Explained | Why the RBI barred lenders from investing in AIFs linked to borrower companies

The alternative investment industry in India, comprising Portfolio Management Services (PMS) and AIF, will grow to Rs 43.64 lakh crore in the next five years, a November 2023 PMS Bazaar report showed.

The Reserve Bank of India’s (RBI) directive on December 19 barring lenders from investing in alternative investment funds (AIFs) linked to borrowing companies is timely, and will prevent the evergreening of loans, experts told Moneycontrol.

Evergreening of loans happens when a bank tries to save a loan from defaulting so that it does not appear as a non-performing asset (NPA) in its books. This is done by giving a fresh loan to a borrower to pay up an old loan.

The central bank brought in the measure to tackle the growing practice of loans being evergreened by lenders, the experts said.

“AIF was apparently being used for transactions that camouflaged the real status of some accounts by borrowing additional funds through the AIF to repay the existing debt of group concerns. Hence, the RBI was prompted to bring directives to prevent such hidden and indirect violations,” said Jyoti Prakash Gadia, Managing Director, Resurgent India.

“Against the backdrop of evergreening, the existing structures in the market operated in a regulatory vacuum of not being prohibited and in more instances than not, failed to pass the smell test on account of the spirit of the existing RBI regulations,” said Veena Sivaramakrishnan, Partner, Banking and Finance and Insolvency and Bankruptcy Practice, Shardul Amarchand Mangaldas & Co.

What did the RBI say?

On December 19, the central bank said that lenders cannot invest in AIFs that have directly or indirectly invested in companies that have borrowed money from the lenders. It highlighted regulatory concerns regarding certain transactions involving AIFs by regulated entities.

“These transactions entail substitution of direct loan exposure of REs to borrowers, with indirect exposure through investments in units of AIFs,” the RBI said. It issued guidelines to address concerns about potential evergreening through this route. They are as follows:

Regulated entities (REs) shall not make investments in any scheme of AIFs that has downstream investments either directly or indirectly in a debtor company of the RE.

The RBI said lenders need to liquidate their investment in the scheme within 30 days if the AIF scheme in which the lenders are already investors makes a downstream investment in any such debtor company, the RBI said.

Also read: RBI bars lenders from investing in AIFs linked to borrowing companies

Further, if lenders have already invested in schemes having a 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, the RBI added. If lenders fail to liquidate their investments within 30 days, they need to make a 100 percent provision on such investments, the RBI said.

It added that investments by REs in the subordinated units of any AIF scheme with a “priority distribution model” shall be subject to full deduction from the RE’s capital funds.

On May 29, RBI Governor Shaktikanta Das highlighted cases of banks evergreening loans. In an address to banks in Mumbai, Das said that the central bank had found instances where innovative ways were being used to conceal the real status of stressed loans, and in some cases, evergreening of stressed loans.

“We have also come across a few examples where one method of evergreening, after being pointed out by the regulator, was replaced by another method,” Das added.

“I have mentioned these instances,” Das said, “to sensitise all of you to keep a watch on such practices. Such practices beg the question as to whose interest such smart methods serve.”

India’s AIF market

The alternative investment industry in India, comprising Portfolio Management Services (PMS) and AIF, will grow to Rs 43.64 lakh crore in the next five years, a November 2023 PMS Bazaar report showed.

Citing data from the past five years (June FY19 to June FY24), PMS Bazaar said the AIF and PMS industry registered a Compound Annual Growth Rate (CAGR) of 26 percent and the assets under management reached Rs 13.74 lakh crore by June FY24. AIFs led the pack in the alternative investment space with a CAGR of 36 percent in the last five years.

How will lenders be impacted?

Sivaramakrishnan said that some structures adopted by certain entities will have to be given a relook. “The RBI’s move does not come as a surprise as it has always been concerned with hidden NPAs and evergreening. The priority / senior or junior structures adopted by certain entities would fall squarely within the purview of this circular, and given the timelines prescribed, they would need to be quickly relooked for alternative structuring,” said Sivaramakrishnan.

Gadia said that the directives, especially the need to make 100 percent provision, may help ensure compliance. “The need to make a 100 percent provision on such outstanding debt is likely to be a big deterrent to such irregularities in transactions,” Gadia said.