RBI Tweaks Norms on Investments in AIFs: A Breather to the Regulated Lenders

[Srishti Multani and Aryan Birewar are 4th year BBA LLB (Hons.) students at Symbiosis Law School, Pune]

On 27 March 2024, the Reserve Bank of India (‘RBI’) released a notification (‘Revised Notification’) relaxing certain directions given to regulated entities (‘RE’) in the notification (‘Previous Notification’) dated 19 December 2023 after due consultation with the stakeholders and industry experts. The carve-outs provided by RBI have cushioned and rationalized the compliances required to be met by the regulated lenders adopting the malpractice of evergreening of loans. 

In the evergreening of loans, a lender provides a fresh loan to the borrower, via an alternative investment fund (‘AIF’) as an investment vehicle, used to repay a prevailing debt owed to the lender to forfend recording and reporting of the concerned loan as a non-performing asset (‘NPA’). According to the RBI Master Circular, 2012, banks are mandated to provision a certain percentage of the total outstanding amount against the NPA. To circumvent the provisioning requirement, which in turn reduces profits, banks were engaging in the evergreening of loans. While this prevents a fall in their credit rating, it misleads stakeholders in terms of the profitability quotient.

Through this post, the authors will deconstruct the Previous Notification, evaluate the carve-outs provided by the Revised Notification, and suggest additional steps to address the evergreening of loans more comprehensively.

Understanding the Previous Notification

Under regulation 2(1)(b) of the SEBI (AIF) Regulations, 2012, AIF is a privately pooled investment vehicle that collects funds from sophisticated investors, for investment in terms of a defined investment policy. The Previous Notification proposed the following changes to address the evergreening of loans.

First, the lender must refrain from investing in an AIF scheme that has a direct or indirect downstream investment in the borrower of the lender. The borrower refers to any company in which the lender currently has or previously had exposure in the last twelve months. While the circular does not define ‘downstream investment’, explanation (g) of rule 23 the Foreign Exchange Management (Non-Debt Instruments) Rules 2019 defines it as an investment made by an Indian entity that is wholly owned by a foreign entity, or an investment vehicle in the capital instruments of another Indian entity.

Second, if an AIF scheme, wherein the lender already has an investment, places money in such a borrower, then the lender must liquidate within a period of 30 days from the date of such investment.

Third, if the lender is unable to liquidate the investment within the stipulated timeframe, they must provision 100% on such investments.

Fourth, investment by the lender in the junior units of an AIF with a ‘priority distribution model’ shall be subject to a complete deduction from the lender’s capital funds. In terms of paragraph 11.2 of the SEBI’s Master Circular for AIF, ‘priority distribution model’ (‘PD Model’) refers to a waterfall distribution mechanism, wherein one class of investors (junior class) shares losses more than pro-rata to their holding in the fund as compared to another class of investors (senior class), owing to the latter’s priority in the distribution of investment proceeds. By way of a circular dated 23 November 2022, SEBI has barred AIFs following a PD Model from making any fresh investments until a final call on such models is taken.

Evergreening of Loans: Unveiling the Modus Operandi

The issue of evergreening arises because of the adoption of PD Models by AIF schemes. SEBI released a consultation paper dated 23 May 2023 discussing how the adoption of the PD Model aids the evergreening of loans.

Certain AIFs have adopted a waterfall distribution mechanism, wherein investors are separated into different classes, resulting in the differential allocation of investment proceeds. Such a separation creates a junior and senior class of investors allowing the latter to enjoy priority in the distribution of investment proceeds.

The lender subscribes to the junior units of the AIF to remove the potential NPAs from their loan portfolio. The anticipated loss in the loan portfolio is used to determine the quantum of investment by the lender in the fund. The fund subscribes to the non-convertible debentures of the borrower allowing them to repay the loans extended by the lender. In substance, the lender replaces the NPAs in their loan portfolio with  the amount repaid by the borrower and junior class of units held in the AIF. Interestingly, this benefits both the lender and the borrower company. The lender steers away from any NPA classification and provisioning compliance, while the borrower repays the loan without any plummet in their creditworthiness.

Deciphering Carve-Outs in the Revised Notification

Provisioning Requirement

According to paragraph 2(ii) of the Revised Notification, the regulated lenders are required to provision only against the amount invested by the AIF in the debtor company. For example, if the lender puts Rs. 100 crores in the fund but the fund only has Rs. 50 crore exposure with the borrower, then the lender is now required to provision only on Rs. 50 crores.

Exclusion of Equity-based Downstream Investments

Under paragraph 2(i), any equity-based downstream investment in the borrower has been excluded from the purview of this notification. This has given a sigh of relief to numerous private equity funds (‘PE Funds’) and venture capital funds (‘VCF’), who can now raise capital from regulated lenders without worrying about the latter having to liquidate on provision on the investment. This carve-out gives relief to Category-I AIFs like NIIF (‘National Investment and Infrastructure Fund’), which focus on growth equity with long-term value creation for MSMEs (‘Micro, Small and Medium Enterprises’) and startups. These are growth funds aiming to foster and cultivate unicorn businesses in India. A sizeable chunk to the tune of 51% of the fund’s capital comes from NBFCs (‘Non-Banking Financial Companies’) and other scheduled commercial banks, who in case of an exposure with the borrower, had to liquidate their investment in terms of the Previous Notification.

This carve-out on equity investments is applicable only upon listed companies. However, private equity or venture capital investments which are in the form of hybrid securities like compulsorily convertible preference shares (‘CCPS’) or compulsorily convertible debentures (‘CCD’) remain unaccounted for. Hence, the confusion is whether such hybrid securities will have to be converted to equity in order to permit the regulated lender to hold investment in the AIF.

Exemption to Fund of Funds (‘FoF’) and Mutual Funds

If investment is made in the AIF through intermediaries like FoF or mutual funds, it will remain exempted from the applicability of the revised notification. Such exemption will increase capital participation in the AIFs, as the role of any intermediary stands eliminated.

Proposed Deduction from Capital

The Circular also makes it clear that a lender’s investment in the subordinated units of any AIF scheme with a ‘priority distribution model’ will only be fully deductible, if there are no non-equity investments in the AIF. The Circular also made it clear that the deduction would come from both its Tier-I and Tier-II capital in equal amounts. On the other hand, the lender will have to sell or make provisions against any non-equity investments in the AIF.

Unaddressed Points of Concern

The basic yet biggest point of concern is that not all lenders having overlapping investments harbour the intention of evergreening their loan portfolio. Some of them are just independent investments without having any purpose of exploiting this tripartite relationship. Ideally, the liquidation or provisioning compliance should only kick-in if there is serious risk of default or distinct evidence of evergreening taking place. Furthermore, there are only handful cases wherein regulated lenders have control over the investment decisions of the AIFs. The Revised Notification runs on the false assumption that the lender inherently has control over the investment decisions of the AIF.

The 30-day liquidation timeline is unreasonable on two fronts. First, a mere 30-day window for conducting a bipartite check about any exposure between the lender and the borrower, followed by having the fund get consent from the investment manager, and then finding single buyers is simply aspirational. Second, Category I and II AIFs are close-ended funds, which restrict redemption and transfer of units sans investment manager consent and satisfaction of lock-in conditions, thus making liquidation of investments even more challenging. Surprisingly, this timeline exclusively puts the onus upon the fund to identify any exposure between the lender and the borrower. No specific obligation lies with the lender or the borrower to halt such a cyclic flow of funds.

Navigating Solutions

It is well established that the fund market is reasonably reliant on lenders for essaying the role of a sponsor. However, even the lenders reap profits from the growth and capital appreciation of SMEs (‘Small and Medium Enterprises’) or startups. This restriction harms all three stakeholders involved. Thus, it becomes vital to chart out solutions for protecting the financial health of the market. 

One thing sufficiently clear is the impracticality of the 30-day window. The regulator must consult with the stakeholders and devise a timeline logistically plausible. This will cushion the unnecessary pressure on all the parties and streamline the process. 

A similar discussion on the suggestions of the Committee to Review Governance of Boards of Banks of India led by Dr. PJ Nayak is cardinal. They rightly identified the misgovernance fraught in the senior management or board of directors permitting significant evergreening of loans. The primary recommendations entailed – resignation by the chairman of the audit committee, partial or absolute recovery of monetary bonuses with the imposition of penalty, and unvested stock options from whole-time directors. Such penalties must be imposed to cause a deterrence effect on the wilful supporters of evergreening. This is apt because it is penalizing the foremost beneficiary of such a malpractice, i.e., senior management, and not the innocent shareholders. In fact, it is the audit committee which must be rightly tasked with ensuring that investment in the AIF is not used for evergreening of loans.

Mr. Shaktikanta Das, the RBI Governor, outlined a 10-point charter, in his inaugural address (Governance in Banks: Driving Sustainable Growth and Stability) at the Conference of Directors of Banks. He sought to place the onus on the board of directors (‘BoD’) for robust corporate governance and bank stability. The board is tasked to establish sound internal management controls and effective risk assessment measures. This stands to reason because integrity and transparency among the board members will fill the loose gaps and rightfully protect public money at stake.

In the RBI Guidance Note on Management of Operational Risk, internal audit or management information systems, give a requisite oversight to the board for enabling a polished understanding of the bank’s aggregate operational risk profile. The two main planks of a robust credit risk management system are – Policy and Strategy and Organisational Structure. A board-approved risk policy will allow risk identification, risk management, and risk grading. This will ensure that the bank subscribes to a prudent risk-taking approach backed by evaluation, supervision, and control to prevent soaring NPA levels in the first place. Further, a board-approved credit risk strategy should establish objectives, market, procedure of lending credit, etc., enabling the senior management of the bank to make informed decisions on trade-offs keeping in mind a certain risk appetite.

Given the cyclical nature of our economy, a credit risk policy and strategy will hold continuity across different credit cycles. On the other hand, a solid organizational structure headed by the BoD and comprising board-level sub-committees must be coupled with the credit risk policy. Furthermore, the RBI Guidance Note on Management of Credit Risk considers such a credit risk policy, strategy, and structure indispensable for an efficient credit risk management system. 

Concluding Remarks

In conclusion, the revised notification has rightly relaxed the provisioning compliance and funding restriction to offer some relief to the severely hit regulated lenders. One lingering concern is the tight window for the liquidation of investments. Logistically, identifying overlapping investments and finding single buyers willing to make such a huge commitment in the span of 30 days is simply unrealistic. The regulator must come out with a relaxation in this regard as well. Recently, according to SEBI, investment commitments in AIFs have crossed a threshold of Rs. 10 trillion for the first time. This goes to show the catapulting size of the fund market and hence the regulator must study the consequences of such a broad policy decision, before passing it.

Srishti Multani & Aryan Birewar

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