The Reserve Bank of India (RBI) has recently issued a circular prohibiting the regulated entities (REs) from making investment in units of Alternative Investment Funds (AIFs) having downstream investments either directly or indirectly in a ‘debtor company’ of the REs. Further, the circular requires the REs, which have already invested in such AIFs, to liquidate their investment within 30 days from the date of downstream investment by the AIF/date of circular (in case of existing investments).
In case REs are not able to liquidate as above, they are required to make 100% provision on such investments.
The term ‘debtor company’ has been defined to include any company to which the RE currently has or previously had a loan or investment exposure anytime during the preceding 12 months.
The circular particularly aims to curb structures which could be used by REs (including NBFCs) for ‘evergreening’ of loans.
Typically, in structures involving AIFs, the RE invests in the AIF which may invest in non-convertible debentures (‘NCDs’) of the debtor company of the RE. Consequently, the debtor company may use the funds raised by issuance of NCDs to repay the overdue loan from the RE – in such cases, the books of accounts of the RE reflect that the overdue debt has been repaid while indirectly the exposure (in the form of investments in the AIF) continues.
Also, the evergreening structure helps prevent any negative impact on the creditworthiness of the debtor company.
While the circular issued by the RBI addresses the potential evergreening structures, a blanket ban on investments in units of AIFs having downstream investments in debtor companies of REs may have unintended consequences. Some of them are: wrongfully classifying all AIF investments (including financially sound companies) as done for the purpose of ‘evergreening’; REs/ AIFs may have to undertake thorough due diligence as well as have internal controls in place to monitor compliance with the circular – this may consequently discourage investment by REs in AIFs; putting domestic institutional capital at a disadvantage in comparison with foreign institutional investors (who broadly make debt investments in India through the NCD/ external commercial borrowing route).
Also, there are certain practical challenges that may have to be considered while complying with the circular.
Firstly, AIFs making NCD investments may typically be Category 1/2 AIFs (which are close-ended in nature) which means that such AIFs will not be able to redeem their units at will as the underlying investments are illiquid and transfers of such AIF units are subject to investment manager consent along with certain lock-in restrictions. Accordingly, to liquidate the investment in AIF units within the prescribed time period may be challenging.
Secondly, finding buyers may be difficult for regulated entities, as buyers would now like to exercise caution before purchasing the AIF units from the REs.
Thirdly, in a situation where the REs act as a sponsor to such AIFs, requiring such REs to liquidate their investments in these AIFs will require finding another sponsor (and also seeking prior approval of the Securities Exchange Board of India). As per SEBI AIF regulations, sponsors are required to have a continuing interest in the AIF over the tenure of the AIF.
While RBI’s concerns with respect to evergreening are valid, the circular in its current form will cause discomfort to genuine REs as well as pose certain practical difficulties as mentioned earlier. Some clarifications from RBI to address concerns of the REs and the AIF industry would be welcomed.
Punit Shah is Partner and Vishal Lohia is Associate Partner at Dhruva Advisors.
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