[Akshat and Aniya are students at National Law University Delhi.]
On 19 December 2023, the Reserve Bank of India (RBI) released a circular imposing a blanket embargo on downstream investments by regulated entities (REs) in alternate investment funds (AIFs). The RBI has now come up with two directions via this circular. First, any RE must not make investments in any scheme where the latter has downstream investment in a debtor. Second, if a RE is already an investor, the investments must be liquidated within 30 days.
This has been done in pursuance of these “regulatory concerns” as to alleged substitution of direct loan exposure of the lenders by means of the AIF structure. Broadly, the RBI has attempted to restrict the exposure of a RE to a single entity through an indirect means such as an AIF.
This piece argues that while the RBI move is well-intentioned, it adopts a rather lazy approach by imposing a blanket ban with the aim of ensuring that the risk to REs is mitigated. We do this through an analysis of the existing regime and the proposed change set against international practices. We also suggest a way forward to meet the purported objective of the aim of risk mitigation in such structures while balancing it against RE autonomy.
AIF Mechanism and RBI’s Problem
In India, AIFs are defined under the Securities and Exchange Board of India (Alternative Investment Funds) Regulations 2012, and refer to any ‘pooled investment vehicle’ established or incorporated in India regardless of whether it is Indian or foreign. However, they are distinct from funds such as mutual funds and collective investment securities in the manner they are created. AIFs are also generally subject to RBI scrutiny in matters such as foreign investment. For instance, an AIF is not permitted to invest more than 25% investible funds and in excess of 500 million dollars abroad.
Similarly, in the present case, where the risk exposure of RE to a debtor entity is involved, the RBI can be said to have the prima-facie locus to regulate such investments. This has what has prompted the RBI to restrict investments in AIF in this case.
REs makes investments with the aim to generate returns which are then passed on to consumers. In this regard, the ‘risk exposure’ that they have to a debtor entity is limited by the RBI in terms of whether they can invest in such structures. This is because regulated banking is averse both to REs being overtly dependent on the fate of a debtor business, and the possibility of malpractice within banks resulting in scams.
This idea has now been extended to AIFs on the same principled basis to mitigate RE risk. However, it must be noted that an AIF involves neither the same manner nor the same extent of risk in terms of capital due to the structure of such funds.
Global Comparative Framework
Consider, for instance, the situation in the US. In the US, a private fund that is not publicly marketed and has less than 100 beneficial owners who are all accredited investors is not subject to registration requirements under the relevant legislation, i.e., Investment Company Act 1940. This has the advantage of not imposing any extra status requirements on the investor except being an accredited investor, such as net worth, total assets, or total investments owned. The Securities and Exchange Commission does prohibit the counting of fund participants from creating feeder vehicles that invest in themselves by "looking through" them through a beneficial owner analysis.
In regard to situations where financing and loan activities are involved, AIFs or their subsidiaries involved in loan origination may be subject to licencing requirements and compliances by some jurisdictions such as California. However, the critical point for our purpose is the lack of any federal blanket ban in terms of investments in REs which undertake loan activities.
Consider also the position in the UK. In the UK, fund houses must make a disclosure under the 'persons with significant control' regime if they have any Scottish legal partnerships (which are frequently utilised as feeder and carry vehicles) in their fund structures. Investment in securitization positions is subject to regulations, and as will be discussed later, there may be certain leverage restrictions. However, AIF will have to abide by their own investment policy in addition to any regulations pertaining to trading and holding such investments. However, even within the UK regime, AIF SLPs are not restricted from borrowing. In our reading, banks, too, do not have an embargo on investing in AIFs.
The RBI is mandated to protect the interests of the public as REs deal with public money. This is the case both in terms of lending (direct exposure) and investments (indirect exposure).
Even though the aim is commendable, the blanket embargo seems excessive and takes away RE autonomy clothed under risk mitigation concerns. By restricting the investment, it chips away too much from the free-market regime which aims to ensure that REs have the ultimate choice of investment.
Hedging RE Risk – Way Forward
In order to ensure that REs are protected against risk while having sufficient autonomy in investment decisions, the decision may be explored for changes in the following manner:
Option of reserve mechanism: It is critical to note that even the present circular, the RBI has indicated that where REs are not able to wind up investments in AIFs investing in debtor entities, REs may make a reserve of like amount. It is suggested that this idea be adopted across the board, giving sufficient autonomy to the RE to either refrain from making an investment or ensuring sufficient reserves to meet such a shortfall. This would meet the twin objective of securing public money through reserves and allowing sufficient autonomy by flexibility in decision making.
Look through approach (LTA) with risk based scoring: LTA or ‘looking through’ structures can be applied when there is sufficient and frequent information about underlying exposures of the relevant RE. Reporting frequency of AIFs must be designed to match or exceed those of REs and mapped against the affordable risk exposure of the bank.
In the case of successive fund layers, banks using LTA must look through each layer. This will ensure that banks accurately assess and assign risk weights to the underlying exposures of investment funds and mapping them against the risk posed to them by lending.
The LTA can be be supplemented with a risk-based scoring system assigning numerical scores to factors like risk exposure, compliance history, and corporate governance practices of the debtor entry. This model will also allow periodic update based on changing market conditions and new risk indicators, which must be mandatorily shared with the RBI, enabling deeper insights into market participants’ behaviour. Using this, the RBI can prioritize regulatory action on a case-to-case basis where the risk criteria outweigh the benefit based on the numerical factor.
Constitution of AIF Risk Advisory Committees to complement the LTA and risk based scoring framework: The RBI can prescribe a mandatory AIF Risk Audit Committee where banks desire to invest in AIFs at all. This will enable risk-based assessment at the RE level even where it is reported to the RBI and can take prudential decisions based on set criteria as to whether investment is permissible in certain cases at all, and what risk exposure the bank can permit and afford.
The RBI’s move comes at a time when AIFs are gaining steam in India, with the primary source of capital being sourced from regulated entities of the RBI. While it is critical to protect public money against structured that shield indirect investments and promoter patterns and channels such as ones via AIF, it is critical that the central bank adopt a balanced approach by allowing a degree of autonomy to the REs in making downstream investments even via AIFs.