A Scenario Debt-Oriented Funds Need to Plan For, Not Just React To
Every debt-oriented Category II AIF eventually faces this question, whether in year one or year seven: what happens when a portfolio company can't pay? The answer, procedurally, runs through the Insolvency and Bankruptcy Code, 2016 — and understanding the mechanics before you're in the middle of a live default is far better than learning them under time pressure.
Financial Creditor Status: What Triggers It
An AIF becomes a financial creditor under the IBC where it holds financial debt owed by a company — arising from debt or debt-like instruments the fund has invested in, such as structured credit, non-convertible debentures, or direct lending arrangements. This is fundamentally different from an equity investment, which does not on its own create financial creditor status.
The CCD Question That Trips Up Many Funds
Compulsorily Convertible Debentures sit in genuinely uncertain territory here. Whether a CCD qualifies its holder as a financial creditor for IBC purposes is a nuanced, instrument-specific question that depends heavily on the actual terms of the instrument and has been the subject of significant judicial interpretation. Funds holding CCDs shouldn't assume either classification without specific legal analysis of the instrument's actual terms — this genuinely matters and genuinely varies case to case.
What Financial Creditor Status Actually Gets You
As a financial creditor, an AIF earns a seat at the Committee of Creditors (CoC) — the body that plays the central decision-making role throughout the Corporate Insolvency Resolution Process, including voting on the resolution plan that determines the distressed company's fate.
Voting Power Is Proportional, Not Equal
Your fund's voting share on the CoC is determined by the proportion of your financial debt relative to the total financial debt owed to all financial creditors — a larger debt exposure means proportionally greater voting influence over the outcome, including resolution plan approval.
The Dual-Position Scenario: Debt and Equity in the Same Company
It's genuinely common for a fund to hold both debt and equity in the same portfolio company, having provided financing across its lifecycle. These positions are treated distinctly in insolvency — financial creditor (debt) rights through the CoC generally take precedence in the resolution process, while equity holders typically face significant value erosion or complete extinguishment depending on the resolution plan's terms. Understanding this asymmetry matters for how you value and manage each position separately.
If Resolution Fails: Liquidation and the Priority Waterfall
Where the distressed company moves to liquidation rather than a successful resolution, financial creditors are paid from liquidation proceeds according to a prescribed priority waterfall — generally ahead of equity claims, but often behind certain priority items like insolvency process costs and workmen's dues up to specified limits. Your actual recovery depends entirely on available asset value relative to total claims ranking ahead of and alongside yours.
Building This Into Your PPM Before You Need It
Sophisticated debt fund PPMs increasingly address the fund's general approach to distressed situations upfront — including who within the fund's team has authority to make time-sensitive CoC voting decisions. Leaving this entirely unaddressed creates real ambiguity precisely when decisions need to be made quickly, often under statutory timelines.
The Valuation Challenge
A distressed debt position needs valuation reflecting realistic expected recovery given the insolvency proceeding's status and likely outcome — a genuinely difficult valuation exercise requiring careful, well-documented judgment, not simply continuing to carry the position at pre-default face value on autopilot.
Why Most Funds Bring in Specialised External Counsel
Given how procedurally intensive and time-sensitive CIRP/CoC proceedings are, most fund managers engage specialised insolvency counsel to represent the fund's interests, while retaining internal governance oversight (per the fund's own delegation framework) on strategic decisions like resolution plan voting.
Supporting Debt-Oriented Funds Through Distressed Situations
We advise debt-focused AIF managers on valuation of distressed positions, financial statement treatment during insolvency proceedings, and coordinating disclosure obligations alongside legal counsel handling the CIRP itself.
This article is for general informational purposes and does not constitute legal advice on insolvency proceedings specific to any fund's portfolio company situation.