Bridge Financing by AIFs to Portfolio Companies — Structuring & Conversion Mechanics

Portfolio companies rarely run out of runway on a convenient schedule. A priced round gets delayed by market conditions, a strategic partnership needs a few months of additional working capital to close, or a company needs a short capital infusion to hit a milestone that will unlock a materially higher valuation. In each of these situations, an Alternative Investment Fund already on the cap table is frequently best positioned to provide bridge financing — but doing so within the boundaries of the SEBI (Alternative Investment Funds) Regulations, 2012 requires structuring that many first-time fund managers underestimate.

Why Bridge Financing Is Structured as Convertible Debt, Not a Plain Loan

The starting constraint for any AIF considering a bridge is regulatory: an AIF is an investment vehicle, not a lending institution, and extending loans as a business activity risks being characterised as a Non-Banking Financial Company (NBFC) activity requiring separate registration and regulatory oversight from the Reserve Bank of India. SEBI's regulatory architecture for AIFs contemplates investment in securities, not systematic lending — so a fund extending bridge capital repeatedly and as a core business line, rather than incidentally as part of an equity investment strategy, exposes itself and its manager to regulatory risk well beyond the specific transaction.

The market's response to this constraint has been to structure bridge financing almost universally as convertible instruments — typically Compulsorily Convertible Debentures (CCDs) or, less commonly, Optionally Convertible Debentures (OCDs) or Compulsorily Convertible Preference Shares (CCPS) — rather than as a plain unsecured or secured loan. This achieves three things simultaneously: it gives the AIF security-like documentation consistent with an "investment" characterisation, it provides the company with capital without the immediate equity dilution and valuation-setting exercise of a priced round, and it builds in a contractually defined path to conversion into equity once a priced round or trigger event occurs.

Core Structuring Mechanics

Conversion Triggers

The debenture or preference share instrument typically converts into equity on the occurrence of a defined trigger — most commonly the closing of the company's next qualified equity financing round (a "Qualified Financing" threshold, often defined by a minimum round size), or, failing that, on a long-stop date (commonly 12–24 months from issuance) at a pre-agreed valuation mechanism.

Conversion Pricing — Discount and Valuation Cap

Because the bridge is, by design, priced before the company's next round sets a fresh valuation, the instrument needs its own conversion pricing mechanism:

• A discount to the next round price (commonly in the 10–25% range), compensating the bridge investor for taking risk ahead of new investors and without the benefit of a priced-round valuation.
• A valuation cap, setting a ceiling price at which the bridge converts regardless of how high the next round is priced, protecting the bridge investor's return in a scenario where the company's valuation appreciates sharply between the bridge and the priced round.
• Where both a discount and a cap are used, the conversion mechanic typically applies whichever produces the lower conversion price (i.e., the more investor-favourable outcome), consistent with global convertible-note market practice.

Interest, Maturity, and Default Mechanics

Even though the instrument is designed to convert rather than be repaid in cash, it is typically structured to carry a coupon (interest accrual, often 8–15% per annum, either cash-pay or, more commonly, accruing and capitalised into the conversion amount) so that if conversion is delayed or does not occur, the instrument still generates a return and behaves as genuine debt for accounting and tax purposes until conversion. Default and acceleration provisions — allowing the AIF to demand repayment or enforce security if the company breaches covenants or fails to raise a qualifying round within the long-stop period — are standard, giving the bridge real teeth as a credit instrument rather than a soft commitment.

Security and Ranking

Whether a bridge is secured depends heavily on the company's stage and the fund's negotiating leverage. Early-stage bridges are frequently unsecured, given the absence of meaningful hard assets. Growth-stage or asset-backed companies may see the AIF negotiate a charge over specific assets, receivables, or a pledge of promoter shares, with the instrument ranking ahead of existing equity and, depending on negotiation, either pari passu with or ahead of other unsecured creditors.

Category-Specific Considerations Under the AIF Regulations

Category I AIFs (venture capital funds, in particular) most commonly use convertible instruments as part of their core investment strategy in early-stage companies, and bridge structuring via CCDs sits comfortably within the investment conditions applicable to that category, provided the instrument is disclosed consistently with the strategy set out in the fund's PPM.

Category II AIFs, which invest primarily in equity or equity-linked instruments and are not permitted to undertake leverage or borrowing except for meeting temporary funding requirements (subject to conditions and limits prescribed under the Regulations), need to be particularly careful that a bridge financing extended to a portfolio company is not itself characterised as the fund taking on leverage or engaging in lending as a business activity — the analysis is always at the level of the instrument and the fund's own borrowing conditions, not just the portfolio company's use of proceeds.

Category III AIFs, which have more flexibility around instruments and can use leverage subject to specified limits, have somewhat more latitude, but the fund's own PPM-disclosed strategy still governs whether direct bridge lending to a portfolio company is within its mandate.

In every category, the manager's compliance team should confirm that the specific bridge instrument is consistent with the investment strategy disclosed in the scheme's PPM — a strategy drafted around equity and equity-linked instruments does not automatically permit a debt or quasi-debt instrument without at least a PPM-consistency review, and in some cases investor consent, particularly where the bridge is large relative to the scheme's corpus.

Related-Party and Conflict Considerations

Bridge rounds frequently happen under time pressure, and it is common for the same existing investors — including the AIF itself — to provide the bridge rather than bring in new capital. Where the bridge involves the AIF's manager, sponsor, or their associates on both sides of the transaction (for instance, if the manager also advises another fund or vehicle participating in the same bridge), this raises related-party considerations under the AIF Regulations, which generally require prior investor consent — commonly a majority of at least 75% by value of investment in the scheme — for transactions between the AIF and entities related to its manager or sponsor. Fund managers should build in time for this consent process rather than treating a bridge as an emergency transaction that bypasses ordinary governance.

Tax Considerations

CCDs are generally treated as debt for tax purposes until conversion, meaning interest accrued is taxable in the hands of the AIF (subject to the AIF's own pass-through tax treatment under the Income-tax Act, where applicable) and may be tax-deductible for the investee company, subject to thin-capitalisation and related-party interest limitation rules where relevant. On conversion, the instrument's holding period for capital gains purposes typically relates back to the date of original issuance of the CCD, not the date of conversion — a point that matters for long-term capital gains qualification and should be documented clearly in the fund's investment records.

Drafting and Process Checklist

• Confirm the bridge instrument (CCD/OCD/CCPS) is consistent with the scheme's PPM-disclosed investment strategy before executing.
• Build in a clear conversion trigger, long-stop date, and discount/cap conversion pricing mechanic.
• Decide on coupon, security, and default/acceleration terms appropriate to the company's stage.
• Check the fund's own borrowing/leverage conditions under its AIF category before treating the bridge as routine.
• Flag and process related-party consent requirements early if manager affiliates are involved on either side.
• Document the tax characterisation and expected holding-period treatment at issuance, not retrospectively at conversion.

Conclusion

Bridge financing lets an AIF protect a portfolio company — and its own prior investment — through a funding gap, but it sits at the intersection of investment strategy, regulatory characterisation, and tax treatment in a way that a plain equity round does not. Structuring it correctly at the term sheet stage, with the conversion mechanics, category-specific compliance checks, and related-party governance addressed upfront, is what separates a well-executed bridge from one that creates regulatory or investor-relations complications well after the capital has already gone out the door.