[Tarun and Navya are students at National Law University Odisha.]
Recently, through a new regulation, the Reserve Bank of India (RBI) has directed the lenders to refrain from making investments in alternative investment funds (AIFs) which have downstream investments in a company that have borrowed from them or had a loan previously within 12 months from them. AIFs are defined under the Regulation 2(1)(b) of the Securities and Exchange Board of India (SEBI) (AIF) Regulations 2012. It indicates any pooled investment fund that is private, in the form of a body corporate or a trust or a company or a limited liability partnership (LLP) and is not covered under any other regulations of the board. Downstream investment is the investment made by the AIF in a company through the funds that have been raised by it from its investors.
The central bank emphasised that regulated entities (REs) engage in units of AIFs as part of their routine investing activities, taking note of specific transactions of REs involving AIFs. Through investments in AIF units, these transactions replace the direct loan exposure of REs to borrowers with indirect exposure through investing in AIFs.
The rationale behind this move is to curb the "evergreening" of loans. The practice of evergreening loans involves a lender making further loans to a borrower who is in arrears or at risk of default in an attempt to keep the debt alive. For a bank, the evergreening of loans procedure is usually a stopgap measure.
Intent behind the Regulation: Curbing Evergreening of Loans
In the usual trend of evergreening of loans, the existing structures operated in a vacuum of having no prohibition. In November 2022, SEBI had reportedly brought to the attention of RBI about the non-bank financiers opting for evergreening of loans through the AIF route and also informed that these cases amount to “tens and thousands of crores”. The AIF route has been exploited as to pave the way for evergreening of loans, as in the last 5 years, the investment amount in AIFs stood at a whopping INR 75,000 crores. This notification’s major targets are the transactions that are undertaken for circumventing the rule prohibiting financial institutions from investing in borrower’s equity and as a result they invest in AIFs having downstream investments in the borrower.
RBI in the past has also highlighted the concern of evergreening of loans to hide the state of stressed loans. There have been instances in the past wherein the REs opted for evergreening of the stressed loans through an AIF to delay the declaration of such loans as non- performing assets (NPAs). NPAs refer to a categorisation for loans that have defaulted or are in arrears on timely payments of the amount or the interest thereon.
In this case, an AIF structure is created by the RE to pump in more money with the borrower which is on the verge of becoming an NPA. The AIF in turn invests in the stressed company, which is used by the lender to repay the money. The standards put loan and investment transactions at an arm's length in order to address conflicts of interest. Accurately identifying an NPA is the initial stage towards expedited resolution.
Issues with the New Regulation
Less time for compliance: The 30-day mandate
The foremost major issue is the timeline which is stipulated in the new circular which mandates RE such as banks and NBFCs that have invested in an AIF, to liquidate their investments within 30 days from the date of such investment. This timeline stipulated offers a very short window to the RE to liquidate their investments, and moreover, the investments of some REs in AIFs constitute a very large amount, so liquidating these large investments will be a very onerous task for the REs. Another problem that will arise while liquidating the AIFs will be that there is no active market where AIF units can be sold, and further, these AIF units are not listed, which further complicates its selling. This short window is also expected to put a lot of pressure on the regulators and cause operational issues as liquidating crores of investments in 30 days will not be a piece of cake. In such a scenario, it would be wise for REs to approach RBI and request the regulator to extend the timeline or allow them to liquidate in a phased manner.
No bar on group companies
The regulation bars banks and NBFCs from investment in AIFs that have downstream investments in debtor funds. However, investment routed through group companies cannot be tracked as there is no specific restriction on banks / AIFs routing investments through group companies. Investment can easily be routed through trusts and family operated offices. Further, it will also impact inflow into AIF and reduce the investable pool.
Reduction of portfolio entities
Even the selection of portfolio entities by funds can reduce, as they will not prefer to invest in new entities where a RE investor is already a lender. One instance is of Piramal Enterprises and IIFL that have invested in AIFs having investments in debtor firms. If they are to cover their exposures, their net worth could be impacted by 10%.
These measures will serve as a barrier for financial institutions for participating in AIFs as they would want to exercise flexibility in lending credit facilities to the portfolio entities of the AIFs. One possible solution to address this would have been to put a threshold for applicability to RE’s. For instance, putting a cap of at least 20% of AIF’s investment in the debtor company.
Freeze of AIF industry
The move by RBI aims to solve a problem which has been existing from a while now. However, the new requirements by RBI will usher in changes in the AIF industry dynamics. One of the consequences of the new requirements will be that it will bring a freeze in the AIF industry as there will be no domestic investment in the AIF by banks and NBFCs. Moreover, there is an estimated investment of INR 8.44 trillion as of June 2023 in the AIFs, so when there will be retraction of these huge investments from the AIFs, it will cause upheaval in the whole AIF industry. Further, forced liquidation of AIFs will cause a significant devaluation of the assets as there will be a huge supply after the investments have been liquidated. However, what will be the real outcome of the RBI's new move remains a mystery till the time the compliance period of 30 days ends.
Principally good, but difficult to implement
Though the main intent of RBI behind introducing the new requirements is based on a very sound reasoning to curb evergreening of loans, but on the other hand, its implementation seems to be onerous task especially for the RE. Further, RBI seems to have adopted a bit extreme solution to stop the evergreening of loans issue, as now, no bank or NBFC will be able to invest in an AIF which will further have an impact on banks and NBFCs. Even if the extremeness of the regulations is set aside for a while, the same will be difficult to implement. RBI should have adopted a system of checks and balances to halt the misuse of AIFs instead of fully mandating the REs to liquidate their AIF investments.
What if no compliance?
The main contention revolves around the question as to how RBI will enforce compliance on the regulators and at the same time keep track of the same. In the circular, it is mentioned that if the REs do not comply with the 30-day timeline and liquidate all their investment in AIFs within 30 days, they will have to provide for 100% provision on such investments, meaning the REs have to set aside an amount equivalent to the investment that has not been liquidated so that potential losses can get covered. Providing 100% provision will further put financial strain on the pocket of the REs.
Conclusion
RBI’s new-year gift for the REs aims to address the critical issue of the rising evergreening of loans through AIFs. However, the new regulations will have a cascading effect on both the RE and the AIFs as REs will face the burden of liquidation, and on the other hand, the AIF market is expected to hit the wall. RBI's stringency, while well-intentioned and principled, is likely to cause disruption in the market. REs are expected to approach RBI to receive some relaxation in the current regulations and probably extend the timeline of the liquidation period.
RBI's objective is based on a sound logic of curbing evergreen loans, but a nuanced approach addressing the existing loopholes and concerns would have helped in ensuring a smoother implementation of the underlying objective.