Framework For Issuance Of Subordinate Units: A Middle Ground To Meet Valuation Expectations.

Framework For Issuance Of Subordinate Units: A Middle Ground To Meet Valuation Expectations.

Introduction

In order to provide flexibility and meet valuation expectations of sponsors, sponsors group and/or their associates, the securities market regulator, Securities and Exchange Board of India (“SEBI”) recently brought out SEBI (Infrastructure Investment Trusts) (Amendment) Regulations 2024 (“SEBI Amendment”). The SEBI Amendment has been rolled out to provide comprehensive framework for issuance of subordinate units by privately placed Infrastructure Investment Trusts (“InvITs”).

An InvITs are trusts registered with SEBI in accordance with SEBI (Infrastructure Investment Trusts) Regulations 2014. These are investment vehicles that raise funds by issuing units to the investors and invest those funds primarily in assets of entities involved in infrastructure sector.

The subordinate units are financial instruments that carry inferior voting rights or distribution rights than ordinary units issued by InvITs but can be reclassified as ordinary units after specific period.

Sponsor is a company, limited liability partnership or a body corporate who establishes/settles InvITs. A sponsor needs to have net worth not less than INR 100 Crores (Rupees Hundred Crores only) in case of a body corporate or a company, or net tangible assets of value not less than INR 100 Crores (Rupees Hundred Crores only) in case of a limited liability partnership.

Earlier, the issuance of subordinate units was allowed under Regulation 4(2)(h) of the SEBI (Infrastructure Investment Trusts) Regulations 2014, which stated that:

“no unit holder of the InvIT enjoys superior voting or any other rights over another unit holder and there shall not be multiple classes of units of InvITs.

Notwithstanding the above, subordinate units may be issued only to the sponsors and its associates, where such subordinate units shall carry only inferior voting or any other rights compared to other units....”

However, due to the absence of detailed guidelines for issuance of subordinate units, market participants had to operate in a grey area in order to ascertain details such as lock in period, maximum limit for issuance of subordinate units, voting rights etc. thereby requiring comprehensive and detailed framework for issuance of subordinate units.

Rationale for Issuing Subordinate Units to Sponsors, Sponsors Group and/or their Associates

The issuance of subordinate units aims to address valuation discrepancies that can occur due to differing perceptions of asset value between the sponsor and the InvIT. This situation happens in event the sponsor, sponsors group and/or their associates are transferring their assets to InvITs and sponsors’ valuation of assets is different from that of InvITs.

In such a case, to combat such difference in value perception of assets, subordinate units are issued to sponsors, sponsor group and their associates as consideration. This is a flexible option to sponsors, sponsor group and their associates to meet their valuation expectations, as it provides option for conversion of subordinate units into ordinary units of InvITs, in case performance benchmark (as agreed upon between the InvITs and sponsors, sponsor group and/or its associates) is achieved.

An in-depth analysis of the SEBI Amendment

The SEBI Amendment has provided detailed framework for InvITs for issuance of subordinate units to sponsor, its associates and the sponsor group by way of initial offer or any offer after initial offer. Some important features of the subordinate units, as laid down in the SEBI Amendment, are as follows:

a. Units to be Demat form:

Primarily, the SEBI Amendment provides that subordinate units shall be in dematerialised form (with an International Securities Identification Number) and shall not carry any voting rights or distribution rights.

b. Determination of Value:

For valuation of subordinate units, the SEBI Amendment provides that the price of subordinate units shall be determined according to the pricing guidelines as applicable to ordinary units.

c. Lock in Period

In terms of the SEBI Amendment, minimum period between issuance of subordinate units and its reclassification into ordinary shares shall be 3 (three) years.

d. Maximum Limit for issuance of Subordinate Units

Another striking feature of the SEBI Amendment is maximum limit upto which subordinate units can be issued by InvITs. In terms of the SEBI Amendment, subordinate units issued at the time of acquisition of an infrastructure project by the InvITs shall not exceed 10% (ten percent) of the acquisition price of the infrastructure project.

As the conversion or reclassification of subordinate units to ordinary units results in dilution of proportionate unitholding for the existing unitholders of the InvITs, therefore, setting a limit on the number of subordinate units by SEBI would help mitigate the impact of this potential dilution.

Further, in order to ensure that other unitholders are aware about impact of reclassification of subordinate units to ordinary shares, the SEBI Amendment provides that the investment manager of InvITs should disclose terms and conditions including impact of potential reclassification of subordinate units into ordinary shares in the term sheet.

The SEBI Amendment also provides that total number of outstanding subordinate units shall not exceed 10% (ten percent) of the total number of outstanding ordinary units issued by InvITs.

e. Transfer of Subordinate Units.

The SEBI Amendment clearly states that subordinate units shall be locked in till its reclassification into ordinary units and that it cannot be transferred to any person except the sponsor, its associates and the sponsor group entities. Transfer of subordinate units should be reported within one working day to the recognised stock exchange.

f. Entitlement Date and Performance Benchmark

Each subordinate units issued to sponsors, sponsors group and/or their associates can be reclassified to ordinary units, subject to meeting predefined expectation known as performance benchmark. The performance benchmark shall be quantifiable, objective, based on audited financial statements and should be clearly defined in the term sheet pertaining to issuance of subordinate units.

In order to keep track of performance benchmark of subordinate units, investment manager shall be responsible to report progress of performance benchmark on regular intervals to SEBI. Also, the investment manager shall disclose such progress in the annual report of InvITs.

Conclusion

The SEBI Amendment highlights significant steps taken by SEBI in order to provide flexible option to market participants in asset acquisition transactions. This framework addresses longstanding ambiguities surrounding the issuance of these units and fosters a more robust and transparent environment for InvITs, facilitating efficient capital raising while safeguarding investor interests.

Disclaimer: This article was first published in the S&A Law Offices - 'Indian Legal Impetus' newsletter in June 2024.