[Sourav is a student at National University of Juridical Sciences.]
On 19 December 2023, the Reserve Bank of India (RBI) vide its circular titled "Investments in Alternative Investment Funds (AIFs)" (Circular) implemented stringent norms to address the concerns pertaining to evergreening of stressed loans. Evergreening of loans, a practice of extending new or additional loans or investments to a borrower who is unable to repay the existing loans, thereby concealing the true status of the non-performing assets (NPAs). This move comes against the backdrop of RBI Governor’s address in May 2023 highlighting the innovative methods deployed by banks to conceal the NPAs. A substantial number of AIFs, estimated to be involved in total transactions worth INR 20,000-25,000 crores, have been identified to be non-compliant with the Circular.
In the recent past, the Securities and Exchange Board of India (SEBI) released a consultation paper dated 23 May 2023 concerning the priority distribution model adopted by the AIFs (see here for a detailed analysis of the consultation paper). SEBI noted that such structuring facilitated evergreening of loans extended by the lenders.
In this backdrop, this article examines the RBI’s Circular and explores the potential regulatory challenges. It also focuses on the modus operandi adopted by the lenders.
Understanding the Modus Operandi
Industry players argue that the evergreening problem arises due to the questionable structuring of the AIFs. SEBI in the consultation paper explained how the priority distribution model is aiding the practice of evergreening of loans (see here for further understanding the process).
The lender in order to remove the potential NPAs from their portfolio subscribes to the junior class units of the AIFs. Under the priority distribution model, an AIF has junior class units and senior class units, wherein the latter enjoy priority in the distribution of proceeds over the former. The lender as a junior class unitholder, assesses the potential loss arising out of the NPAs or the haircut, whereas, the senior class unitholders invest based on the fair market value of the assets acquired by the AIF. Interestingly, the AIF subscribes to the non-convertible debentures of the borrower companies. This allows the borrower companies to furnish the loans disbursed to them by the lender. In essence, the lender replaces the NPAs in their portfolio with – (a) the sum received from the borrower company to service the loan and (b) the investment made in the junior class units of the AIF. It allows the lender to circumvent the extant regulatory framework pertaining to classification, provisioning and other compliances pertaining to potential NPAs. It results in a win-win situation for both the lenders and the borrower company. The lender instead of booking a loss in the loan repayment transaction portrays a loss in the investment to the AIF. On the other hand, the borrower company is allowed to service the loan without any setback to the creditworthiness of the company.
In summary, the borrower company receives investments from the AIF which is used to service the existing debt extended by the lender. Therefore, in a cyclical circulation of funds, the lender is settling the borrower company’s debt, a classic formula to evergreen a loan.
Analyzing the RBI’s Circular
RBI vide the Circular has barred the regulated lenders from making any investments in AIFs which has downstream investments, directly or indirectly in a debtor company of the regulated lender. If the regulated lender has extended a loan to any company within the preceding year, such company will be classified as a debtor company. It is expected that the blanket restriction imposed by the RBI would help in breaking the cycle of funds circulation through the AIFs to avoid NPA classification.
The RBI has given a 30-day period to liquidate the regulated lender’s investments in AIFs provided the AIF’s portfolio comprises of such debtor companies. If the regulated lenders fail to liquidate their investments within 30-day timeframe, they need to make a 100% provision on such investments. Furthermore, the regulated lender’s investments in the junior class units of any AIF scheme with a priority distribution model shall be subject to full deduction from the lender’s capital funds.
Potential Regulatory Challenges
The RBI’s strategic move is in line with their persistent concerns related to concealment of NPAs, and the practice of evergreening of loans through AIF structures. It is imperative to note that these structures were not per se illegal, rather they operated in a regulatory void due to lack of clarity. However, the existing structures were squarely outside the RBI’s vision to put an end to such practices.
The Circular particularly scrutinizes the priority distribution model adopted by the AIFs, thereby echoing the concerns outlined in the SEBI’s consultation paper. It is expected that the 100% provisioning requirement would serve as a deterrent against such structuring methods favoring evergreening of loans. Nevertheless, the provisioning requirement should be specific and more nuanced in nature. It is proposed that the percentage for provisioning should be equal to the proportion of the funds deployed by the AIF to the borrower company to service their debt. As per the existing regulatory framework, a 100% provisioning requirement would be imposed provided any relationship between the lender and the borrower company is established, irrespective of the quantum of funds invested by the AIF. Furthermore, the RBI has introduced a 12-month lookback period for classifying a debtor company, which is retrospective in nature. Consequently, even if the AIF intends to sever ties or adjust portfolios now, the lookback period would render such corrective measure futile.
The RBI has also introduced a 30-day liquidation timeline which is extremely disproportionate to the purpose of the Circular. It is imperative to understand the difficulty in disposing off such assets by AIFs within such a short timeline. As per the SEBI (Alternative Investment Funds) Regulations 2012, AIFs are primarily divided into Category I, Category II and Category III funds. Category I and Category II funds majorly deal in illiquid investments as compared to Category III funds which may access capital markets and invest in listed securities. Consequently, due to the regulatory restrictions, it would be difficult to liquidate the assets as per the Circular within such a short timeframe, specifically for Category I and Category II funds.
Interestingly, a careful analysis of the RBI’s Circular would reveal that the entire onus to curb the vicious cycle of fund circulation has been placed on the AIF. The framework does not impose any disclosure and reporting obligation on the limited partner i.e., the lender or the portfolio company i.e., the borrower company. The obligation is on the AIF to find out the debtor borrower company of the lender and delink their portfolio. Furthermore, there are no penalties imposed on the players involved in the evergreening of loans process.
As per the PMS Bazaar Report released in November 2023, the AIF industry experienced a compounded annual growth rate of 26% from June FY19 to June FY24. It is expected to grow to INR 43.64 lakh crore by 2028. The conducive regulatory environment has played a major role in supporting the AIF industry’s growth story in India. However, it is evident that market players have taken advantage of the relaxed regulatory approach to use AIFs for evergreening of loans. In this context, the RBI’s circular is a welcome move and a testimony of the regulator’s proactive approach. Nevertheless, the concerns as raised in this article need to be ironed out to ensure the regulatory strategy is proportionate and balances the interests of the various stakeholders involved in the AIF space. Additionally, there is an urgent need on the part of the regulators to assess the nuanced impact of the Circular on the AIF industry in general.