Illiquid asset workout in mutual funds

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Illiquid asset workout in the context of Indian mutual funds refers to the process through which an AMC manages, restructures, and attempts to recover value from debt securities in a scheme’s portfolio that have become illiquid, defaulted, or severely distressed. Unlike equity holdings, which can be sold on an exchange even under stress (at a price), debt securities that are in default or have a credit event may have no willing buyers in the secondary market, requiring the AMC to engage directly with the issuer, work through resolution or insolvency proceedings, or accept partial recovery over an extended period.

SEBI restrictions on illiquid securities

SEBI caps the exposure a mutual fund scheme can have to illiquid securities:

  • Regulation 44 of SEBI (Mutual Funds) Regulations, 1996: Limits total investment in illiquid securities (unlisted debt instruments and privately placed debt) to 15% of net assets for open-ended debt schemes (with a higher limit of 20% permitted with trustee approval).
  • SEBI Circular: Tightened the definition of illiquid securities and mandated that any security with no trades in a specified recent window be classified as illiquid for valuation purposes.

These caps exist to ensure that open-ended schemes (which promise liquidity to investors through daily redemptions) do not become trapped in portfolios they cannot liquidate.

What happens when a security becomes illiquid

  1. Valuation markdown: The SEBI-empanelled valuation agency marks down the security’s price to reflect the credit event or illiquidity. The fund’s NAV drops on the day of the markdown.
  2. Segregated portfolio: If the credit event triggers SEBI’s side-pocketing criteria, the AMC creates a segregated portfolio, ring-fencing the distressed security from the main portfolio.
  3. Restriction on new subscriptions: For the main portfolio, new subscriptions continue normally. No new investors can access the segregated portfolio.
  4. Active workout: The AMC’s credit team engages with the issuer, the lead lender (if a bank-led consortium), or the resolution professional (under IBC proceedings).

Workout mechanisms

Negotiated settlement

For smaller or unrated issuers, the AMC may negotiate directly with the promoter or company management for a restructured payment schedule. This could include:

  • Extension of maturity with higher interest.
  • Partial principal repayment followed by a reduced settlement.
  • Conversion of debt to equity (permitted in limited circumstances under SEBI’s framework).

Insolvency and Bankruptcy Code (IBC) proceedings

When the issuer has filed for insolvency (or has been taken to the National Company Law Tribunal by a creditor), the mutual fund, as a financial creditor, participates in the resolution process. The AMC must engage a resolution professional and participate in the committee of creditors. Recovery under IBC can range from zero (in liquidation) to 60%–80% of face value (in a successful resolution plan), and typically takes two to five years.

The AMC may pursue legal action against guarantors, promoters who provided personal guarantees, or security trustees who hold collateral on behalf of debenture holders.

AMC obligations to investors

SEBI’s framework requires that AMCs:

  1. Disclose all illiquid security holdings in monthly portfolio disclosures.
  2. Report any credit event to the scheme’s trustees within 24 hours.
  3. Disclose recovery proceedings and outcomes to investors through website updates and scheme information updates.
  4. Distribute recovery proceeds to segregated portfolio unitholders as and when received.

Investor recourse

Investors in schemes with illiquid or defaulted assets have limited direct recourse:

  • They cannot force redemption at par from a defaulted security.
  • They can approach SEBI’s SCORES (SEBI Complaints Redress System) if they believe the AMC failed to exercise due diligence in acquiring the security.
  • If the investment violated SEBI’s concentration or credit limits, investors can pursue SEBI enforcement action.

References

  1. SEBI (Mutual Funds) Regulations, 1996, Regulation 44, Illiquid securities limits.
  2. SEBI Circular SEBI/HO/IMD/DF2/CIR/P/2018/160 (28 December 2018), Segregated portfolio.
  3. SEBI Master Circular for Mutual Funds (2024).
  4. Insolvency and Bankruptcy Code, 2016, Financial creditor provisions.

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