Alternative Investment Funds (“AIFs”) have emerged as dynamic players in the financial landscape, wielding vast pools of capital for diverse investment opportunities. Aimed at sophisticated investors with high-risk appetites, AIFs invest in unlisted companies, private equity, venture capital, real estate, and other alternative assets not readily accessible to the average investor. This flexibility has propelled them to prominence, offering potentially high returns and diversification benefits within investment portfolios.

However, amidst their ascent, a worrisome trend has grabbed the attention of the Reserve Bank of India (“RBI”): the “evergreening” of loans through AIFs. Evergreening, a euphemism for concealing bad debt, often involves rolling over existing loans to postpone default recognition. In the context of AIFs, the RBI identified a concerning practice: banks and financial institutions replacing direct exposure to struggling borrowers with indirect exposure through investments in AIFs holding stakes in those same companies. This essentially shifts the burden from their loan books to the AIF, potentially masking financial strain and jeopardizing investor interests.

Recognizing the potential for systemic repercussions, the RBI stepped in to curb this practice. The recent circular, Investments in AIFs – RBI/2023-24/90,[1] marks a significant regulatory intervention aimed at safeguarding financial stability and protecting investor interests within the AIF ecosystem. By analyzing the limitations imposed and their likely impact, we delve deeper into the RBI’s attempt to tackle the evergreening conundrum and its implications for AIFs, lenders, and the broader financial market.

Regulatory Restrictions

The RBI’s circular wields a two-pronged attack on evergreening: a blanket ban on overlapping exposures and stricter rules for certain AIF structures. These are:

    1. Prohibition on Overlapping Exposures: The core thrust lies in clause 2(i), which states that “Regulated Entities (“REs”) shall not make investments in any scheme of AIFs which has downstream investments either directly or indirectly in a debtor company of the RE.” This effectively cuts off the pathway for evergreening through AIFs. For instance, there is Bank A with a troubled loan to Company X. Under the new rules, Bank A cannot invest in any AIF holding shares in Company X, directly or through another investee company. This prevents the bank from simply shifting its bad debt to the AIF’s books.
    2. Time for Restructuring: Recognizing existing overlaps, the RBI offers a 30-day grace period for REs to divest from AIFs with conflicting exposures. This provides flexibility for unwinding existing arrangements without causing undue disruption. However, non-compliance comes at a hefty price: 100% provisioning on such investments, effectively treating them as non-performing assets on the RE’s books. This serves as a strong deterrent against attempting to circumvent the regulations.

Priority Distribution Units

Moving beyond the core prohibition, the RBI casts a critical eye on AIF structures with “priority distribution models.” In these models, certain investors receive preferential payouts during liquidation or winding up, potentially leaving other investors with meagre returns. Clause 2(iii) addresses this concern by mandating full deduction of such investments from REs’ capital funds. This means that investments in AIFs with priority distribution models will weigh heavily on an RE’s capital adequacy ratio, discouraging such investments unless the potential returns are significantly high. To ensure clarity, the circular references the SEBI definition of “priority distribution model” provided in their November 2022 circular. Essentially, such models prioritize payouts to specific investor classes (e.g., sponsors) before distributing the remaining assets to other investors. This can create an uneven playing field and expose non-privileged investors to higher risks.

By imposing these restrictions, the RBI aims to safeguard the AIF ecosystem from becoming a dumping ground for bad debt and protect investor interests. The clear timelines, strict provisioning requirements, and additional scrutiny on priority distribution models showcase the RBI’s commitment to maintaining financial stability and fostering a healthy AIF landscape.

Implications

The recent RBI regulatory measures addressing evergreening practices through AIFs have broad implications for AIFs, REs, and the lending landscape.

Impact on AIFs

    • The ban on overlapping exposures will shrink AIFs’ potential investor pool, particularly affecting those focused on distressed assets.
    • AIFs may shift focus to healthier sectors, promoting responsible investment practices.
    • Regulatory scrutiny may drive AIFs to adopt higher transparency standards, attracting long-term capital.

Impact on REs

    • Stricter regulations incentivize REs to adopt rigorous due diligence and lending practices.
    • Existing cases of evergreening through AIFs may face challenges during unwinding, impacting profitability.
    • Compliance may divert resources from REs’ core lending activities, especially for smaller institutions.

Impact on Lending Landscape

    • Curbing evergreening aims to foster a healthier lending environment, prompting genuine debt resolution.
    • Evolving risk-reward dynamics may lead to a reassessment of asset valuations and market dynamics.
    • Regulatory clarity is essential, given potential uncertainties until implementation details are fully addressed.

Challenges in Implementation

    • Monitoring compliance, especially identifying indirect exposures, poses a complex task for the RBI.
    • Abruptly transitioning from evergreening practices may lead to short-term market disruptions.
    • Ensuring consistent application of regulations across different REs and AIFs is crucial to maintaining a level playing field.Conclusion

The RBI’s regulatory measures addressing evergreening practices through AIFs reflect a significant intervention aimed at safeguarding financial stability and protecting investor interests within the AIF ecosystem. The comprehensive circular imposes a ban on overlapping exposures and introduces stricter rules for certain AIF structures, addressing concerns related to evergreening and priority distribution models. These measures are designed to prevent AIFs from becoming repositories for bad debt, ensuring transparency, and fostering a healthy AIF landscape. The implications of these regulations span across AIFs, REs, and the broader lending landscape, influencing investment strategies, transparency standards, and lending practices. While regulatory clarity is crucial, challenges in implementation, such as monitoring compliance and managing market disruptions, underscore the complexity of transitioning away from existing evergreening practices.

 

Authors: Vatsal Gaur and Krishnan Sreekumar

Footnotes

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12572&Mode=0.

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