[By Lavanya Chetwani]
The author is a student of National Law University Odisha.
INTRODUCTION
Recently, the Reserve Bank of India (‘RBI’) vide its circular dated December 19 has issued guidelines to prevent all Regulated Entities (‘RE’) from holding units of Alternative Investment Funds (‘AIF’) which have invested in a debtor company of the RE. AIFs are currently regulated by the Securities and Exchange Board of India (‘SEBI’) under the SEBI (AIF) Regulations, 2012 (‘The Regulation’) and SEBI Master Circular For AIFs, 2023 (‘MC-AIF’). The guidelines issued by the RBI is motivated by a consultation paper issued by SEBI on 19 May 2023. SEBI had identified in its consultation paper certain structures which could be used for “evergreening” of loans by regulated entities. However, the guidelines might have an impact beyond the stated intent.
UNDERSTANDING THE GUIDELINES
AIFs have been defined by SEBI in paragraph 2(1)(b) of the Regulation as any fund established or incorporated in India which is a privately pooled investment vehicle which collects funds from sophisticated investors, whether Indian or foreign, for investing it in accordance with a defined investment policy for the benefit of its investors. As per paragraph 3(4) of the regulations, there are three categories of AIFs. Category I include infrastructure funds, angel funds, venture capital funds etc. Category II include funds like private equity funds, debt funds etc. and Category III includes funds which give returns under a short period of time like hedge funds.
The latest guidelines by the RBI bring the following changes:
1. Investment Restriction
The guidelines prohibit REs from investing in any scheme of the AIFs which has downstream investments in a ‘debtor company of the RE’. Downstream investments, though not defined in these guidelines, have been defined under Rule 23 Explanation (g) of the Foreign Exchange Management (Non-Debt Instrument) Rules, 2019 as investment made by an Indian entity which has total foreign investment in it, or an Investment Vehicle in the capital instruments or the capital, as the case may be, of another Indian entity. The circular is unfavourable for REs with genuine investments in these AIFs, and due to strict timelines, there is a high probability that these REs will struggle to liquidate their investments.
2. Liquidation time
Moreover, if in case, the RE has already invested in an AIF scheme and that AIF later makes a downstream investment in the debtor company of the RE then the RE has to liquidate its investments in such AIF scheme within 30 days. Additionally, should the RE already have invested in an AIF scheme, the 30-day timeframe will start on the date of issuance of circular i.e. 19 December 2023. The guidelines also lay out that the REs have to make 100 percent provision on such investments if they are unable to comply with the stipulated timelines. These regulations strengthen transparency and compliance through clear definitions and timeframes, but also raises concerns about administrative burden, exit challenges, and potential unintended consequences like decreased RE participation and concentration risk.
3. Priority Distribution Model
The directions also provide that investment by REs in the subordinated units of any AIF scheme with a ‘priority distribution model’ will be subject to a full deduction from RE’s capital funds. The explanation of this clause provides that ‘priority distribution model’ shall have the same meaning as in the circular issued by SEBI. According to paragraph 3 of the circular it means AIF schemes that use a waterfall distribution model suffer a share loss relative to other investor classes or unit holders that is greater than pro rata to their investment in the AIF because the latter has priority in distribution over the former.
While transparency and risk mitigation improve, REs face limited options and AIFs with these models may struggle to attract investors.
EVERGREENING OF LOANS
The RBI in its circular mentioned that the guidelines have been issued in order to deal with the problem of REs ‘evergreening’ loans through the AIF route. The similar issue was highlighted and informed by the SEBI to the RBI last year. In simple words, evergreen loans mean loans that never end. Evergreening of loans imply instances when REs provide the borrower another loan through AIF as an investment vehicle in order to repay the previous in default debt. Then, in order to demonstrate a low percentage of non-performing assets on their books, REs turn to these loans. The REs do so because once classified as such, they will have to provide for losses, which will in turn reduce profits. It has the potential to mislead about the profitability and asset quality of banks and to postpone the identification and resolution of stressed assets.
However, the circular is unclear about whether AIFs in the Debtor Companies are pursuing this evergreening through fresh debt or equity infusion. Consequently, the circular refers to “investments” without making a distinction between debt and equity infusion.
DECIPHERING THE GUIDELINES: UNVEILING KEY CONCERNS
It is pertinent to highlight that SEBI, through paragraph 11 of the MC-AIF, has already imposed a restriction on arrangements incorporating priority distributions. Consequently, this broad prohibition by the RBI has the potential to negatively affect REs’ capacity to engage with AIFs that provide risk-adjusted returns for diverse groups of investors via various unit classes.
Additionally, the RBI Circular appears to be at odds with the inherent characteristics of AIFs. AIFs (Category I and Category II) are legally structured as privately pooled blind investment vehicles, characterized by a close-ended nature. AIF investors typically lack visibility into the AIFs’ investments and lack the right to freely redeem their units due to the highly illiquid nature of the AIF’s investments. Moreover, any transfer of AIF units necessitates explicit consent from the investment manager of the AIFs. In contrast, the RBI Circular mandates regulated entities to liquidate their investments in AIFs with downstream investments in debtor companies within 30 days. Assuming consent from the investment manager for the transfer, regulated entities may encounter challenges in finding buyers in the market, given the substantial cheques issued for AIFs, which may not easily be absorbed by a single buyer. Furthermore, even if a buyer is identified, the stringent timelines set by the RBI could compel regulated entities to write off 100% of their AIF investments, considering the necessity for a comprehensive due diligence exercise involving significant sums of money and addressing tax and valuation concerns.
Additionally, the circular seems to presuppose that the REs who have invested in AIFs which has overlapping investments, do so with the intention of evergreening loans. There is no clarification as to the genuine independent investments by the REs in such AIFs.
NAVIGATING THE POSSIBLE IMPLICATIONS AND CONSEQUENCES
While the intent of the RBI behind introducing these guidelines is to prevent evergreening of loans, the scope of these is wide, non-discriminatory and disproportionate. It doesn’t solely impact affiliated AIFs; instead, it affects any AIF across the board, causing a drain on funding from REs. Although the restriction specifically targets AIFs with investments in “debtor companies,” it will be challenging in practice for REs to prevent overlapping investments. Due to the significant consequences of non-compliance, REs mindful of compliance issues are likely to abstain from investing in AIFs.
The circular is also unfavourable for the REs which had genuine investments in these AIFs and considering the strict timelines, there are high chances that these REs will not be able to liquidate their investments.
The circular also has the potential to affect many other stakeholders. Predominantly, domestic investment in Indian AIFs comes from REs, putting domestic institutional capital at a disadvantage compared to foreign capital.
CONCLUSION
Overall, the restrictions go beyond the stated purpose, even though the RBI had a reasonable reason for enacting these laws. The AIF industry has yet again faced a setback due to these guidelines as it will significantly impact their access to domestic institutional capital. The stringent timelines for liquidation may pose challenges for REs, impacting genuine investments. While addressing evergreening is crucial, the guidelines need refinement to avoid unintended consequences, ensuring a balanced approach that promotes transparency without stifling investment avenues.