Part 42 addresses a scenario increasingly relevant to debt-oriented Category II AIFs — what happens, procedurally, when a portfolio company they've lent to or hold structured credit in ends up in insolvency proceedings.
Q1. Under what circumstances does an AIF become a "financial creditor" under the Insolvency and Bankruptcy Code, 2016?
An AIF becomes a financial creditor where it holds a financial debt owed by a company — typically arising from debt or debt-like instruments the fund has invested in (such as structured credit, non-convertible debentures, or other lending arrangements), as distinct from an equity investment, which does not create financial creditor status.
Q2. Do Compulsorily Convertible Debentures (CCDs) held by an AIF qualify the fund as a financial creditor, or are these treated as equity for IBC purposes?
This is a nuanced, instrument-specific and often litigated question — the classification of CCDs and similar quasi-equity instruments for IBC purposes depends on the specific terms of the instrument and relevant judicial interpretation, and shouldn't be assumed either way without specific analysis of the instrument's actual terms.
Q3. What rights does an AIF have as a financial creditor if a portfolio company enters the Corporate Insolvency Resolution Process (CIRP)?
As a financial creditor, an AIF is entitled to participate in the Committee of Creditors (CoC), which plays the central decision-making role in the CIRP — including voting on the resolution plan for the distressed company, subject to its voting share being proportionate to its financial debt relative to the total financial debt of the company.
Q4. How is an AIF's voting share on the Committee of Creditors determined?
Voting share is generally determined based on the proportion of the AIF's financial debt relative to the total financial debt owed by the corporate debtor to all financial creditors — a larger debt exposure translates to proportionally greater voting influence in CoC decisions, including approval of the resolution plan.
Q5. Can an AIF that holds both debt and equity in the same distressed portfolio company participate as a financial creditor for its debt position while also holding an equity stake?
Yes, this dual position is possible and reasonably common for funds that have provided both debt and equity financing to the same company over its lifecycle — the fund's rights as a financial creditor (through the CoC) and its position as a shareholder are distinct, with financial creditor rights generally taking precedence in the resolution process, while equity holders typically face significant value erosion or extinguishment depending on the resolution plan's terms.
Q6. Does an AIF's Category classification (I, II, or III) affect its rights or standing as a financial creditor under IBC?
No — IBC creditor rights attach based on the nature of the debt instrument held and the fund's status as a financial creditor, not based on the fund's SEBI AIF category classification, which is a separate regulatory framework entirely.
Q7. What happens to an AIF's investment if the distressed company undergoes liquidation rather than a successful resolution?
In liquidation, financial creditors are paid from liquidation proceeds according to the priority waterfall (order of payment) prescribed under the IBC, generally ahead of equity/shareholder claims but often after certain priority claims (such as insolvency resolution process costs and workmen's dues up to specified limits) — the AIF's actual recovery in liquidation depends entirely on the available asset value relative to the total claims ranking ahead of and alongside it.
Q8. Should a debt-oriented AIF's PPM specifically address how the fund will handle a portfolio company's potential insolvency proceedings?
Increasingly, sophisticated debt fund PPMs address the fund's general approach to distressed situations, including participation in insolvency proceedings, workout negotiations, and related governance (such as who within the fund's team has authority to vote on CoC matters) — leaving this entirely unaddressed can create ambiguity about decision-making authority precisely when time-sensitive CoC decisions need to be made.
Q9. How does IBC participation interact with the fund's own valuation of the distressed debt position for NAV purposes?
The fund's valuation of a distressed debt position needs to reflect the realistic expected recovery given the insolvency proceedings' status and likely outcome — this is a particularly challenging valuation scenario (see Part 12 of this series and our Valuation of Unlisted Securities article) requiring careful, well-documented judgment rather than continuing to carry the position at pre-default face value.
Q10. Can an AIF itself initiate insolvency proceedings against a defaulting portfolio company as a financial creditor?
Yes — a financial creditor, including an AIF holding qualifying debt, has standing under the IBC to file an application to initiate the Corporate Insolvency Resolution Process against a corporate debtor in default, subject to meeting the applicable threshold and procedural requirements under the Code.
Q11. Does an AIF's participation in a CIRP as a financial creditor require any specific SEBI disclosure or reporting?
Material developments affecting the fund's portfolio, including a significant investee company entering insolvency proceedings, would generally warrant appropriate disclosure to investors consistent with the fund's periodic reporting obligations, alongside being reflected in the fund's valuation and Annual/Quarterly Activity Report disclosures as relevant.
Q12. Is IBC-related distressed debt expertise something debt-oriented Category II AIFs typically build in-house, or engage external counsel for?
Given the specialised, time-sensitive, and procedurally intensive nature of IBC proceedings, most fund managers engage specialised external legal counsel to represent the fund's interests in CIRP/CoC proceedings, while retaining internal oversight and decision-making authority (per the fund's governance framework) on strategic matters like resolution plan voting.
Supporting Debt-Oriented Funds Through Distressed Situations
We advise debt-oriented AIF managers on valuation of distressed positions, financial statement treatment of investments in insolvency proceedings, and coordination with legal counsel on the fund's broader compliance and disclosure obligations during a CIRP.
This FAQ is for general informational purposes and does not constitute legal advice on insolvency proceedings specific to any fund's portfolio company situation.