Sebi cracks the whip on AIF-structures helping regulated lenders hide stressed assets

In a consultation paper released on May 23, SEBI has proposed that AIFs no longer sell schemes that allow this through what is known as a ‘preferential distribution (PD) model’.

In doing so, the regulator has set aside the recommendations made by a working committee set up last November to address regulatory concerns. The committee had suggested an evaluation of checks and balances to prevent misuse of the PD model, and had recommended that the model not be entirely prohibited.

The problem 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 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. The senior unitholder may be compensated for the loss out of the residual capital of the junior class investors, according to the SEBI paper.

When a profit is made, distribution is first made to senior class investors till a hurdle rate is met; then the remaining is distributed to the junior class investors.

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 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 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.

“It is pertinent to note that the regulated lender’s investment in AIF units, which appear to represent the haircut in the loan portfolio, may be shown in its books of accounts at value at par with senior class units,” stated SEBI’s paper.

“This may facilitate the regulated lender in avoiding the classification, provisioning and other applicable compliance requirements with respect to the loans in or expected to be in default. Further, the probable loss in loan repayment, if any, may reflect as loss in investment in AIF, in future,” it added.

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While this arrangement hides bad loans, it also masks the deteriorating creditworthiness of the borrower-investee company, according to SEBI.

“SEBI believes that this (PD model) could create a systemic risk,” said Venkatakrishnan Srinivasan, a debt market veteran and founder of advisory Rockfort Fincap.

“There are certain sets of investors who are also being given side letters, which say that in case of any problem, they will be the first to be compensated or given an exit. Other investors may not know about this (arrangement through the side letters)… Therefore, SEBI does not want this practice to continue, or if it continues, it should be done by informing the other investors about this. That should be done without hiding the information from the other investors,” he added.