What wrongdoing has RBI found regarding bank investments in AIFs?

Without getting into the specifics, the Reserve Bank of India has indicated that certain transactions of regulated entities (banks and NBFCs) involving AIFs or alternate investment funds raises regulatory concerns.

While Tuesday’s circular did not explain exactly the nature of these transactions, it said that “they entail substitution of direct loan exposure of regulated entities to borrowers, with indirect exposure through investments in units of AIFs”.

Let’s explain this with an example. Say, Bank A has lent ₹100 crore to XYZ and Bank A has also invested in an alternate investment fund, LMN. If LMN has invested through debt or equity in XYZ , then RBI is disallowing such relationship.

This is because, the funds received from the LMN could have been used by XYZ to pare its exposure to Bank A. So, instead of a direct loan exposure to XYZ, Bank A now has an indirect exposure to XYZ through the investment in LMN.

Private credit, which is the mushrooming segment in the credit space, often opt for AIF structures. The circular seems to be the first step taken by the banking regulator to tighten the screws on private credit funds.

What has the RBI directed banks regarding investment in AIFs now?

The notification aims at curtailing the exposure of REs in AIFs where the AIF is also in a relationship with the same borrower. As the most preferred option, REs shall not make investments in any scheme of AIFs which has investments either directly or indirectly in a debtor company of the RE. In case the AIF scheme already has a relationship with the RE’s debtor, the RE should liquidate its investment in the scheme within 30 days from the date of such investment by the AIF. In circumstances where the RE is not able to liquidate the investments, it should make a provision for 100 per cent of the such investment value deployed by the RE to the AIF.

Will the RBI’s move be enough to check evergreening of loans?

The sheer cost prohibitive nature of structuring a debt transaction between REs, AIFs and the debtor, which could take the colour of a commingling structure, would deter REs from entering such transactions or merely investing in AIFs unless it’s a critical aspect of an RE’s investment strategy. Given that there could also be need for disclosure in case 100 per cent provisioning, this could further deter REs from engaging in such loan transactions.

Is there a possibility of loans being evergreened through other investment vehicles such as PMS funds or other quid pro quo?

While PMS or other alternative vehicles may not be as lucrative and promising in size to suit mid-to-large ticket corporate loan exposures, certain operating agreements with other subsidiaries of REs are often viewed as corporate structures which lend themselves to questionable transactions. However, with the RE being supervised and overseen by the RBI, especially the large banks and non-banks, these transactions can be traced easily.

Hence REs generally avoid such arrangements. Also, there are also not too many loose-ends in terms of regulations that REs could take advantage from an evergreening perspective.