[By Sibasish Panda & Disha Bandyopadhyay]
The authors are students of National Law University Odisha.
Introduction
India’s economy stands as one of the fastest-growing major economies worldwide. The growth in the investment market has been impeccable especially with the Alternative Investment Funds (AIFs) now surpassing the mutual funds (MFs) in terms of growth rate. With transparent structures, a diversified portfolio, and a promise of superior returns the industry has attracted investment from a wider spectrum of investors encompassing High Net individuals (HNIs) and Ultra High Net Individuals (UHNIs). AIFs have experienced a remarkable Compound Annual Growth Rate (CAGR) of 26%, resulting in impressive assets under management (AUM) of ₹13.74 lakh crore as of June FY24. SEBI as of June 2023 reported the total commitment by the AIF industry to stand at Rs 8.44 trillion. The Security Exchange Board of India (SEBI), and the Reserve Bank of India (RBI) are working hand in hand to make the market more investor-friendly by curbing shoddy practices such as “Evergreening of loans” through AIFs. SEBI was reported to investigate such cases involving Rs15,000 crores to Rs 20,000 crores. In November 2022 it also banned the priority distribution (PD) model of the AIFs and now the RBI has come up with a circular directing lenders investing in alternative investment funds to liquidate their holdings if the funds invest in a debtor firm.
The authors in this blog try and analyse the impact of the RBI guidelines on the players involved in the industry.
Background
RBI noticed a practice whereby banks or Non-Banking Finance Companies (NBFCs) when they find that a borrower is unable to repay, float an AIF, invest funds in that AIF, and lend the money to the stressed company so that it can repay the bank or the NBFC. Now since AIFs redeem themselves after six or seven years the borrower company has enough time to turn A naround. This practice of extending new loans to a borrower to pay the existing loans thereby concealing the status of non-performing assets is known as the Evergreening of loans.
In May 2023 SEBI floated a consultation paper highlighting the regulatory arbitrage of “priority distribution (PD)” among AIFs. It envisages that AIFs maintain the pro-rata rights of the investors since they are privately pooled investment vehicles. Now in a PD model an investor who subscribes to a junior tranche suffers loss more than the one who subscribes to a senior tranche thus disrupting the pro-rata harmony. This arrangement is used by regulated lenders to offload the bad loans to the AIFs and to mitigate the initial impact on their books.
The regulated lenders subscribe to the junior class of investors and their investment is equivalent to a loss on the loan portfolio given to the borrower. The AIF then onboards other investors to its senior class and subscribes to the Non-convertible Debentures (NCDs) of the borrower company. This investment, representing the expected loss or haircut on the loan portfolio, is shown at par with senior class units in the lender’s books. This structure potentially helps regulated lenders avoid compliance requirements related to defaulting loans, while also deferring the recognition of the deteriorating creditworthiness of the investee company. Now the junior class of AIFs is structured to absorb losses hence by subscribing to the junior class the lender also ensures that in case of any further default by the borrower, the risk is proportionately distributed among the whole class of investors of the AIF and bad loan is not reflected in the books of the lender.
Although the borrower may still default on the AIF, the AIF can hold defaulted debt for extended periods, waiting for potential recovery. The risk is somewhat concealed as the NBFC’s exposure to the AIF doesn’t immediately reflect the default, and the AIF can take several years before declaring the debt as unrecoverable. This process allows the NBFC to maintain the appearance of a healthy portfolio by avoiding the immediate recognition of bad loans and creating a situation commonly known as “evergreening,” where the default is obscured over time.
RBI’s Stringent Measures: Impact on Regulated Entities, Market Disruptions, and Investor Confidence
To prevent this regulatory arbitrage, the RBI in the recently released circular takes a restrictive stance. It has directed investor Regulated Entities (REs) and NBFCs not to invest in any AIFs that have a downstream investment in debtor companies that have loans or investment exposures from the same REs in the preceding 12 months. It further directs the REs to liquidate their investment in the AIFs within 30 days of the AIF’s investment in the debtor company. This timeline applies to both investments as of the issuance of the circular and also in case of any future investments.
This short timeline would trigger panic selling among the investors and they would rush to comply with the directive. Such abrupt liquidation of investments and mis-selling in such a short period can cause market disruptions and negatively impact asset prices. The 30-day timeline would be inadequate to carry out thorough due diligence. This raises the risk of undervaluation of assets and diminished return as a result of forced selling.
Another flagged issue is the circular’s broad application to all REs would inadvertently impact Development Financial Institutions (DFIs) such as SIDBI, NABARD, NHB, NIIF, etc. These DFIs often have a developmental mandate to channel capital into specific sectors for economic growth. Unlike entities engaging in evergreening practices, DFIs may not have the intent of concealing non-performing assets. However, the circular, by applying uniformly to all REs, including DFIs, may unintentionally subject them to the same regulatory provisions. This could be counterintuitive to the primary purpose of DFIs, potentially hindering their ability to fulfill their developmental objectives by imposing restrictions meant to address issues unrelated to their specific operations.
Now to make a 100% provision on their investments, regulated entities (REs) must essentially recognize their entire investment as a potential loss by setting aside the entire amount as a provision. This affects the REs as the provision will be treated as an expense in the books of the RE. If the expenses of the REs are higher, they will have more losses (lower profits), and their “shareholder equity” will be reduced. This will have an immediate negative effect on the REs’ financial statements and possibly hurt their overall financial health and profitability. Setting aside the entire amount as a provision will also impact the capital adequacy ratio of the REs. Their capacity to engage in new lending or investment activities may be restricted if they are forced to re-evaluate their capital position to maintain regulatory compliance.
Navigating Challenges: AIFs Grapple with Regulatory Impact and Capital Constraints
The recent guidelines pose a challenging road ahead for the AIF industry. AIFs are pooled investment vehicles with a significant contribution from banks, NBFCs, and other financial institutions that look for suitable investment opportunities. Since the industry is in the nascent stages, finding a replacement for that proportion of investment will be arduous. With the reduction of their investable corpus, it will be difficult for AIFs to find the best investment opportunity and honour further obligations. In a bid to sell their units amidst increased scrutiny and regulatory constraints, the AIFs will start fetching foreign investors which then cannot be screened under the purview of the RBI. This oversight gap increases the possibility of fraud, market manipulation, and other wrongdoings in the AIF Sector.
The 100% %provisioning norm of the RBI regulations puts a blanket ban on the investment of a RE even though only a single bad loan with any borrower might be detected. In the case of AIFs that have investments in certain REITs or InVITs, this provisioning norm and potential constraints on REs might challenge the AIFs in terms of capital availability. This could affect their ability to contribute to new projects or expand their existing investments in these infrastructure-related entities. Although the fund does not attract a penalty provision, sometimes the fund managers might be unaware of a stray working capital loan accessed by the borrower, from the lender in the past. Hence, this “Shut the road for all” approach of the RBI is prone to discourage investments.
A significant number of AIFs also have investments in publicly listed companies, and some of these financial institutions may have already extended credit to these AIFs. For instance, Sidbi, the government’s credit initiative has invested 90,000 Crore in these funds which are to be further invested in various start-ups. Now due to the blanket bank even if the entity where an AIF intends to invest has utilized a credit card or banking service from a bank or NBFC, these financial institutions are prohibited from investing in the specific AIF according to the proposed regulations. Hence this reduction of investment corpus is likely to impact the money from other investors and halt the progress of such initiatives.
The way forward
Keeping in sight the operational challenges and potential repercussions of liquidating investments within 30 days, this timeline needs to be mulled over by the RBI and extended to a more realistic duration. It should engage all the stakeholders including REs, AIFs, and other industry experts in thorough consultation for a phased implementation of a revised timeline.
The major hit of the circular is to the NBFCs compared to banks and other financial institutions which have a cap of 10 percent on their investments into the AIFs. The evergreening strategy employed by some NBFCs involves these companies’ contributing 40 percent of the capital to an AIF. This allows NBFCs to delay recognizing defaults on their asset books. Now instead of a 100% provisioning, even if the RBI imposes a regulatory limit, such as capping the exposure of lenders in AIFs to 10 percent of the fund corpus within six months, it can make the NBFCs investment in the AIFs unviable once it exceeds such cap. Since NBFCs would have to reduce their AIF exposures within a stipulated period to comply with the new regulations, this limitation may potentially disrupt their ability to use AIFs for evergreening.
Investor protection and transparency in these funds can also be increased by asking them to hold their assets and liabilities in dematerialized form as it reduces the risk of fraud and facilitates efficient reporting and disclosure mechanisms. In conclusion, the recent stringent measures introduced by the RBI aimed at curbing practices such as “Evergreening of loans” through AIFs have sparked significant debates and concerns within the financial landscape. Rather than outright prohibiting regulated entities from investing in AIFs that have exposure to RE borrowers, a more practical approach might be to impose restrictions based on the status or performance of the RE accounts relative to their customers. This strategy aims to balance risk weightage accuracy on REs’ balance sheets, enabling their contribution to AIFs without hindering growth and innovation in the credit market, also aligning with the RBI’s goal of managing stressed loans through regulations.