Regulating Capital at a Cost: A Commercial-Legal Analysis of RBI’s Draft AIF Directions

[Shlok is a student at NALSAR University of Law.]

On 19 May 2025, the Reserve Bank of India (RBI) released the Draft Directions on Investment in AIF (Draft Directions) prescribing regulatory guidelines for investments by regulated entities (REs) in alternative investment funds (AIFs). Once finalized, these directions will replace the “existing framework”, namely the circular dated 19 December 2023 and the subsequent clarification dated 27 March 2024.

The 2023 directions imposed a stringent prohibition on REs from investing in any AIF with downstream exposure their debtor companies. The intent behind such prohibition was to prevent evergreening of loans through AIFs. Evergreening refers to the practice whereby a lender extends fresh credit to a stressed borrower primarily to enable repayment of existing loans. RBI observed that some REs were indirectly channeling funds to their debtor companies through AIF schemes, prompting the prohibition.

Evergreening is a regulatory concern because it masks the true financial health of lenders by artificially improving asset quality thereby misleading regulators, investors, and other stakeholders. It also delays the timely recognition of non-performing assets and therefore contributes to systemic risk.

From Prohibition to Proportionality: What the Draft Directions Propose

Rather than continuing with a blanket prohibition, the Draft Directions take a more balanced approach. The key proposals include:

1. Individual REs may invest up to 10% in an AIF’s corpus; aggregate exposure from all REs capped at 15%;

2. Definition of debtor company excludes even hybrid instruments such as compulsorily convertible preference shares and compulsorily convertible debentures;

3. Provisioning requirement limited to the extent of actual exposure to the debtor companies;

4. Downstream investment through debt instruments permitted up to a limit of 5%, beyond which, provisioning applies. 

Rationale Behind the Revision

RBI’s decision to revisit this framework stems from both market developments and stakeholder feedback. The existing framework had a chilling effect on RE investment in the AIF industry. RBI’s shift in approach appears to be a course correction in response to the rapid growth of AIF industry in India. With the total committed capital exceeding INR 13.5 lakh crore, nearly a threefold increase over the past 5 years, the sector plays a vital role in channeling long-term capital into priority sectors such as infrastructure, fintech, private credit, and areas such as startups that are often underserved by traditional lending channels.

The provisioning mandate under the 2023 directions was particularly onerous. REs were required to either make a full provision on their AIF investments or liquidate them within 30 days. This rigid approach imposed disproportionate financial burdens. Piramal Enterprises, for instance, was forced to make a provision of approximately INR 3,164 crore. This had a material impact on the company’s profitability and the resulting financial disclosures triggered a 12% decline in its stock price over just two trading sessions.

Equity Investment: Exempt on Paper, Constrained in Practice

The Draft Directions clarify that equity instruments are excluded from exposure calculations. However, the language of Clause 6(a) is unqualified, suggesting that even where the downstream investment is purely in equity, the 10% individual limit remains applicable. The reason behind capping even equity exposure is that even equity infusions into distressed companies may indirectly facilitate evergreening. The capital received by the debtor may be utilized to repay outstanding liabilities owed to the RE. In substance, this creates a circular flow of funds, thereby replicating the risks associated with evergreening.

One Size Does Not Fit All

The Draft Directions apply uniformly to all REs, including NBFCs. In doing so, they fail to take into account the varied business models and risk profiles. Core Investment Companies (CICs), for instance, are a distinct category of NBFCs that are specifically regulated to hold equity investments in group entities. 

RBI’s CIC Master Directions 2016 mandate that at least 90% of a CIC’s net assets be invested in group companies, and at least 60% of such investments must be in the form of equity instruments. CICs are also prohibited from undertaking lending activities outside their group structure. Accordingly, the risk of evergreening through CICs is minimal. Extending the same restrictions and provisioning requirements to such entities imposes unnecessary compliance burdens. 

A parallel concern arises from the uniform application of these restrictions to all categories of AIFs ignoring the unique structure of Category III AIFs, such as hedge funds and other market-driven investment vehicles.

These funds typically do not invest in stressed borrowers or illiquid debt instruments. They aim to generate returns through short-term market movements. SEBI data supports this view, indicating that Category III AIFs allocate only 2% of their total investments to debt instruments which is far too small to pose a systemic risk. Consequently, evergreening risk in this case is negligible and a differentiated regulatory treatment for Category III AIFs would have been appropriate.

Legal Limit or Practical Barrier? The Problem with 5% Rule

While the 10% cap on an individual REs investment in an AIF sounds reasonable, in practice, it would end up as a 5% cap as it is the threshold beyond which provisioning requirement kicks in. Given the balance sheet consequences of provisioning, REs are likely to treat 5% as a safe harbour.

Consider, for instance, a typical RE such as a commercial bank. Large banks usually have credit relationships with hundreds or even thousands of companies at any given time. Since “debtor company” is broad and includes any company with current or past debt exposure in the last 12 months, the pool is even larger. AIFs too have a portfolio of multiple companies. So, the possibility of AIF’s investee company being a debtor company of the RE is quite significant and not something that the REs can ignore.

It would already be challenging for REs to find an AIF with no overlap between its investee companies and the RE’s debtor list. Even after REs identify such an AIF, the possibility of provisioning in the future (due to RE giving a loan to one of AIF’s investee company or due to a change in AIF’s portfolio) acts as a strong disincentive to invest more than 5% in any AIF.

Collective Cap: Practical Consequences

RBI’s rationale for imposing a 15% collective cap is likely an attempt to prevent multiple REs from evergreening each other’s debtor exposures. This aligns with RBI’s goal of financial discipline but also introduces a practical implication.

There are only around 1,600 AIFs currently registered with SEBI as on 28 June 2025 while the number of REs covered under the draft directions crosses 10,000. 

Considering the 5% de facto limit that we discussed, large institutions will need to split their AIF exposure across multiple funds. HDFC Bank, for instance, had INR 1,220 crore AIF book in Q3 of FY 2023-24. To maintain this level of exposure while avoiding provisioning, it must split the amount across many funds, increasing operational burden and diligence requirement. This added complexity may discourage RE participation in AIFs. 

Regulatory Spillover: AIFs Bear the Brunt of Compliance Burden

While the Draft Directions provide some relief to REs, the regulatory burden appears disproportionately skewed against AIFs. REs usually maintain only a marginal exposure to AIFs. Consider HDFC Bank’s AIF book, which stood at INR 1,220 crore in Q3 of FY 2023–24. If we look at its financial statements during the same period, we find that its AIF exposure amounted to a mere 0.2% of total investments. The same is true for ICICI Bank as well, with an even lower share of 0.1%. Notably, these already minimal levels were recorded before any RBI-imposed restrictions. With the new investment caps in place, this exposure is likely to shrink further. On the other hand, AIFs are much more dependent on REs for capital inflows. Limiting this capital source to 15% may slow down the growth of the AIF industry.

While the Draft Directions seek to regulate REs’ investment behaviour, it ends up burdening AIFs. Complying with these directions would require AIFs to monitor the lending history of each RE while also providing portfolio disclosures. Such a compliance headache not only increases costs but also introduces uncertainty into investment decision-making, particularly for Category III AIFs, because of their dynamic, fast-changing portfolios. As a result, the draft framework may inadvertently constrain the capital-raising capacity of AIFs.

Unresolved Ambiguities in the Draft Directions

Lastly, there are some ambiguities that need to be addressed:

1. There is no clarity on the treatment of pre-existing exposures that exceed the proposed caps. Would they need to be liquidated, or are they grandfathered?

2. The scope of definition of ‘debtor company’ – does it include group companies or associate companies of the borrower? Ambiguity risks inconsistent interpretation.

3. Funds-of-funds and mutual funds are specifically exempted under the existing framework. However, the Draft Directions are silent on their treatment, leading to interpretive uncertainty.

Conclusion

The Draft Directions mark a welcome evolution from the prohibitive regime of 2023. By introducing proportionality, excluding hybrid instruments and exempts REs from compliance requirements where their exposure to an AIF scheme is limited to 5%, RBI has made significant attempt to balance systemic concerns with market growth. However, several structural shortcomings remain. The broad-brush treatment of heterogeneous entities, uncertainty around transitional provisions, and operational hurdles in implementation could stifle the very innovation and capital flow the AIF regime is meant to enable. A nuanced and clearly articulated final framework—accounting for different risk profiles, transitional concerns and operational feasibility will be essential to achieving the RBI’s twin goals: preventing evergreening while promoting a vibrant, well-regulated AIF ecosystem.