Startup funding may face the heat after RBI crackdown on evergreening loans to AIFs

RBI move may worsen startup funding drop trend.

You can almost call it the central bank's curse. First, it fell on fintechs. And, as the year draws to a close, it is now coming for venture funds.

Last week, the Reserve Bank of India came out with a diktat that has struck fear in the hearts of venture capital investors.

Here's what the RBI's latest diktat effectively says: Suppose that a VC fund invests in a particular startup. If a bank or NBFC has lent money to that startup, it can't invest in a VC that also funds the same startup.

This is a move to crack down on banks and non-banking financial companies indulging in the evergreening of loans through Alternative Investment Funds(AIFs), the regulated vehicles of VCs.

Evergreening of loans means that a lender is using financial structures to offset its provisioning for bad loans. Some large NBFCs were doing it — they sold their bad loans to AIFs which in turn were funded by the NBFCs.

VCs say that the unintended consequences of this could be a worsening of the startup funding situation, which has already dropped this year by more than two-thirds.

"India has always lacked domestic pools of capital flowing into venture capital firms. This move by the RBI will only worsen the situation for a handful of domestic VC firms who have banks as LPs,” said a partner of a VC firm who didn't want to be named.

According to industry estimates, domestic VCs don't account for more than a third of the funding for startups at present. Moreover, contributions from foreign limited partners make up most of the corpus of the domestic VCs. Only in the last 4-5 years have the country's banks been gradually warming up to the idea of backing VC funds or co-investing in startups with them.

“There were a few NBFCs that had used lending through AIFs to evergreen their assets. We are not questioning RBI's action but we are concerned about the fact that there was no consultation. This will have unintended consequences on a lot of funds including the crucial development funds like SIDBI,” said Gopal Srinivasan Chairman and MD of TVS Capital

The Impact on SIDBI

One of the largest investors in the venture ecosystem is SIDBI, which is the Small Industries Development Bank of India, and these investments also stand to get impacted by this circular unless the regulators choose to clarify to the contrary, said Ashish Fafadia,  partner at Blume Ventures

Multiple VCs told Moneycontrol that this move inadvertently sends a wrong message to the VC firms’ overseas LPs when one of the most important regulators in the country effectively tells domestic financial institutions that investments in VCs and startups through approved routes can also attract regulatory sanctions.

“So foreign LPs may say if it is deemed unsafe for our own local money to be invested in startups, why should overseas investors take the risk?," said the VC partner quoted above.

“There are a lot of funds where the LPs are banks. Some banks have invested a lot of money in Debt Funds. Most of these have not indulged in evergreening but this development will impact the whole of the ecosystem,” Fafadia  of Blume added.

Over the last few years, AIFs have become a major route for startup funding and AIF as an investment vehicle helped a lot of investors to source funds domestically. This move by the central bank also puts the domestic funds in a disadvantageous position vis-a-vis foreign funds.

“Government of India backed SIDBI has acted as a fund of fund for a lot of domestic VC and seed funds, venture debt firms and financial institutions that lend to startups. Now if any limited partner has to liquidate within 30 days, in the private market in such a tough market could pose a problem for a lot of startups and the funds backing them,” said Vikram Chachra, founding partner at 8i Ventures.

According to VC partners, some of the bad apples in the industry had been abusing the system and the regulators and the government should prevent that rather than bring down the trust in the whole ecosystem.

According to a couple of investors, IVCA has already reached out to the RBI and is looking to appraise the regulator of the situation.

According to a VC investor and fintech founder, this will eventually force domestic funds to circumvent and take the circuitous route through tax havens and jurisdictions such as Mauritius, Singapore and the Netherlands among others.

Investors’ hopeful of relief

Chachra was hopeful that RBI would likely fine-tune the regulation and request more transparency from AIFs. “AIFs should not be at a disadvantageous position compared to overseas funds,” he added.

Another partner of a VC firm said that over the next one month before the deadline for the RBI diktat kicks in, the VC industry will have to burn the midnight oil to convince both the RBI and Sebi to not go ahead with this, or somewhat dilute the rules.

"One suggestion from us is to just increase the credit risk weightage for the asset class as the RBI did for unsecured consumer loans," he said.

The VC ecosystem and the fintech industry have approached RBI to submit recommendations.

“In our recommendations, we are highlighting that instead of a drastic stop on investment, we enhance governance systems and disclosures. This will have a transparent approach and banks and LPs can decide and the regulator will also be privy to this data,” said Blume Ventures’ Fafadia to Moneycontrol.

“The regulators over the last 18 months, are willing to listen to the challenges of the various participants of the ecosystem, So we are awaiting more clarification and this is my hope,” he added.
TVS Capital’s Srinivasan also said that recommendations are being submitted.

“The 10% investment rule put on banks to invest in AIFs should also be brought to NBFCs. At 10% investment, they will not be able to influence the functioning of the AIF. Wherever the investment is less than 10% they can be left out and the development finance institutions like NIIF and SIDBI should be spared as these are developmental capital,” He said.

However, a couple of industry experts argued that the industry impact could be minimal as the regulator’s measure is mostly to prevent NBFCs and banks from evergreening loans and VC firms are not beneficiaries of such funds.

"I don't think there will be a significant impact of this on startups and venture debt firms. Banks selectively invest in VC firms anyway. In cases where they do invest in VC firms from now on, they will have to ensure that they are not giving debt to the particular VC's portfolio companies," said Suraj Malik, a veteran management consultant who works with family offices.

Banks and NBFCs are working towards creating a provision for the exposure in investment instead of unwinding altogether, said Madhukar Sinha, founding partner at India Quotient.

“Now as far as I'm hearing, instead of pulling the investment, some banks are creating a provision. This might not be very large as they were restricted to investing less than 10%,” He said.