RBI Clarifies Rules on Investments in Alternative Investment Funds (AIFs) for Banks and Financial Institutions

The Reserve Bank of India (“RBI”) issued a clarification on March 27, 2024,[1] regarding its Circular titled “Investments in AIFs”, dated December 19^th, 2023 (“December 2023 Circular”).[2] This clarification aims to address concerns raised by stakeholders and ensure consistent implementation of the rules.

Key Points of Clarification

1. Equity Carve-out: Regulated Entities (“REs”) can now invest in AIFs that hold equity shares in companies they have lent to previously. Previously, any downstream investment in a debtor company by the AIF was restricted.
2. Provisioning Adjustments: REs only need to make provisions on the portion of their investment in the AIF that is further invested in the debtor company, not the entire investment.
3. Subordinated Debt Treatment: The capital deduction rule for investments in subordinated units of AIFs with priority distribution applies only if the AIF has no downstream exposure to the RE’s debtor companies. Provisions related to subordinated debt now include sponsor units.
4. Fund of Funds Exemption: Investments in AIFs via fund of funds or mutual funds are not restricted by the circular.

Background

The December 2023 circular aimed to prevent a practice called “evergreening” where banks might move bad loans to AIFs to avoid classifying them as non-performing assets. To know more, please read our previous article on the same here. The clarification provides some relief to REs while maintaining the core objective of addressing potential regulatory risks.

Potential Impact

For REs, the clarification offers a mixed bag of benefits and challenges. On the positive side, the allowance for equity holdings in AIFs expands their investment scope. This would enable them to explore a wider range of strategies and enhance diversification. This increased flexibility is particularly crucial in navigating dynamic market conditions. Moreover, the clarification on provisioning limits alleviates some of the financial burdens faced by REs, especially in scenarios where only a fraction of AIF investments directly benefit debtor companies. However, REs still face the spectre of scrutiny, especially regarding concentrated exposure to debtor companies even if held through AIFs. Thus, while the clarification offers leeway, thorough due diligence remains imperative to mitigate risks effectively.

For AIFs, the implications are equally significant. The clarification potentially enhances their attractiveness to REs, presenting an opportunity for increased fundraising and broader investor participation. However, this attractiveness hinges on AIFs’ ability to provide clear and comprehensive disclosures regarding their downstream investment strategies. As REs become increasingly discerning about compliance considerations, transparent communication becomes a crucial factor in maintaining investor trust and confidence.

Investors in AIFs may see changes in how risks are managed. While efforts to prevent risky practices and increase transparency could make investing safer in the long term, there might be some confusion as regulations evolve in the short term. On the regulatory side, the clarification gives clearer rules, making it easier for banks and NBFCs to follow. However, the RBI needs to make sure these rules don’t hinder fair investing or encourage misuse of AIFs. It’s a balancing act that requires constant monitoring and adjusting to keep the market healthy and growing.

Looking Forward

Looking forward, both the RBI and stakeholders in the AIF ecosystem should keep a close eye on a few key areas. For the RBI, consistent implementation of the revised guidelines is crucial. Monitoring REs’ investment activities and AIFs’ downstream exposures will be essential to ensure the effectiveness of the regulations. Stakeholders, on the other hand, should focus on enhancing transparency. AIFs should provide clear and regular disclosures about their investment strategies, particularly regarding potential downstream exposures.

In terms of legal changes, we may not see significant alterations to the core premise of preventing evergreening. However, the RBI might consider further refinements based on the practical implementation of the current framework. Potential adjustments could include categorization-based exemptions for certain AIF classes (like Cat 3 hedge funds) or a more nuanced approach to defining affiliated AIFs. Overall, the focus will likely be on calibrating the regulations to achieve a balance between effective risk management and fostering a healthy AIF investment environment.

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12639&Mode=0.

[2] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12572&Mode=0.