Why RBI Wants To Curb Lender Investments Into AIFs

On Tuesday evening, as fund managers at alternative investment funds were starting to wind up their day, there was a shock announcement from the Reserve Bank of India. Banks and non-bank lenders can no longer invest in an AIF which has investments in borrower companies.

The move, aimed at curbing evergreening of loans, will require lenders to unwind their exposures to such AIFs within 30 days. If they fail to do so, these lenders would need to make 100% provisions.

The news started spreading fast on WhatsApp groups and urgent meetings were called. Those in office and even those on their annual leave had to log in to figure out what the potential hit could be.

People were trying to call whoever they could at other regulators to complain about why the RBI was being so unfair toward AIFs, according to one person with knowledge of the matter, who spoke on condition of anonymity. Of course, it did not yield much.

By dinner time, the line to be taken was clear.

The RBI is doing a tremendous job of protecting the financial system from those who are trying to game it. But these guidelines may have unintended consequences, which will hurt genuine deal structures.

And who are the ones trying to game the system? "Not me, I am clean. It has to be the other guy." Fund after fund repeated the same line to reporters who were calling them all evening.

The Genesis

AIFs came up as a potentially new way to pool investments and buy into areas where traditional mutual funds could not enter.

These are typically divided into three categories in India:

• Funds which invest in areas where they can get government concessions.

• Funds where private money is used to invest in various situations.

• Short-term return funds like hedge funds.

Over the years, as AIFs became more popular, the assets under management rose to over Rs 8 lakh crore in the last fiscal. Compared with about Rs 49 lakh crore in the mutual fund industry as of November, this is still lagging.

Over the last one year, the Securities and Exchange Board of India was highlighting the problem with some categories of AIFs using new and risky financial structures. In November 2022, the markets watchdog decided to bar priority distribution models at AIFs, where one set of investors would take on a significantly higher risk than the others.

SEBI Whole Time Member Ananth Narayan G, in October, even warned against two sets of AIF investments. One, where structures were being used to avoid recognising non-performing assets; and the other where sectoral investment/lending caps were being breached.

According to another person with direct knowledge of the matter, SEBI informed the RBI of such instances it had noticed in the market earlier this year. Tens of funds, with deals worth over Rs 20,000 crore, were raising eyebrows at the market regulator's headquarters in Bandra Kurla Complex.

Mint Street, though, took its time. It reviewed everything closely and noticed that the size of the problem was not big. But it had the potential of spreading like wildfire if left unchecked, according to another person who spoke on the condition of anonymity.

So, almost a month after it busted the unsecured loan party at banks and non-bank finance companies, the RBI came out heavily against such AIF structures on Tuesday.

'Structural' Problems

The core of the problem, according to industry executives, is with the questionable structures some funds have entered into with lenders.

According to three people with direct knowledge of the matter, this is how a typical questionable model would work:

A bank or an NBFC would find a real estate or infrastructure exposure they are nervous about. It is likely that if the borrower continues to remain on the book, there would be higher provisions and ballooning bad loans.

So, instead of recognising a stressed account, the lender would go to a friendly fund manager. The fund manager (for a hefty fee) would create a fund which could take the problematic borrower off the lender's book.

The lender would participate by becoming a junior or subordinate class investor by putting up about 5-25% (sometimes even more) of the investment pool. The senior class consisted of your above-average-Joe who had at least Rs 1 crore to invest in higher yielding investments.

In these senior-subordinate structures, the lenders would willingly agree to take on higher losses for a higher return ratio. For the senior investor, it meant priority payouts while the underlying asset was still performing.

The borrower would get some investments from the fund, which would be specifically used to repay its outstanding debt to its original lender. So, essentially the lender was (at least partly) paying itself to avoid an NPA--popularly known as evergreening.

Deepak Shenoy of Capital Mind has an excellent explainer on this process too.

Some other questionable models may include AIF investments in other group companies, which could be routed to the problematic borrower.

One large non-bank, while selling its stressed real estate portfolio to another large investor, even built in specific clauses to continue funding some of these projects. The clause also specified that once the projects started earning returns beyond a threshold, the non-bank would be eligible for a portion, according to a legal expert with first-hand experience of such transactions.

Another large NBFC, which is currently bankrupt, has even built an entire shadow loan book which consists solely of exposures to AIFs, the legal expert said on the condition of anonymity.

To be clear, there was nothing illegal about this. But guidelines were not very clear till recently, which emboldened the ecosystem to use these structures to primp their books.

The Fallout

Those in the AIF industry are trying to now get clarifications from the RBI and maybe some amendments, if they are able to.

In an interview with NDTV Profit, Kotak Special Situations Fund's Eshwar Karra said that ideally the provisioning requirement should only be implemented on a lender's funds which were used by the investee company to retire debt. The way the current norms are drafted, all of a lender's investments into an AIF can attract 100% provisions if a problematic relationship with a borrower is detected.

The manager of a Singapore-based fund, also speaking on the condition of anonymity, would like to know if an AIF investing in a borrower's group company would attract regulatory action. While these achieve the same outcome as directly investing in a borrower firm, the current guidelines don't cover them for any penalties, this manager said.

There were many small and large violations in the market, explained another fund manager. These violations could range from someone spitting on the road to someone committing murder on the road, he explained.

Having said that, there are genuine situations where the fund is completely unaware of a stray working capital loan the borrower may have accessed from a lender in the past, he said.

To extend the fund manager's analogy, instead of dealing with individual offenders to the extent of their violations, the banking regulator seems to have chosen to simply shut the road for all.