RBI Tightens Norms For Banks, NBFCs Investing In AIFs

The Reserve Bank of India (RBI) has issued guidelines to all regulated entities including banks and non-banking financial companies (NBFCs) to not make investments in any alternative investment funds (AIFs) that have invested in a borrower or investee of that lender.

In November last year, the Securities and Exchange Board of India (SEBI) informed RBI about instances of non-bank financiers evergreening loans through the AIF route.

Reportedly SEBI has detected at least a dozen cases involving $1.8 Bn to $2.4 Bn where AIFs have been misused to circumvent rules of other financial regulators including the RBI.

In October this year, Ananth Narayan G, a whole-time member of SEBI, said the regulator had come across multiple instances of entities using alternative investment funds to circumvent financial norms and urged the industry to form a quasi-self-regulatory body. SEBI has also seek commitment from fund managers to make sure that AIFs will not be misused.

The guidelines have been issued in order to curb such misuse of AIF funds.

What Are Evergreen Loans?

In simple terms, evergreen loans are the loans which never end. This means that to repay the earlier unpaid loan, the regulated entity offers the borrower another loan through AIF as an investment vehicle. AIF, being a  private credit fund, looks for such deals with the belief that with a small investment these companies could bounce back.

Banks and NBFCs resort to such loans to showcase low percentage of non-performing assets (NPAs) in their books.

“In some cases, non-bank lenders have sold non-performing loans (NPLs) to AIFs that they have partially set up themselves. The fresh funds received by the AIFs are then used to repay the original debt, preventing the loans from being classified as bad loans. This practice is seen as a classic example of evergreening,” said Mayank Mehra, managing partner, SphitiCap.

Key Guidelines Issued By RBI

To address concerns relating to possible evergreening through this route, it is advised as under:

Regulated entities (REs) shall not make investments in any scheme of AIFs which has downstream investments either directly or indirectly in a debtor company of the RE to which the RE currently has or previously had a loan or investment exposure anytime during the preceding 12 months.

If an AIF scheme, in which RE is already an investor, makes a downstream investment in any such debtor company, then the RE shall liquidate its investment in the scheme within 30 days from the date of such downstream investment by the AIF. 

If REs have already invested into such schemes having downstream investment in their debtor companies as on date, the 30-day period for liquidation shall be counted from the date of issuance of this circular. REs shall forthwith arrange to advise the AIFs suitably in the matter.

In case REs are not able to liquidate their investments within the above-prescribed time limit, they shall make 100% provision on such investments.

In addition, investment by REs in the subordinated units of any AIF scheme with a ‘priority distribution model’ shall be subject to full deduction from RE’s capital funds.

This move by the RBI has been seen in the right direction by some. According to reports, the credit exposure of banks to NBFCs stood at INR 14.8 Lakh Cr in October 2023, indicating a 22.1% year-on-year (y-o-y) growth. Further, there are currently more than 1200 registered alternative investment funds in the country as of December 2023. If remain unregulated, this poses a significant risk to the economy considering that bad NPAs may lead to a liquidity crisis in the banks, thereby triggering the ripple effect. 

However, there is a flip side to this coin as well. According to Punit Shah, Partner, Dhruva Advisors, the intention of the move by RBI is to prevent evergreening of loans by Banks, NBFCs etc. However, the circular prohibits any exposure by these entities to specified AIFs, which can be extremely damaging and can have unintended negative impact on the AIF industry, especially sponsored by financial services players.