AIF Registration

RBI Tightens Norms for lenders investing in alternative investment funds

The Reserve Bank of India has taken firm action to fight the practice of renewing bad loans.It has issued regulations prohibiting banks and non-banking financial institutions (NBFCs) and other financial institutions from using the alternative investment fund (AIF) route to ‘evergreen’ loans that make downstream investments by the AIF with bankrupt enterprises. This action intends to address concerns about the substitution of direct loan exposures for indirect exposures via alternative investment funds investments. 

 AIFs and their Regulatory Implications 

An alternative investment fund is a privately pooled investment vehicle that collects funds from investors and invests them according to a predetermined investment policy for the benefit of its investors. Alternative investment funds refer to any Indian investment vehicle that accumulates assets from sophisticated investors, both Indian and foreign, to invest according to a predetermined investment policy. While these funds are part of regulated entities’ (REs’) routine investing activities, the RBI has expressed worry about some transactions involving alternative investment funds, which effectively swap direct loan exposures for indirect ones through alternative investment funds investments.

High-net-worth individuals, family offices, and institutional investors can all benefit from alternative investment fund investment methods. Alternative investment funds investment provide a broader choice of investment options and various asset management strategies. AIF investment Funds are trusts, limited liability partnerships (LLPs), or corporations that invest in assets that are not normally available through regular investing.

Reason for the Circular

The tightening of alternative investment funds investment norms follows RBI Governor Shaktikanta Das’s ¹ May 2023 speech, in which he drew the attention of bank directors to central bank supervisors discovering instances of lenders using innovative methods to conceal the true status of stressed loans.

To mask the stress, good borrowers are enticed to enter into structured arrangements with a stressed borrower. Usage of internal or office accounts to change the borrower’s repayment responsibilities; loan renewal or distribution of new/additional loans to the stressed borrower or connected companies closer to the loan’s due date. The Governor went on to say that the RBI had come across a few cases where one form of evergreening was substituted by another after the regulator pointed it out.

Problems with Indirect Loan Exposures

The RBI’s announcement emphasises the practice of loan evergreening, in which lenders try to resurrect failing loans by offering more credit to the same debtors. This approach is frequently used as a band-aid solution, obscuring the underlying state of the bank’s loan portfolio. According to the most recent data, there are 1,220 alternative investment funds registered with SEBI, with a considerable increase in total investment commitments and funds raised. 

RBI Introduces New Regulatory Measures to Make Investments

To fight potential evergreening via alternative investment funds, the RBI now requires regulated entities to refrain from investing in any alternative investment fund scheme that includes direct or indirect interests in a debtor firm of the RE. This criterion encompasses any company in which the RE has had a loan or investment exposure in the previous year.

Using Alternative Investment Funds to Combat Evergreening as Part of their Regular Investment Operations

There have been reports of regulated businesses using alternative investment funds to fund stressed loans, postponing their designation as non-performing assets (NPAs). RBI said in its new strict rule that REs must liquidate their investments in alternative investment funds schemes within 30 days if the schemes invest in debtor enterprises.

Reserve Bank of India Norms for Lenders Investing in Alternative Investment Funds (AIFs)

The central bank is attempting to halt transactions that include the substitution of direct loan exposure of lenders to borrowers with indirect exposure through investments in units of alternative investment funds, as such transactions mask the true position of stressed loans. Below are the norms issued by the Reserve Bank of India for lenders investing in alternate investment funds as regular investment operations.

Regulated Entities make investments in Alternative Investment Funds as part of their regular investments in units of AIFs. However, the RBI has been aware of certain RE transactions employing alternative investment funds investment that present regulatory problems. These transactions include the substitution of direct loan exposure of REs to borrowers for indirect exposure via investments in alternative investment fund units.

To address concerns about possible evergreening along this path, the following is recommended:

• REs shall not invest in any AIF scheme that has downstream investments in a debtor firm of the RE, either directly or indirectly. For this purpose, the debtor company of the RE shall mean any firm to which the RE now has or formerly had a loan or investment exposure anytime during the preceding 12 months.
• If an AIF scheme in which the RE is already a participant makes a downstream investment in any such debtor firm, the RE must liquidate its interest in the scheme within 30 days from the date of the AIF’s downstream investment. Suppose REs already have an investor invested in such schemes and have downstream investments in their debtor enterprises currently. In that case, the 30-day liquidation period will begin from the date that the circular is issued. REs must immediately make plans to notify AIFs of the situation.
• If REs are not able to liquidate their investments within the period specified above, they must make a full provision on such investments. Furthermore, RE investments in subordinated units of any AIF scheme with a ‘priority distribution model’ are subject to a full deduction from the RE’s capital funds.
• These instructions have been issued by the authority granted by Sections 21 and 35A of the Banking Regulation Act of 1949, as read with Section 56 of the Banking Regulation Act of 1949; Chapter IIIB of the Reserve Bank of India Act of 1934; and Sections 30A, 32, and 33 of the National Housing Bank Act of 1987.

Liquidation Period for Regulated Entities 

Lenders have 30 days to liquidate the aforementioned types of investments from the date of such downstream investment. Furthermore, if lenders are unable to sell their interests within this time frame, they must make a full provision for such investment units of AIFs as part.

The aforementioned guidelines are part of the RBI’s “Investments in AIFs” circular, which was distributed to commercial banks, urban cooperative banks, all-India financial institutions, and non-banking finance businesses, including home finance firms.

If lenders hold interests in the subordinated units of any alternative investment funds scheme with a ‘priority distribution model,’ the central bank has mandated a full deduction from their capital funds. Certain alternative investment funds schemes have a distribution waterfall in such a way that one class of investors (other than the sponsor/manager) share loss more than pro rata to their holding in the AIF investment vis-à-vis other classes of investors/unit holder because the latter has distribution priority over the former.

Evergreening Mode of Operation

A debtor company that is required to repay a loan or instalment might provide the lender with a list of mutual funds/fund houses that have invested in their equity or debts through alternative investment funds.

This list may also include alternative investment funds that have not yet invested in the debtor company but believe it is suitable for an investment from them. 

The lender invests in the alternative investment funds with an understanding that the money will, in turn, be invested partly or fully in its debtor company. The debtor company uses the money from alternative investment funds (usually as debt) and repays the lender on the due date. After clearing old debts, this company receives additional financing or new funds from the lender.

Reactions From the Alternate Investment Funds Industry, which Makes Investments in Units of AIFs as Part

To address the issue of loan evergreening, they have made it practically impossible for any RBI-regulated entity, particularly banks and NBFCs, to invest in an alternative investment fund.

According to an international fund set-up advisory, any lender compelled to liquidate its investment in the AIF within the 30-day redemption period indicated in this circular must redeem it based on the AIF’s current Net Asset Value (NAV). As a result, considering that these AIFs are designed to provide returns for their investors over a lengthy time horizon, they may see a large decrease in the value of their initial investment. 

Most banks in the private sector have asset management firms, which run AIFs as well. AIFs are purchased by banks, and if an alternative investment fund purchases a listed company, the listed company will not be able to conduct business with the bank for a full year. As a result, AIFs have access to a much smaller pool of investable assets. Alternatively, lenders must make a full provision in their books for the invested amount, limiting their ability to use the money for any other financing activity. Industry participants intend to contact the RBI for clarification on the circular. 

Implications for the Financial Sector

This reform is expected to have a substantial impact on regulated firms’ investment strategy in alternative investment funds, encouraging more transparency and prudential lending standards. The demand for a 100% provision on such assets is anticipated to dissuade anomalies, thus improving the financial sector’s general health and stability. 

Impact of the AIF Circular

The possible impacts of the circular are mentioned below: –

• Alternative investment funds are linked with the majority of the larger REs. The flow of monies from the RE to them would cease entirely. 
• The RBI circular sweep is broad and non-discriminatory. Not only connected AIFs, but any AIF in general, will be cut off from RE financing. 
• While the bar is only for alternative investment funds that have invested in “debtor companies,” avoiding overlapping investments will be difficult for REs. 
• Given the serious consequences of a breach, compliance-conscious REs will avoid investing in AIFs. Because there may be overlapped investments, there is immediate disinvestment pressure on AIFs. 
• The assets of alternative investment funds are usually illiquid, making it difficult for RE investors to leave. In many circumstances, there are also lock-in restrictions.

Conclusion  

The Reserve Bank of India’s orders will take effect immediately. However, this RBI Circular has gone well beyond its intended scope and should be reconsidered and softened. Practical implementation of this circular, assuming a RE invests in an alternative investment fund at all, will be difficult. AIFs will be required to share their possible investment list, which will be subject to any investment manager’s discretion. Assuming there is an overlapped investment, the RE must leave within 30 days, causing liquidity issues for AIFs in addition to challenging the lock-in rules.

FAQs: –

1. https://en.wikipedia.org/wiki/Shaktikanta_Das