This article has been written by Bhabesh Satapathy and Shreeya Kajaria, 3rd year law students at National Law University, Odisha and O P Jindal Law School, Sonepat, respectively.
Recently, the Reserve Bank of India, (“RBI”) in response to mounting concerns over regulatory violations and the misuse of Alternative Investment Funds (“AIF”) by Regulated Entities (“RE”), has issued a notification which seeks to address concerns of evergreening of loans by banks and Non-Banking Financial Companies (“NBFC”). Here, evergreening in simple terms, is a financial practice in which lenders extend or renew existing loans that are at risk of default to defer the recognition of losses, creating the appearance of a healthier loan portfolio. At the heart of these concerns is the clandestine substitution of direct loan exposure by REs to borrowers with indirect exposure through AIF investments.
The surreptitious manoeuvre of substituting direct loan exposure with indirect AIF investments not only obscures the transparency of stressed loans but also ominously taints the financial credibility of banks, NBFCs, and other involved institutions. As these financial entities grapple with the regulatory notification, the multifaceted implications and concerns of the RBI’s stance on AIF investments resonates across the industry.
This blog aims to discuss the rationale behind this notification and provide an overall overview of the key mandates given by the RBI. It shall critically analyse the notification and further, delve into the various broader concerns and ramifications associated with the notification.
Background & Intent Behind This Move
AIFs are the financial entities that aggregate funds from high-net-worth individuals (“HNI”), corporate treasuries, international investors, and domestic institutional investors like banks, NBFCs. The pooled funds are subsequently deployed, with the aim of generating returns in accordance with a predetermined strategy as outlined in the Securities and Exchange Board of India (Alternative Investment Funds) Regulations 2(1)(b), 2012.
The concerned RBI notification responds to the recent Securities and Exchange Board of India (“SEBI”) revelations of circumvention involving substantial financial amounts. Last month, a SEBI official internally reported[ME1] [bhabesh2] providing the RBI with data illustrating the structuring of AIFs for evergreening financial sector assets, attempting to avoid non-performing asset (“NPA”) recognition and publicly raised the alarm about numerous cases of egregious regulatory violations by AIFs, amounting to a staggering $1.8 billion to $2.4 billion, with RBI’s concurrence. Aligned with SEBI’s assessment, the RBI acknowledged this information.
The RBI Governor Shaktikanta Das’s pivotal address in May 2023, exposed innovative methods used by lenders to obscure the true status of stressed loans. Usually, elevated NPAs unsettle the investors, prompt potential stock selloffs and downgrade the credit rating. This, in turn, hampers the company’s ability to secure financing, leading to higher interest rates.
Financial entities resort to different methods to conceal NPAs, safeguarding their interests. These methods include collaborative evergreening of loans, structured deals to mask stress, and the use of internal accounts to adjust repayment obligations.
Key Mandates in the Notification
This notification, disseminated by the RBI introduces a nuanced spectrum of considerations for REs in regards to their investments in AIFs, necessitating a thorough comprehension of its principal mandates.
Firstly, through this notification, the RBI seeks to prescribe entities under its regulatory purview, encompassing commercial banks, cooperative banks, NBFCs, and All-India financial institutions, from engaging in investments in AIFs with downstream investments, whether direct or indirect, in debtor companies existing at present or in the recent past. In this context, ‘recent’ encompasses all companies to which the RE has had investment or lending exposure in the preceding 12 months, including the current period.
Secondly, in instances where a RE is an investor in an AIF’s scheme with a downstream investment in a debtor company as of the notification’s issuance date, the stipulated thirty-day period for liquidation commences from the notification’s issuance date. However, if the given timeframe elapses without successful liquidation, the REs are mandated to make a full provision of 100% for such investments.
Moreover, the notification imposes an advisory responsibility upon the RE with respect to the relevant AIFs. This obligation requires a meticulous examination of the portfolio companies within the AIF schemes wherein the REs have investments. Subsequently, the REs are obligated to promptly notify the AIFs in the event that any portfolio company within these schemes is identified as a debtor entity of the RE.
And, lastly, if the REs have allocated any capital to the subordinated units of AIF schemes employing a ‘priority distribution model’ (“PDM”)’, it shall be deducted in full from the capital funds of the REs. The term ‘PDM,’ as defined in the SEBI circular dated November 23, 2022, pertains to a model wherein a specific class of investors is afforded preferential treatment in the distribution of exit proceeds over other classes. This model, grounded in the principle of ‘higher the risk, higher the reward,’ enables the precedent class to manage risks effectively and potentially attain a more favourable risk-reward ratio.
Critical Analysis
The recent notification by the RBI introduces a multifaceted landscape of considerations for REs contemplating investments in AIFs. While ostensibly addressing concerns related to evergreening, the notification’s potential impact on the financial ecosystem demands a meticulous analysis.
Firstly, the notification, with its provision mandating either exit or a full 100% provision if the invested AIF subsequently invests in a debtor company of the same bank or NBFC, raises concerns about its impact on future RE investments. This stringent approach, while addressing evergreening concerns, may inadvertently deter REs even for legitimate purposes like risk diversification. Anticipating this, REs may seek commitments from AIFs pre-investment, ensuring that the AIF refrains from investing in any existing debtor company associated with the RE. Such commitments may find a place in the AIF’s Private Placement Memorandum through amendment or a side-letter, subject to investor consensus.
Secondly, the notification’s impact could potentially have been mitigated with specific thresholds. For instance, triggering the prohibition on REs investing in AIFs that have invested in debtor companies could be contingent on factors such as the RE’s investment constituting at least 25% of the AIF’s investment in the debtor company, coupled with the RE’s loan to the debtor company maturing within a specified timeframe. The absence of such detailed thresholds introduces ambiguity and adds complexity to compliance.
Thirdly, exploring scenarios where AIFs invest in subsidiaries while RE invests in holding companies introduces regulatory complexity. Clear understanding and guidelines are essential to navigate the interplay between these complex shareholding structures. Also, it is pertinent to note that the notification doesn’t become applicable when a RE participates in an AIF scheme, even if another scheme within the same AIF or any scheme managed by an AIF with the same investment manager invests in a debtor company of the RE.
And, lastly, the notification’s broad impact, without specific categorization considerations, may disproportionately affect Category II AIFs, including real estate and debt funds, because they tend to have more lender participation. Further, the outright curb on investments by REs disproportionately affect Category III AIFs, commonly known as “hedge funds”, which extend beyond the intended scope as they typically engage in equity long/short strategies and other leveraged trades. Notably, considering the extensive array of investments made by Category III AIFs, avoiding any overlap with the borrowers of REs would prove exceptionally challenging.
Possible Impact on the AIF Industry
The immediate consequence of this notification could be an increase in the number of failed deals and the associated expenses. A substantial proportion of contributors to AIFs in India comprises banks, NBFCs and financial institutions. AIFs might encounter challenges in securing capital commitments, directly affecting the availability of alternative sources of capital.
These limitations might result in a heightened dependence on foreign institutional capital, potentially shutting off the flow of domestic institutional capital, even in cases where the AIF managers have no affiliations with the regulated entities.
Given the immediate implementation, certain NBFCs may find themselves urgently liquidating their units or facing significant impacts on their financial results. This scenario could prompt a downgrade in the ratings of these NBFCs, subsequently causing higher capital impacts on bank exposures. Ultimately, this could culminate in a funding shortage for several NBFCs.
Way Forward
The notification effectively addresses the RBI’s valid concern about the long-term adverse effects of loan evergreening on the economy and investor wealth. However, it lacks specificity and context in its application. For instance, the provisioning requirement could have been proportionate to the regulatory concentration limits imposed on AIFs, usually capped at 25% of their investable corpus for each investee. The impending challenges for the AIF industry due to the lack of clarification from the RBI may necessitate significant provisions by regulated entities. Additionally, the new regulations, while aiming to curb evergreen loans through AIFs, are expected to have a cascading impact on both the RE and AIF sectors. The RE sector may bear the burden of liquidation, prompting entities to approach the RBI for relaxation and a potential extension of the liquidation period. A more nuanced approach, addressing existing concerns and loopholes, would better facilitate the regulations’ smoother implementation, aligning with the RBI’s objective.