On December 19, 2023, the Reserve Bank of India (RBI) issued a notification whereby regulated entities (REs) (including all commercial banks, and non-banking financial companies) were prohibited from making investments in any scheme of alternative investment funds (AIFs) which has downstream investments either directly or indirectly into any company to which the RE currently has or previously had a loan or investment exposure anytime during the preceding twelve months (debtor company). The move was intended to tackle the problem of structures which are intended to result in evergreening of bad debts, and while the intentions were right, AIFs are REs are still reeling under the impact of the notification. Even a month after the notification came into effect, the repercussions of the notification are being felt as REs announce the consequences of the notification on their financials, and measures they are taking to address the fallout.
The notification:
The notification seeks to address investments by an AIF, into which an RE has invested, into companies which have also received investments or borrowings from the RE directly. Thus, if a scheme of an AIF in which an RE is already an investor, makes a downstream investment in any such debtor company, the notification stipulates that the RE would be required to liquidate its investment in the scheme within thirty days from the date of such downstream investment by the AIF. Going one step further, the notification further clarifies that if REs have already invested into such schemes having downstream investment into their debtor companies as on the date of the notification, the REs would be required to liquidate its investment in the scheme within thirty days from the date of the notification. If the REs fail to liquidate their investments within the aforementioned thirty-day period, the notification requires REs to create a provision for one hundred percent of the value of such investments. The scope of the notification was to cover not only current debtors / investees of the REs, but also any companies / debtors / investees which had received such loans or investments from the REs concerned, during the 12 months preceding the investment by the AIF.
In addition, investment by an RE in the subordinated units of any AIF scheme with a ‘priority distribution model’ shall be deducted fully from the RE’s capital funds.
The consequences:
Immediately after the notification became public, several questions arose – how would an AIF be able to find out if its investment triggers the notification? How would an AIF facilitate an RE which has invested in to exit the investment in a short period of just 30 days? What would be the impact if such liquidation of investment is not possible, and the REs are required to provision for the value of such investments? Should there not be some effort to distinguish bad-faith transactions from perfectly legitimate ones? Many of these questions still remain unanswered.
The relevant stakeholders have been waiting for clarifications or amendments to the notification which would make it easier for AIFs to go back to investments without worrying about whether the notification would get triggered, but to no avail.
RBI/2023-24/90 DOR.STR.REC.58/21.04.048/2023-24
A distribution waterfall in which one class of investors of an AIF (other than sponsor/manager) share loss more than pro rata to their holding in the AIF vis-à-vis other classes of investors/unit holders, since the later has priority in distribution over former.
In the short term, the balance sheets of the REs may take a turn for the worse, since they would either be required to liquidate their holdings in the AIF schemes which have exposure to the RE’s debtor companies, or provision for the full value of such investments. The Piramal Group has suffered a consolidated net loss of INR 2,378 crore in the third quarter of the financial year ending March 31, 2024 on account of provisioning for INR 3,540 crore of its AIF investments. HDFC Bank and Kotak Mahindra Bank have also made contingent provisions of INR 1,220 crore and INR 143 crores, respectively, on their AIF investments. State Bank of India is understood to be seeking an exemption from the applicability of the notification for funds managed by it that focus on distressed companies.
Partner at JSA
Considering the illiquid nature of the units of AIF schemes, and the thirty-day period for compliance with the notification, REs may be forced to take a haircut on the value of their investments to ensure that they are compliant with the deadline under the notification. Exit from AIFs sponsored by the REs would also require the prior consent of the Securities and Exchange Board of India, further straining compliance with the deadline. The transaction costs associated with the divestment would only add to the woes of REs.
Going forward, REs would also be required to strengthen their internal controls to ensure compliance with the notification, thereby increasing their compliance burden. While the RBI’s move to curb evergreening of loans is welcome, the notification has the side effect of limiting AIFs’ access to domestic credit. This will also create challenges for companies to access domestic funding, during a period which is already being described as a “funding winter”.
Co-author: Nikhil Joseph
Archana Tiwary is a partner at JSA and Nikhil Joseph is a principal associate at JSA
