RBI seeks to prevent evergreening of loans through investments in AIFs

The Reserve Bank of India has issued a notification dated December 19, 2023 (Notification), which seeks to address concerns of evergreening by banks and NBFCs. The Notification, which states that there have been certain transactions which entailed substitution of direct loan exposure of Regulated Entities to borrowers, with indirect exposure through investments in units of AIFs, is addressed to all commercial banks, co-operative banks, All-India financial institutions and NBFCs (including housing finance companies) (Regulated Entities) and prohibits Regulated Entities from investing in any scheme of an alternative investment fund (AIF) which has downstream investments either directly or indirectly in a debtor company of such Regulated Entity. For this purpose, any company to which the Regulated Entity currently has or previously had a loan or investment exposure anytime during the preceding 12 (twelve) months shall be considered to be a debtor company of the Regulated Entity.

The Notification further stipulates the following:

• is already an investor, makes a downstream investment in a debtor company, then the Regulated Entity has to liquidate its investment in the AIF scheme within 30 (thirty) days from the date of such downstream investment by the AIF. This stipulation makes it clear that the Notification does not impose any obligation on AIFs. The RBI is also aware that Regulated Entities which invest in AIFs cannot control investment decisions by AIFs.
• If a Regulated Entity is an investor in an AIF’s scheme which has a downstream investment in a debtor company as on the date of the Notification, the 30 (thirty) day period for liquidation shall be counted from date of issuance of the Notification. The Notification states that Regulated Entities are required to forthwith arrange to advise the AIFs suitably in the matter. This requires Regulated Entities to review the list of portfolio companies of the AIF schemes in which they have invested and inform the AIFs if any such portfolio company is a debtor company of the Regulated Entity.
• In case Regulated Entities are not able to liquidate their investments within the above-mentioned time limit of 30 (thirty) days, they are required to make 100% (one hundred percent) provision on such investments.
• Investment by Regulated Entities in the subordinated units of any AIF scheme with a ‘priority distribution model’ shall be subject to full deduction from Regulated Entities’ capital funds.  A ‘priority distribution model’ is one which allows one or more classes of investors to have priority in distribution of exit proceeds over other classes. A ‘priority distribution model’ usually disrupts the pooling of profits and losses among investors and allows those investors with priority to reduce their risks vis-à-vis other investors. The RBI probably assumes (and rightly so) that Regulated Entities which invest in AIFs in order to evergreen a loan indirectly may also seek a ‘priority distribution model’.

This Notification is likely to discourage Regulated Entities from investing in AIFs in future even for genuine reasons (such as diversification of risk) since, after an investment in an AIF has been made, if the AIF invests in a debtor company of such bank/NBFC, the Regulated Entity will have to either exit from its investment in the AIF or make 100% (one hundred percent) provision on such investment. It is also likely that henceforth, before investing in an AIF, Regulated Entities, shall require a commitment from the AIF that the AIF shall not invest in any existing debtor company of such Regulated Entity. Such a commitment may be inserted in the AIF’s PPM through an amendment, with the consent of a super-majority of investors or may be contained in a side-letter issued by the AIF to the Regulated Entity if the AIF’s PPM permits the issuance of side-letters.

The Notification would have caused less collateral damage if it had contained thresholds for its application. For example, the Notification could have provided that the prohibition on Regulated Entities investing in AIFs that have invested in debtor companies would apply only if a Regulated Entity’s investment in the AIF is atleast 25% of the AIF’s investment in the debtor company and such Regulated Entity’s loan to such debtor company shall fall due within one year of such Regulated Entity’s investment in the AIF.

Interestingly, the Notification does not apply when a Regulated Entity invests in an AIF’s scheme even if another scheme of the same AIF or any scheme of an AIF which has the same investment manager, invests in a debtor company of such Regulated Entity. Therefore, if a bank has invested in Scheme A of an AIF, a plain reading of the Notification does not prohibit Scheme B of the same AIF or Scheme K of another AIF which has the same investment manager as Scheme A, from investing in a debtor company of the bank.

Please find the notification here

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Vinod Joseph, Partner – Email – vinodjoseph@elp-in.com