RBI bars lenders’ investments in AIFs investing in their borrowers

– Team Finserv | finserv@vinodkothari.com

The Reserve Bank of India on 19th December 2023 issued a notification imposing a bar on all regulated entities (REs) with respect to their investments in AIFs. Highlights of the notification are as below –

What has the RBI done?

• Prohibited all regulated entities (REs), including banks, cooperative banks, NBFCs and All India Financial Institutions from making investments in Alternative Investment funds (AIFs), if the AIF has made any investment into a “debtor company”.
• Debtor company means a company in which the RE currently has or previously had a loan or investment exposure anytime during the preceding 12 months
• The bar applies immediately, that is, effective 19th Dec 2023. No further investments to be made.
• If investments already exist, the RE shall exit within 30 days, that is, by 18th Jan 2024
• Further, if an RE has made an investment in an AIF, and the AIF invests in a debtor company, the RE shall make an exit within 30 days.
• Investment by REs in the subordinated units of any AIF scheme with a ‘priority distribution model’ subject to full deduction from RE’s capital funds.

What was the intent?

• Since several REs have affiliated AIFs, routing the money through AIFs to borrowers might have led to evergreening. That is, the AIF would invest the money into a debtor company, and consequently, debtor company would keep its account as a performing asset.

What will be the impact of the Circular?

• Most of the larger REs have affiliated AIFs. Flow of funds to them from the RE would stop completely.
• The sweep of the circular is wide and non-discriminatory. Not only affiliated AIFs, but any AIF in general will be dried of funding from REs. While the bar is only for those AIFs which have invested in “debtor companies”, it will be practically tough for REs to avoid overlapping investments. Given the severe implications of a breach, compliance-sensitive REs will avoid investing in AIFs.
• There is an immediate disinvestment pressure on AIFs, as there may be overlapped investments. AIFs’ assets are mostly illiquid – ensuring exit to RE investors may be tough. In many cases, there are lock-in restrictions as well.

Concern areas

• Ideally, the bar should have been limited to affiliated AIFs. Affiliated AIFs could have been defined appropriately – for example, a related party, or where the investment manager, or sponsor is a related party of the RE. Extending the bar to all AIFs is quite far from the intent of the circular – which is, admittedly, to curb evergreening. It is difficult to see how unrelated AIFs can be used by an RE to evergreen, as investment decisions of these AIFs are not exercised by the investors.
• Ideally, the bar should have been limited only to Cat 1 and Cat 2 AIFs. Cat 3 AIFs, widely known as hedge funds, typically play in equity long/short strategies, or do other leveraged trades. REs find such investment a useful way to diversify their funds into hedge funds. Hedge fund investments are common by institutional investors all over the world; an outright curb on these investments by REs is, once again, beyond the stated intent. Notably, given the wide range of investments that Cat 3 AIFs make, avoiding an overlap with the RE’s borrowers will be quite impractical.
• Practical implementation of this circular, if at all a RE invests in an AIF, will be quite tough. AIFs will have share their potential investment list, which will against any investment manager’s choice. Assuming there is an overlapped investment, the RE will have to exit within 30 days, which will create liquidity issues for AIFs, in addition to challenging the lock-in restrictions.

In conclusion, in our view, this Circular has traveled much beyond its intent, and needs to be reviewed and softened.

Our other resources on the subject:

1. SEBI’s standard approach, standardising valuation for AIFs
2. Comparison between non-deposit accepting NBFC – Investment and Credit Company (NBFC-ND-ICC), Core Investment Company (CIC) and an Alternative Investment Fund (AIF)
3. Snippet on credit of existing & issue of new units of AIFs in demat form
4. SEBI amends framework for Large Value Funds