After a crackdown by the Securities and Exchange Board of India (SEBI) on Alternative Investment Funds (AIFs) being used to hide stressed assets of regulated entities, the central bank has also now cracked the whip on such practices.
On December 19, the Reserve Bank of India (RBI) issued a notification prohibiting regulated entities (REs) from making investments in any scheme of AIFs which has downstream investments either directly or indirectly in a debtor company of the RE.
Also read: Mutual funds are not permissible investment for Cat III AIFs: Sebi's informal guidance
"Regulated entities (REs) make investments in units of AIFs as part of their regular investment operations. However, certain transactions of REs involving AIFs that raise regulatory concerns have come to our notice. These transactions entail substitution of direct loan exposure of REs to borrowers, with indirect exposure through investments in units of AIFs," said the RBI notification.
SEBI released a consultation paper on this practice by AIFs on May 23, saying that such schemes could help hide stressed loan books, through the evergreening of loans and tranching of securities that leads to a lack of transparency for investors, much like the tranching of collateralised debt obligations (CDOs) did during the 2008 financial crisis.
Therefore the regulator proposed that AIFs no longer sell schemes that allow this practice through their preferential distribution model.
What is the PD model?
Under the PD model, the profits or losses are not distributed pro rata — proportional to investment — but are distributed based on the ‘waterfall’ method.
That is, one set of unitholders (‘junior class/tranche’) other than the sponsor/manager absorbs a loss that is more than the proportion of their holding in the AIF versus another class of unitholders (‘senior class/tranche’). For example, if a junior unitholder owns 20 percent of the AIF’s investment, the unitholder may absorb a loss not of 20 percent but higher. This is because the senior unitholder is prioritised in the distribution of proceeds.
However, profits are first distributed to the senior-class investors and then given to the junior-class investors.
Also read: How a proposed change in Special Situations Fund norms could end roundtripping through AIFs
How is this model open to misuse?
If a regulated lender wants to take out loans that are at risk of default from its books, it can subscribe to the junior class units of an AIF/scheme set up for this purpose. The size of the investment made by the regulated lender seems to be determined by the expected loss on the loan portfolio at the time of structuring (haircut). Then, the AIF gets on board investors, who are willing to subscribe to the senior class of units. Investors in the senior class put money to the extent of the perceived fair market value of the assets acquired by the AIF from the regulated lender.
Then, the AIF invests in non-convertible debentures (NCDs) of the borrower companies that are expected to use these funds to repay the loans extended to them by the regulated lender.
The regulated lender replaces the loan portfolio on its books with the amount repaid by the borrower-investee company and investment in units (junior class) of the AIF.
This arrangement helps the regulated lender from classifying stressed assets and making adequate provisioning.
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