, the AIF Regulations mandate the wound-up AIF to: (a) refrain from making any further investments from the date of such notification; and (b) liquidate its assets within one year from the date of the aforementioned notification, distributing the proceeds to investors after fulfilling any outstanding liabilities.

In the realm of winding up a closed-end fund, certain fund terms come into play, either working in harmony with or potentially influencing the process. Here, we delve into these terms and their implications:

Early Termination

Under circumstances not governed by the AIF Regulations, early termination may occur if the investment manager determines that continuing the AIF would result in a violation of the law. Additionally, if certain misconduct relating to the manager or the AIF has been established through adjudication, and the limited partners (LPs) collectively decide to wind up the fund, termination on such grounds can have economic consequences for the AIF manager.

Failure to Replace the Investment Manager

Should the AIF manager be removed, and investors fail to find a replacement manager through a 75% vote by value, dissenting investors have the option to exit the AIF. However, the outgoing AIF manager is not incentivized under the AIF Regulations to provide an exit for dissenting investors. Consequently, in such cases, the AIF manager is likely to gravitate towards winding up the AIF.

Transfer of Units

Upon winding up, the AIF manager is granted a one-year period to liquidate the AIF. During this time, the transfer of AIF units, even to affiliates, is typically not permitted. This restriction allows for the proper assessment of LPs' liabilities and aims to prevent administrative inefficiencies, including those related to time and cost, considering the statutory timelines involved.

Parallel Funds or AIVs

In situations involving parallel funds or alternative investment vehicles, where the portfolio holdings of such vehicles overlap with the main fund, the termination of the main fund can trigger the termination of the parallel funds, even in the absence of any triggering events specifically related to those funds. This occurs when it becomes legally impracticable to segregate the portfolio holdings of the parallel funds.

Restructuring/Rebranding of the AIF

At the time of exit, many investment managers consider selling the investment vehicle, with its existing portfolio, as a going concern to a new replacement general partner (GP) for their own set of LPs. However, it remains uncertain whether, in the context of Indian AIFs, only the AIF registration is wound up while the entity holding such registration (e.g., a trust, an LLP, a company) applies for a new AIF registration for the new GP. Additionally, the applicability of section 56(2)(x) of the Indian Income-tax Act, 1961 is often discussed concerning units of an AIF. The potential for double taxation arises if LPs are taxed both on the consideration amount for the AIF units during LP secondaries and on the income received from such units when the AIF makes distributions to them.

Confidentiality Provisions

Throughout the fund's tenure, investors have a statutory entitlement, as well as commercial expectations, to receive reports and information from the manager. Such information may include confidential details about the manager, trustee, portfolio companies, and even associates and affiliates. This information could be price-sensitive and potentially used to gain unfair competitive advantages. Consequently, investors are typically bound by confidentiality obligations for an agreed-upon period after winding up and liquidation.

In Conclusion

Termination is an essential phase in the life cycle of a fund, much like its formation. Various factors can lead to terminating a fund, such as weak investor demand, unfavorable economic conditions, or commercial decisions made by the entity overseeing the fund's operation. Once the decision to terminate the AIF is made and the AIF is officially terminated, the liquidator proceeds with liquidating the AIF's assets within a predetermined timeframe and in accordance with the constitutional documents