This article analyses the RBI’s December 2023 circular restricting investments by banks, financial institutions and NBFCs in AIFs.
On 19 December 2023, the Reserve Bank of India (RBI) issued a circular regarding “Investments in Alternative Investment Funds (AIFs)” (Circular) to address the substitution of direct loan exposures of all regulated banks, financial institutions, and non-banking financial companies (Regulated Entities or REs) to borrowers, with indirect exposure through investments in units of Alternative Investment Funds (AIFs).
Through the Circular, the RBI has directed REs not to invest in AIF schemes that have direct or indirect downstream investments in a company to which a RE currently has, or has previously had, a loan or investment exposure at any time during the preceding 12 months (Debtor Company). Where an RE is already an investor in an AIF scheme, and the AIF subsequently makes a downstream investment in any such Debtor Company, the RE must liquidate its investment in the AIF within 30 days of the date of the downstream investment. If the RE has already invested in an AIF scheme having such downstream investment in a Debtor Company as on the date of the Circular, it must liquidate its investments within 30 days of the date of the Circular – i.e. by 18 January 2024. In case REs are unable to liquidate their investments in AIFs within the prescribed time limits, they must make a 100% provision on such investments.
Additionally, under the Circular, investments by REs in the subordinated units of any AIF with a priority distribution model are subject to full deduction from the RE’s capital funds. The priority distribution model is described in the Securities and Exchange Board of India’s (SEBI) Master Circular for Alternative Investment Funds (AIFs) dated 31 July 2023 as a distribution waterfall mechanism adopted by certain AIF schemes whereby 1 class of investors (junior class) shares losses more than pro rata to their holding in the AIF, compared to another class (senior class), since the latter has priority in distribution over the former. SEBI has, through its circular dated 23 November 2022, prohibited schemes of AIFs that have adopted the aforesaid priority distribution model from accepting any fresh commitments or making an investment in a new investee company till SEBI takes a final view on priority distribution models.
The Circular addresses concerns relating to the evergreening of loans through structures where REs invest in AIF units, and the proceeds of their investments are then invested by an AIF in the Debtor Company to repay the loans availed by the Debtor Company from the RE. Through such structures, REs could avoid the classification, provisioning, and other applicable compliance requirements with respect to loans that are in default or expected to be in default.
While the restriction imposed by the Circular seems to be a step in the right direction as it will curb camouflaged evergreening of loans and build-up of unrecognized non-performing assets through complex AIF structures, the blanket ban on all investments in AIFs appears to be disproportionate. The Circular does not clarify whether the prohibition on investments is in relation to investments in debt or equity. Further, investment by REs in AIFs which may have invested in the equity of a Debtor Company may not raise any concerns in relation to evergreening of loans since, under such structures, borrowers typically utilise proceeds from the issuance of debt instruments to AIFs to repay the original loan amounts due to the REs.
Further, the above restrictions are likely to dissuade REs from investing in AIFs in the future even for genuine purposes such as diversification of risk, as the REs will have to either exit from the investment in the AIFs or ensure 100% provisioning on such investments in cases where the AIFs invests in a Debtor Company. The REs may, in the future, therefore, require a commitment from the AIFs that the AIF shall not invest in any existing Debtor Company of the REs.
Even though the statutory bar under the Circular is only for those AIFs that have invested in Debtor Companies, there may be practical difficulties in ensuring that there are no investments in AIFs that have invested in Debtor Companies. Given the severe consequences of a breach, compliance-sensitive REs may avoid investing in AIFs entirely, thereby restricting growth and funding to this sector due to the reduction of AIFs’ pools of investible assets. Due to the presence of overlapping investments in the market, there will also be pressure on AIFs to disinvest immediately. It is also possible that the rigid timelines stipulated by the RBI under the Circular may force REs to write off some of their investments in AIFs.
Moreover, the Circular is likely to create issues in launching and managing AIF schemes. For AIFs with multiple REs as investors, along with other non-regulated investors, creating an investment portfolio that satisfies all parties will be highly complex. This is because REs have restrictions on debtor exposures, while other investors do not. Balancing the conflicting investment requirements and limitations between different investor classes in the same AIF scheme will be a difficult task for investment managers. They may find it challenging to either bring together a viable mix of investors for the AIF or identify appropriate investment opportunities that align with the various restrictions imposed on different types of investors. Investment managers will now have to ensure that the investors who are REs are bound to make disclosures regarding the name and, or, identity of their respective Debtor Companies, prior to the AIF scheme’s initial closing, and, going forward, through the tenure of the scheme.
Considering these challenges, a more viable approach that could be considered by RBI to curb evergreening would be that any restrictions on investments under the Circular should only apply to affiliated AIFs. This could be facilitated by defining affiliated AIFs as related parties or AIFs where the investment manager or sponsor has ties to the RE. Broadening the restriction to all AIFs, even unrelated ones where investment decisions are not controlled by the RE, goes beyond the objective of curbing evergreening.
In this regard, it would have also been apt to limit the prohibition on investments only to Category I and II AIFs. Category III AIFs function as hedge funds, usually employing equity strategies and other leveraged trades. Hedge fund investments are an accepted practice by institutional investors globally. Imposing an outright ban on such hedge fund investments appears to be excessive. Moreover, given the extensive range of investments that Category III AIFs engage in, avoiding overlaps with the RE’s borrowers would be largely impractical.
While this Circular’s motive of dissuading evergreening structures is valid, the RBI’s sweeping ban on investments to curtail the misuse of AIF structures by REs, added with the rigid timelines stipulated by RBI in the Circular, may force the REs to write off some of their AIF investments. This could potentially destabilize the growth of the AIF industry which is not in line with the SEBI’s objectives of promoting investments in early-stage companies. The Circular suffers from several legal and administrative issues that need to be addressed and revised by the RBI after considering the representations of all the stakeholders impacted by the Circular along with the commercial realities of the AIF industry.
