Deccan Yield: temporary borrowing that became leverage, plus a total return swap
Deccan Yield Fund, a Category II AIF with an INR 250 crore corpus, invests in performing corporate credit. In FY2024 it did the following: borrowed INR 45 crore for 45 days to fund a large follow-on purchase, repaid it, and repeated this on five occasions, booking INR 6.8 crore of interest cost; entered a total return swap referencing a basket of listed NBFC bonds to add 1.5x exposure for six months; and borrowed INR 20 crore to fund the purchase of a distressed loan portfolio from a bank, using the portfolio's cash flows to repay over three months. The manager describes all of this as 'temporary funding' and notes that each transaction was approved by the investment committee and disclosed in the quarterly investor report. One investor has complained to the trustee, and a prospective investor's consultant is asking how much leverage the fund actually runs.
1. Test each borrowing and the swap against the rules applicable to a Category II AIF.
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The temporary-funding envelope for a Category I/II fund is: not more than 30 days, not more than four occasions in a year, and not more than 10% of investable funds. On a INR 250 crore corpus, the ceiling is about INR 25 crore.
- INR 45 crore for 45 days, five times breaches all three limbs: 18% of the corpus against a 10% cap, 45 days against 30, and five occasions against four. The fact of repayment before the next drawdown does not reset the count.
- INR 20 crore repaid over three months is not temporary funding at all; it financed the acquisition of a portfolio, with repayment from the asset's own cash flows. That is acquisition financing, i.e., leverage.
- The total return swap adds 1.5x exposure to listed bonds. Derivatives for a Category II fund are limited to hedging; this is non-hedging leverage.
Investment committee approval and quarterly disclosure do not cure a regulatory cap. The manager's label is wrong on facts and on law; the fund has been running Category III-style leverage inside a Category II registration.
2. What remediation, reporting and control steps are required, and what should the prospective investor be told?
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Remediation should be treated as a material breach, not an administrative slip.
- Stop new borrowing and new non-hedging derivative positions; unwind the swap and cure the excess exposure within a defined, documented timeline.
- Put the breach to the trustee/board with dates, amounts, peak leverage, purpose and correction; minute the decision.
- Report the breach to SEBI in the prescribed compliance reporting and disclose it to all investors, including whether NAV, fees or distributions were affected.
- Test whether any performance fee was earned on returns inflated by leverage and correct if so.
- Fix the root cause: a borrowing register that tests the 30-day/4x/10% limits before each drawdown, compliance pre-approval, a derivatives-use policy limited to hedging, and training for the investment committee.
For the consultant, the honest answer is the actual peak leverage (at least 18% from direct borrowing plus 1.5x swap exposure), the breach and the corrective action. Concealment converts a compliance failure into a disclosure and fiduciary failure.
3. The manager argues the fund should simply be re-registered as Category III to regularise the past positions. Is that a valid response?
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No. A category change operates prospectively. It requires SEBI approval, amendment of the registration and disclosures, and investor consent; it cannot retroactively validate positions taken outside the Category II permission. Past leverage remains a breach that must be reported and assessed.
Prospectively, if the strategy genuinely needs leverage and swaps, a Category III registration is legitimate, but it brings its own conditions: investor consent for leverage, exposure capped at 2x the scheme's NAV, appropriate risk and monthly reporting discipline, and a higher continuing-interest commitment (the lower of 5% of corpus and INR 10 crore). The investor base would be capped at 500, which may not fit the existing register.
The trustee should also consider whether the manager's attempt to recharacterise the strategy shows a control culture problem. The correct sequence is: stop, report, remediate, then - if the strategy truly warrants it - seek approval for a new Category III scheme, rather than relabelling the existing one.