Lenders Disguising Loans To Reduce Exposure: AIFs Appeal To RBI

An AIF industry lobby has told the Reserve Bank of India (RBI) that it would accept a directive that forces lenders which have used Alternative Investment Funds (AIF) to 'evergreen' loans to limit its exposure to 10 per cent of a fund corpus within six months from the date of RBI's circular. It has also suggested a limit on investment by any non-banking finance company (NBFC) in an AIF.

The lobby said that the AIF industry is ready to function under a regulatory framework that imposes such a cap the way it exists for banks.

While a bank's investment in an AIF is generally restricted to ten per cent of the size of the fund, there is no such rule exists for NBFCs.

The strict haves and have-nots imposed by RBI in a circular on 19 December 2023 are aimed at restricting lenders from using AIFs to move funds to related borrowers and hide the issue in their balance sheet.

But since the RBI directive encompasses all regulated entities and the AIFs, irrespective of the size and nature of the deals. Therefore several wholesale lenders, as well as fund managers now fear that investments by banks and NBFCs into AIFs could virtually dry up.

Thus, while the AIF industry is embracing regulatory steps because it would curb practices such as loan evergreening, it has reached out to RBI to protect bona fide transactions.

Firstly, as per the industry, the fund body suggests that development finance institutions like Sidbi, Nabard and Exim Bank should be exempted from the new, overarching RBI regulations.

This exemption is proposed based on their high governance standards and the particular role played by many of these institutions in supporting the government's initiatives concerning AIFs.

Secondly, banks whose investment in an AIF remains within the regulatory-mandated threshold of 10 per cent of the fund's paid-up capital should be exempt from these newly introduced regulations.

Thirdly, there is a request for the establishment of an exposure limit for NBFCs, potentially set at 10 per cent similar to that for banks. Furthermore, it is urged that NBFCs meeting this investment criterion remain outside the scope of the recently introduced regulations, as outlined by the regulator.

The recent regulations by RBI last week prohibit a bank or NBFC from investing in an AIF if that AIF has, in turn, invested in a company that has borrowed from the investing bank or NBFC.

In instances where such investments are already in place, lenders must either liquidate the investment within 30 days from the circular's issuance date or provision 100 per cent on said investment.

"AIFs are usually close-ended. Exiting within a month entails significant losses, while provisioning would adversely impact the financials of entities invested in these AIFs," expressed a source familiar with the situation.

"Given these challenges, it is imperative to extend the 30-day timeline to a more realistic duration. This is crucial to protect the interests of banks and NBFCs that have not employed AIFs for loan evergreening.”

The most important point in RBI's note states, "Investment by REs in the subordinated units of any AIF scheme with a 'priority distribution model' shall be subject to full deduction from RE's capital funds.”

Transactions of this nature, presumably prompting the introduction of the new RBI rules, involve a lender, often an NBFC, striking an arrangement with a foreign credit fund. This arrangement typically entails a 30:70 or 40:60 ratio investment to establish a local AIF.

Subsequently, the AIF makes downstream investments in debentures issued by distressed borrowers of the NBFC.

These borrowers then utilise the newly acquired debt funds from the AIF to settle their dues with the NBFC.

Simultaneously, the AIF issues senior units to the foreign investor, holding the primary claim on repayments by debenture issuers and junior units to the NBFC, which receives payment only after the foreign partner is settled.

This technique, perfected by a select few NBFCs, served as an evergreening method to postpone defaults impacting their asset books, all done without technically violating any rules.

"The AIF industry comprehends the rationale behind RBI's actions. Consequently, it suggests that such NBFCs should be obligated to reduce their exposures to AIFs to below 10 per cent within a six-month period," shared another informed source. "Given that this evergreening strategy necessitates an NBFC to contribute 40 per cent of the AIF capital, the transaction becomes unviable if the NBFC investment surpasses the 10 per cent threshold.”