Investment curbs in AIFs - A Regulatory Chokehold

Private credit in India, akin to many global markets, has gained a lot of momentum considering many factors such as restrictions on banks and other regulated entities to fund certain kinds of transactions, the allure of higher returns offered by private credit funds to its investors and relatively lesser regulatory obligations. All these factors have led to investors entrusting their money to private credit funds. Recognising this rise of private credit, banks and other regulated entities are also capitalizing on the momentum. Notably, ‘The Economic Times’, a leading national daily, recently reported a surge in the registration of alternate investment funds, with fifteen having registered and more than fifty applying for registration with the Securities Exchange Board of India in the first half of 2023.

In a significant move, the Reserve Bank of India (RBI), by way of its circular dated December 19, 2023 (“circular”), has, inter-alia, prevented banks and non-banking financial companies (“NBFCs”) (referred as “Regulated Entities” or “REs”) from investing in schemes of Alternative Investment Funds (“AIFs”) that have direct or indirect downstream investment in debtor companies of such REs.

The circular further provides that if an RE is already an investor of an AIF scheme that makes a downstream investment in any such debtor company, then the RE is required to liquidate its investment in the scheme within thirty days from the date of such downstream investment. Further, the circular also aims to strike at existing investments of the REs by providing that if the REs have already invested into such schemes having downstream investment in their debtor companies as on date of the circular, then the period of thirty days provided for liquidation of its investment in such scheme shall be counted from the date of issuance of the circular.   

In case the REs are unable to liquidate their investment in the prescribed schemes within the said time limit, they are obligated to make 100 percent provision on such investments. The circular also provides that investment in the subordinated units of any AIF scheme with a priority distribution model will be subject to full deduction from the RE’s capital funds.

The objective of the circular is stated to be a preventive measure to tackle evergreening of loan exposures by REs in stressed borrowers, by adopting the route of substituting direct loan exposure of REs to such borrowers, with indirect exposure through investments in units of AIFs.

The evolution of the credit market has been influenced by various factors, including changes in the economic landscape, regulatory frameworks, and the emergence of new financial entities.

Traditionally, banks and NBFCs played a central role in meeting the credit needs of the investors. The regulatory frameworks for banks and NBFCs were designed to ensure financial stability and ensure protection of investors. However, as economies expanded, certain investors with a high-risk appetite sought more diverse, flexible, and specialized financial products, viewing traditional banking options as restrictive.

In response to this demand, specialised financial products were structured for these sophisticated private investors seeking higher returns and diversification beyond traditional debt instruments. To facilitate investments in these products, pools of funds, such as Venture Capital (VC) Funds or AIFs, were generated from these investors. The financial structuring of these products was managed by specialised professionals, tailored to the preferences of investors with an appetite for high-risk/high-return opportunities. The regulatory environment for these funds also provides more flexibility compared to the stringent regulations governing banks and NBFCs.

Given the extreme risk-reward profile, in order to diversify their risk, REs also started investing a portion of their funds in such products. This investment model has been driven by the confidence derived by other investors in such AIFs, that is, while, on one side, REs benefit from the expertise of fund managers who make informed decisions for investors, leveraging their knowledge and experience, on the other side, AIFs also capitalize on the confidence that other investors derive from having an established RE as part of the investor group.

To uphold the integrity of the relationship between sponsors and AIFs, the regulatory framework also incorporated specific provisions. Notably, under Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”), investment manager or sponsor are required to maintain a continuing interest of at least two and a half percent (five percent in case of category III AIF) of the fund's corpus or five crore rupees (ten crores in case of category III AIF), whichever is lower.  Similarly, Regulation 21 of the AIF Regulations mandates sponsors and investment managers to promptly disclose all conflicts of interest as they arise or appear likely to arise.

As stated above, the objective of the circular has been stated to curb the practice of evergreening of stressed loans by REs by making indirect investments in the concerned borrowers through AIFs. Evergreening is a practice where institutions extend or renew existing non-performing loans to avoid recognizing losses. In past few years, many instances have come to light where an AIF invested in companies that have existing loans from the regulated entities, which in turn have  investments in such AIFs. These investments were then utilised to evergreen the loans given by REs allowing the REs to avoid recognizing non performing assets.

Further, the SEBI in its circular SEBI/HO/AFD-1/PoD/P/CIR/2022/157 stated that it has been brought into SEBI attention that “certain schemes of AIFs have adopted a distribution waterfall in such a way that one class of investors (other than sponsor/manager) share loss more than pro rata to their holding in the AIF vis-à-vis other classes of investors/unit holders, since the latter has priority in distribution over former."

In view of this increasing trend of indirect evergreening of loans, the RBI has promulgated the circular, mandating REs to either liquidate their investments in the AIFs or else make 100 percent provisioning for such investments.

While the circular appears to aim at addressing the practice of evergreening, the blanket restriction imposed by the circular raises further issues and inadvertently introduces challenges that hinder the advantages of the AIF structure:

1. Potential loss of superior investment opportunities:

   Established REs may have already made investments in certain borrowing companies by conducting their due diligence, having a proven track record and establishing credit worthiness of such borrower and their projects/businesses. Despite the challenges associated with evergreening, it's crucial to recognize that the credit history and relationships maintained by REs with their borrowing entities, brings a sense of comfort to AIF funds and other non-RE investors. The restriction imposed by the circular will prevent the AIFs from investing in such borrowing entities which already enjoy credit facilities from the REs based on their performance parameters. This can potentially lead to a situation where the AIFs miss out on superior investment opportunities as the REs are already invested in them, and may have to look for other investment avenues which may be inferior in value or return or may carry greater risk. The crux of the issue lies in the fact that, under this new restriction, any superior deal where REs themselves directly invest would exclude AIFs associated with these REs from sharing the risk in such deals.

2. Impact on non-RE investors:

   If REs opt out of AIF investments due to individual relationships with debtors, it will impact the AIF itself. The reputation and expertise of REs influence the selection of AIFs by non-RE investors. The restriction alters the landscape, compelling investors to allocate capital based on regulatory constraints rather than credit worthiness of borrowers.  The fact that an AIF has certain REs as limited investors, demonstrates a strong dedication to achieving positive returns and reinforcing investor confidence in the fund's success.

3. Role of sponsor:

   In AIFs, REs often play a crucial role as sponsors or general partners. Certain AIFs may have specific conditions in place that dictate investments only in entities with an existing relationship with the general partner/sponsor (which, in this case, might be the RE); or there may be a requirement of co-investment which requires the sponsor/general partner to also co-invest in the concerned borrowing entity along with the AIF. This is to ensure that the sponsor/general partner always has a skin in the game and there are greater checks and balances on the investment decisions taken by the AIF, thereby giving more comfort to the other investors in the AIF. It is also important to note that the AIF Regulations also recognises the concept of ‘co-investment’. It merely imposes a condition that the terms of co-investment (including terms of exit) shall not be more favourable than terms of investment in AIF. 

4. Operational challenges:

   The directive poses operational challenges as REs are significant players with investments in numerous entities. Identifying and liquidating these investments within the thirty day timeframe required by the regulation may be difficult and can result in liquidity challenges for the concerned AIFs.

5. Market stability:

   This decision of the regulator could inadvertently disrupt the overall stability of the market, as investment strategies may shift towards meeting regulatory requirements rather than pursuing promising opportunities.

If the intention behind this RBI step is to combat evergreening, a more effective way may have been where RBI could have collaborated with SEBI to establish specific norms to curb the practise of evergreening. There could have been prescribed compliance norms to be followed by the AIFs while identifying potential investment avenues and laying down of certain objective parameters to determine credit worthiness of potential borrowers by AIFs which may have served the purpose in a better manner, rather than imposing a blanket restriction on investments under the circular.   

In the above vein, the Indian Venture and Alternate Capital Association (IVCA) is reportedly in discussions with central government officials to address some of the challenges which may be faced by REs and AIFs in light of the circular.

While evergreening is definitely a practice which needs to be curbed, addressing this issue requires a pragmatic and constructive approach rather than imposing restrictions that may adversely impact financial avenues and result in a situation where AIFs are left with limited investment opportunities which will ultimately lead to an adverse impact on the larger interest of its investors.

About the authors: Devyani Dhawan is an Of-Counsel and Ayushi Parnami is a Senior Associate at SNG & Partners.