On December 19, 2023, the Reserve Bank of India (RBI) restricted banks, non-banking financial companies, financial institutions, asset reconstruction companies and other entities qualifying as Regulated Entities to invest in alternative investment funds (AIFs) that have portfolio investments in entities which are borrowers or investees of any such regulated entity.
This notification from the RBI comes with a stated intent of addressing concerns around evergreening of loans. Evergreening means substitution of a loan through another source of investment or credit exposure directly or indirectly, leading to masking the true status of the original loan.
It has been observed that a few regulated entities also have an indirect exposure in their borrowers or investees through privately placed pooled investment products being AIFs. Some regulated entities have sought to do evergreening of their loans, delaying timely recognition of non-performance of the loan while simultaneously impacting on-time resolution of such non-performing asset.
The RBI also prescribed that a regulated entity shall liquidate its investment in an AIF within 30 days from the date on which such an AIF makes an investment in the borrower or investee of the regulated entity. This 30-day period shall start from the date of the RBI notification where such a relationship between the regulated entity, AIF and the borrower or investee already exists.
The requirement of exiting the investment or the prohibition on making an investment in an AIF comes with a 12-month look-back period for the regulated entity having a lender or investor relationship with the investee of such an AIF.
The RBI mandated that all regulated entities failing to liquidate their investments in accordance with its notification shall be required to fully provide for such investments.
Practical challenges
AIFs are pooled products that call committed amounts from its investors on as-needed basis when suitable investment opportunities are identified. Since the notification prohibits any future investments (which includes unfunded commitments) in AIFs that have invested in borrowers or investees of the regulated entity, the managers of such AIFs may find it increasingly difficult to honour the AIF’s future funding obligations to its portfolio entities owing to a reduction in AIF’s investable corpus.
Most AIFs are closed-ended products and the investor’s ability to transfer its units is highly restricted. The secondary market in India for AIF units is also in its nascent stage with not many stakeholders available that will be able to absorb the units of regulated entities.
Most of the regulated entities having exposures in AIFs, which, in turn, have invested in the regulated entities’ debtors or investee entities, may have to make 100% provisioning for such investments. This will be an added financial cost on such entities.
Going forward, regulated entities will have to ensure that the AIFs they are invested into do not make investments in such entities which are borrowers or investees of the regulated entities. AIFs may have to ensure that their investees do not set up a credit facility or take investment from regulated entities that are also an investor in the AIF. Specific rights of this nature may not be commercially feasible.
Impact on AIF industry
An uptick in the number of broken deals and associated costs may be an immediate effect of this notification.
A significant portion of the contributors to AIFs in India are banks, non-banking financial companies and financial institutions. AIFs may find it difficult to raise capital commitments. This can have a direct impact on the availability of alternative source of capital.
Such restrictions may lead to an over-reliance on foreign institutional capital and close the tap for domestic institutional capital even in cases where the managers of AIFs are unrelated to the regulated entities.
Way forward
In our view, the notification is trying to address an extremely valid concern of the RBI. Evergreening of loans has the potential to hurt the economy in the long term and destroy investor wealth.
However, it would have been germane if the notification was contextualised and pointed in its applicability. For instance, the requirement of provisioning could have been made applicable on a proportionate basis given the fact that AIFs have a regulatorily mandated concentration limit to invest their funds in any one investee, which is generally capped at 25% of investable corpus.
The AIF industry is expected to suffer and the regulated entities are expected to make significant provisions, if the RBI doesn’t come up with a clarification soon.
Vivaik Sharma is Partner, Kartik Dhir is Senior Associate and Siddharth Shukla is Associate at law firm Cyril Amarchand Mangaldas.
