The recent SEBI (Alternate Investment Funds) (Third Amendment) Regulations, 2022 introduced the long-awaited concept of for-profit social impact funds. While the amendment is a step in the right direction, there still are significant gaps in the policy governing social impact investments in India. Most importantly, the government must provide additional incentives and relaxations to social impact funds (as a separate asset class) to attract impact investments.
What are Social Impact Investments?
SOCIAL Impact Investments (‘SII’) are investments that generate positive measurable social or environmental benefits along with financial returns. SIIs aim to finance organisations that address one of the 17 Sustainable Development Goals. SIIs can be in the form of traditional investments, blended financing investments, or investments through innovative pay-for-success models such as social impact bonds and development impact bonds.
According to the Global Impact Investing Network, the global market size of impact investing was USD 715 billion as of June 2020. In India, the concept of SIIs gained traction only in recent years. According to the Impact Investors Council’s 2021 report, India attracted approximately USD 6.8 billion in equity-based SIIs in 2021, which is a 135 per cent increase over similar investments in 2020.
Given the immediate and dire threat of climate change, and the rising calls for profit with a purpose, investors are increasingly moving towards SIIs. In India, the Prime Ministers’ panchamrit goals and the call for USD 1 trillion in climate finance during the 2021 United Nations Climate Change Conference have drawn the international community’s attention towards impact investing in India. To cater to this interest, India has come up with a few legal and regulatory changes to ease impact investing. However, the Indian legal and regulatory regime is yet to keep up with the dynamic progress of SIIs.
SIIs under the SEBI (AIF) Regulations, 2012
Alternative Investment Funds (‘AIFs’) are a popular source of SIIs due to their lenient regulatory and tax regime. Until recently, the only form of impact investment funds categorically recognised by the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (‘SEBI (AIF) Regulations, 2012’) were not-for-profit social venture funds. In order to qualify as a social venture fund, a fund had to meet the following three thresholds:
(i) it had to primarily invest in securities/units of social ventures entities, which are trusts, charities, microfinance institutions, or section 8 companies (i.e., companies formed under Section 8 of the Companies Act, 2013 for charitable purposes which intend to prohibit the payment of any dividends to its members);
(ii) it had to satisfy the social performance norms laid down by the fund; and
(iii) its investors must agree to restricted or muted returns.
Consequently, social venture funds focused only on social benefits and not financial returns. Unsurprisingly, social venture funds were only seen as vehicles for providing grants to non-profits and not as profit-making investments. Funds looking to make impact investments had to classify themselves as regular AIFs to make profits.
The lack of tangible advantages or labels associated with impact investments disincentivised several investors from investing in impact funds. It is due to this reason that as of June 30, 2022, social venture funds only attracted INR 585.39 crores. In comparison, all AIFs attracted a total of ₹ 3,11,343.35 crores. SEBI recognised this issue and released the SEBI (AIF) (Third Amendment) Regulations, 2022 to introduce the concept of for-profit impact investments in India.
Recent Amendment to the SEBI (AIF) Regulations, 2012
The SEBI (AIF) (Third Amendment) Regulations, 2022 dated July 25, 2022 officially recognised the concept of for-profit SIIs, thereby opening India’s potential to receive billions of dollars in foreign and domestic impact investments. Under the amendment, social venture funds are renamed as social impact funds (‘SIFs’). SIFs are permitted to invest in both social ventures and social enterprises. While the definition of social ventures remains the same as before, the definition of social enterprises includes for-profit organisations, thereby permitting SIFs to invest in for-profit organisations pursuing social causes.
Social venture funds focused only on social benefits and not financial returns. Unsurprisingly, social venture funds were only seen as vehicles for providing grants to non-profits and not as profit-making investments. The lack of tangible advantages or labels associated with impact investments disincentivised several investors from investing in impact funds.
(i) It must be involved in any one of the 17 criteria listed in Regulation 292E(2)(a) of the SEBI (ICDR) Regulations;
(ii) It must target underserved or less privileged population segments or regions recording lower performance in the government’s development priorities; and
(iii) At least 67 per cent of its immediately preceding three-year average revenue, expenditure, total customer base, or total number of beneficiaries must relate to providing any of the seventeen eligible activities to the target population.
Accordingly, SIFs can now invest in for-profit social enterprises. The new amendment to the regulation also permits a blended financing model of SII. SIFs can issue ‘social units’ to investors who agree to receive only social returns or benefits and no financial returns. This is in addition to the fund’s right to issue ‘units’ for financial returns. Thus, SIFs can now raise both not-for-profit grants and for-profit investments. However, this flexibility is not available for foreign grants since, under the Foreign Contribution (Regulation) Act, 2010, foreign contributions cannot be received without the government’s permission.
Lastly, a for-profit social enterprise can identify itself as a social enterprise on the regular stock exchange.
Thus, slowly but surely, India is moving towards a model of distinguishing SIIs as a separate asset class.
The path forward for SIIs under SEBI (AIF) Regulations, 2012
While SEBI is working towards regulating and incentivising SIIs, there still are significant challenges in this field. In order to attract SIIs, the regulator must provide additional benefits to SIFs. SIFs are still classified as Category-I AIFs and enjoy the same benefits as other venture capital funds, SME funds, infrastructure funds, special situation funds, or other funds. SIFs are not offered any additional incentives, relaxations, or tax breaks. Some potential benefits that could be provided to SIFs are detailed below.
SIIs in the MSME Sector and their ability to provide loans
Arguably, the most critical sector which requires impact investment in India is the MSME sector. According to the Micro, Small and Medium Enterprises Development Act, 2006, MSMEs are micro, small, and medium enterprises with less than ₹ 50 crore investment in plant and machinery/equipment, and ₹ 250 crore turnover.
Spread primarily in rural and semi-urban areas, the MSME sector contributes to approximately one-third of India’s GDP. However, this sector still relies on traditional fossil fuels, and has limited access to finance or new technologies that could improve its social and environmental footprint. According to the International Finance Corporation’s report, Financing India’s MSMEs, as of 2017, the overall addressable credit gap in the MSME sector is $ 397.5 billion. The report drew a comparison with the credit gap in 2010 and concluded that the gap is increasing. There are several reasons for the credit gap, such as information asymmetry, inadequate collateral, and high-risk perception, among other things.
While the definition of social ventures remains the same as before, the definition of social enterprises includes for-profit organisations, thereby permitting SIFs to invest in for-profit organisations pursuing social causes.
Therefore, it is pertinent for India to solve the credit gap in the MSME sector and, more importantly, ensure that this sector’s growth aligns with the overall sustainable development objectives of the nation. SIFs have highly sophisticated investors and a higher risk appetite. They also have the resources to undertake credit analysis to evaluate an MSME’s creditworthiness instead of depending on traditional collateral. For the reasons mentioned above, SIFs should be encouraged to invest in the MSME sector.
Presently, SIFs can invest in MSMEs by investing directly in their securities or by investing in Non-Banking Financial Company (‘NBFCs’) or banks that provide loans to MSMEs. The former investment model is not scalable since most MSMEs do not have a sophisticated understanding of investments and the latter model is needlessly multi-tiered. Further, in the latter model, most MSMEs would be unable to access loans since most NBFCs and banks rely on traditional lending parameters and require collateral. Note that only 16 per cent of MSMEs have access to traditional banking systems.
Therefore, a better way to channelise funds from SIFs into MSMEs would be to allow them to grant loans directly to MSMEs. Under the current regulations, AIFs cannot grant loans, although there has been some contention on this matter.
According to the Adjudication Order No. RA/JP/235 -236/2017 issued on November 29, 2017, SEBI held that if an AIF specifically mentions that providing a loan is a part of its investment policy/strategy, then it can provide loans from its investible funds. The Reserve Bank of India, which regulates lending in India, disagreed with SEBI’s decision. Afterwards, SEBI took a contrary view in its settlement order issued on July 25, 2018 for the same case, wherein it ordered the parties not to engage in any loan activity.
Further, per SEBI’s Frequently Asked Question #7, an AIF cannot use its investable funds to provide loans. In conclusion, it is more or less settled that AIFs cannot grant loans in India. In comparison, other jurisdictions, such as Germany, permit AIFs to grant loans, subject to certain restrictions to prevent misuse. An example of such restriction in the German model is that AIFs cannot lend more than 20 per cent of their investible funds to one entity.
A better way to channelise funds from SIFs into MSMEs would be to allow them to grant loans directly to MSMEs. Under the current regulations, AIFs cannot grant loans, although there has been some contention on this matter.
Accordingly, to encourage SIFs to invest in the MSME sector, the regulator must permit SIFs to provide direct loans to MSMEs. Removing the requirement of a frontier bank would ease the investment process and embolden SIFs to invest in the sustainable development of the MSME sector. The regulator can, of course, set some restrictions to prevent misuse.
Opening the MSME sector to sophisticated investors is a profitable strategy; a ready example would be Aye Finance. Aye Finance is an NBFC that uses investments from AIFs to provide strategic loans to clusters of MSMEs without a collateral requirement. With its innovative investment strategy, Aye Finance has been able to generate profits consistently. By removing frontier banks and intermediaries, the regulator would make SIFs the most attractive category for investments, and would also be able to close the credit gap in the MSME sector.
Single project funding structures through SIIs
Under the new amendment, the minimum corpus requirement for an SIF is just ₹ 5 crore. In comparison, the minimum corpus requirement for a general AIF is ₹ 20 crores. This reduced corpus amount is a step in the right direction. SIFs could use the lower minimum corpus amount to fund a single project effectively.
However, the current regulations do not permit investment of 100 per cent of an AIF’s investible funds into one investee organisation. A Category-I AIF (which includes SIFs) may not invest more than 25 per cent of its corpus (50 per cent for large-value funds with accredited investors) into one investee company. Thus, SIFs cannot be structured for the benefit of one impact project.
Several funds or instruments overstate or falsify their funds’ positive environment or social claim to attract investors who want to align their investments with a positive impact. Without a shared understanding of what constitutes an SII and how to measure the same, SIIs can be prone to misuse.
The regulations must create an exemption from the 25 per cent limit for SIFs to allow single-project structuring. SIFs can concentrate on one impact project at a time and make profits from successful completion of such impact projects.
One of the most significant issues around SIIs is impact washing. Several funds or instruments overstate or falsify their funds’ positive environment or social claim to attract investors who want to align their investments with a positive impact. Without a shared understanding of what constitutes an SII and how to measure the same, SIIs can be prone to misuse. In order to tackle this issue, OECD has called for an impact imperative: “A shared understanding of how we measure the impact of our collective investments in sustainable development.”
Several mature markets, such as the United States and the European Union, already have a workable framework of disclosure norms surrounding impact investments. The E.U. has introduced the Sustainable Finance Disclosure Regulations, which apply to asset managers, pension funds, and insurers who must disclose Environmental, Social, and Governance(‘ESG’) risks concerning their investment and clarify how the funds contribute to ESG goals. This deliberation requirement would prevent greenwashing/impact washing by forcing funds to think and substantiate their claims. In the U.S., the Securities and Exchange Commission is also about to roll out an ESG disclosure requirement.
The general ESG risk disclosures required from all AIFs are not detailed. In order to prevent impact washing or greenwashing by SIFs in India, the regulator must extend the current framework of the Business Responsibility and Sustainability Report (‘BRSR’) to SIFs. The top 1,000 Indian listed companies must release a BRSR, starting from the financial year ending March 31, 2023. SIFs can be subject to the same BRSR disclosure norms to increase transparency and accountability.
Why changes to SIFs are required
Recently, the Indian government has introduced several programs to shift manufacturing from China to India. While India is emphasising development, it is critical for such development to be sustainable. For this purpose, SIFs must provide additional perks and advantages over and above what is granted to AIFs to incentivise impact investments over other investments. While the legal and policy regime surrounding impact investments in India has been moving in the right direction, it still has a long way to go.