On May 21, 2012, the SEBI (Alternative Investment Funds) Regulation, 2012 (“AIF Regulations”) ushered in a new era for the private equity and venture capital industry.
Laying out a structured framework for pooling money from investors (foreign/Indian) on a private placement basis, the AIF Regulations set the foundation for the funding boom that ensued in the latter part of the decade. The AIF Regulations provide for three categories of funds (i.e., Category I, Category II, and Category III) along with the investment parameters for each category.
The AIF Regulations, coupled with the circulars/notifications issued by the Reserve Bank of India (“RBI”) and Securities and Exchange Board of India from time to time, plays a crucial role in refining and addressing any gaps or complexities in the regulations as needed over time.
Shifting Gears for the AIF Sector in 2024 – Curtains down on evergreening loans
Certain transactions involving Regulated Entities (defined below) and Alternative Investment Funds (“AIFs”) entailed substitution of direct loan exposure of Regulated Entities to borrowers, with indirect exposure through investments in units of AIFs. To tackle concerns regarding possible evergreening through this avenue, on December 19, 2023, the RBI issued a Notification (“Notification”) in exercise of its powers under the Banking Regulation Act, 1949, the Reserve Bank of India Act, 1934 and the National Housing Bank Act, 1987.
The Notification bars commercial banks, co-operative banks, All-India financial institutions, NBFCs including housing finance companies (“Regulated Entities”), from investing in any scheme of AIFs which have downstream investments (either directly or indirectly), in a company to which the regulated entity currently has or previously had a loan or investment exposure (i.e., a debtor company) within the preceding 12 months.
Liquidation Requirement for Regulated Entities in AIFs with Downstream Investments: Starting Point for the 30 Day Timer
The Notification prohibits any investment (directly or indirectly) in an AIF Scheme by a Regulated Entity, where the AIF Scheme has a downstream investment in a debtor company. The RBI has set the tone for strict compliance, by providing that:
In the event that Regulated Entities do not liquidate their investments within the specified 30-day time limit, the Regulated Entities must make a 100% provision on such unliquidated investments.
Scrutiny on Investment in Subordinated Units with ‘Priority Distribution Model’
The Notification mandates that if a Regulated Entity invests in the subordinated units of AIF schemes employing a ‘priority distribution model’ such investments will be subject to a full deduction from the Regulated Entities’ capital funds. This provision appears to be an indication that the RBI is aware of instances where Regulated Entities have invested in AIFs with such a ‘priority distribution model’ and that the RBI takes a dim view of such investments.
Potential Implications and Conclusion
Designed to foster transparency and mitigate conflicts of interest between Regulated Entities and debtor companies associated with AIFs, the Notification has shifted the gears for the AIF sector in the year 2024, particularly in the run up to January 19, 2024.
The Notification mandates that Regulated Entities promptly inform the AIFs of such situations, necessitating a thorough review of the portfolio companies within AIF schemes to identify any debtor companies associated with the Regulated Entity. The immediate concern for Regulated Entities will be to identify a market for liquidation of their investment in the AIF Scheme (which has not been demarcated as a prohibited transaction). Either way, if the liquidation does not fructify, the costs of provisioning unliquidated investments will have to be borne by the Regulated Entities within the stipulated time frame. The Notification, while addressing a relevant concern, lacks clarity on the means and mechanisms for provisioning, limiting its effectiveness.
In the long-term, Regulated Entities will have to exercise caution and conduct adequate due diligence to ensure that they invest in AIFs which have not / do not invest in entities that are borrowers of the regulated entity.
While the objective of the Notification is well intended i.e., to curb the evergreening of loans, its introduction and implementation could have been phased in gradually. Further, a more lenient timeframe than the 30-day limit could have provided some relief. It remains to be seen if parties affected by the Notification will take legal recourse to challenge the Notification and/or seek a stay on its implementation before the appropriate judicial forums. Nevertheless, the deck for the AIF sector in 2024 has certainly been shuffled in view of changes that will come about following efforts to comply with this Notification.
We trust you will find this an interesting read. For any queries or comments onthis update, please feel free to contact us at firstname.lastname@example.org or write to our authors:
VINOD JOSEPH – PARTNER | Email – email@example.com
ASHISHCHANDRA RAO – PARTNER| Email – firstname.lastname@example.org
Disclaimer: The information contained in this document is intended for informational purposes only and does not constitute legal opinion or advice. This document is not intended to address the circumstances of any individual or corporate body. Readers should not act on the information provided herein without appropriate professional advice after a thorough examination of the facts and circumstances of a situation. There can be no assurance that the judicial/quasi-judicial authorities may not take a position contrary to the views mentioned herein.