|
Powered by AltAlpha AI
|
Ritu Raj and Satchith Subramanyam are a 4th year B.A., LL.B. (Hons.) students at Gujarat National Law University in Gandhinagar.
Introduction
On December 19, 2023, the Reserve Bank of India (RBI) issued a circular imposing stringent restrictions on Regulated Entities i.e. banks & NBFCs (REs) vis-à-vis their participation in Alternate Investment Funds (AIFs). The circular expressly prohibits REs from engaging in any investment activity with AIFs that exhibit direct or indirect downstream investments in entities to which the REs have, within the preceding 12 months, maintained either loan or investment exposure. To reinforce compliance with this prohibition, the RBI has mandated the expeditious liquidation of extant investments in AIFs with downstream investments in debtor companies. The REs are obligated to effectuate such liquidation within 30 days from the realization of the AIF’s downstream investment. Non-adherence to this stipulation compels REs to make a comprehensive provision, amounting to 100% of their investments in the concerned fund.
Furthermore, the circular obligates REs holding investments in the subordinated units of any AIF scheme featuring a ‘priority distribution model’ to effectuate a full deduction from their capital funds equivalent to the entire amount of their investments therein.
The RBI’s intervention seeks to safeguard the financial system from the potential instability arising from default evergreening practices facilitated by AIFs. Through these evergreening practices the REs (particularly NBFCs) have been reported to have infused funds in debtor companies who are on verge of default through AIFs. It is done to enable the debtor company to repay the outstandings and avoid their classification as Non-Performing or Sub-Standard assets. Consequently, circumventing the provisioning requirements mandated by RBI by merely substituting their direct debt exposure with an indirect investment in the debtor. However, such sweeping restrictions on participation of REs (particularly NBFCs) in AIFs can have an unwarranted impact on availability of finance for critical sectors like the startups that extensively rely on AIFs for initial fundings and potentially jeopardize the growth of the AIF ecosystem in the country.
Against this backdrop, this post endeavors to understand evergreening and zombie lending practices undertaken by REs and the role played by AIFs in facilitating the circumvention of the extant regulatory framework pertaining to stressed assets. It delves into the nuanced implications that the stance adopted by the RBI may have on the future of the AIFs ecosystem and related industries. Through a comparative analysis of regulatory frameworks addressing analogous malpractices, it seeks to evaluate whether the proposed regulatory regime is an inhabitable necessity or a case of regulatory overshoot. Through the analysis it also attempts to explore a regulatory middle ground that may accommodate both the concerns of the regulator and functionality of the AIF industry.
Understanding Evergreening of Defaults
Evergreening is a practice where REs manipulatively structure transactions to substitute potential nonperforming loans with indirect investments or shadow lending to avoid their classification as stressed assets. Typically the incentive to engage in such practice is to defer acknowledging losses expecting that the (i) borrower’s financial situation improves; (ii) the responsibility can be pawned off to the subsequent management, and (iii) to avoid creating mandatory regulatory provisions against the stressed asset. Further, if a bank already has a significant stake in a distressed firm, there is a higher probability of the bank refinancing its current loans to that firm, especially when the bank is undercapitalized and has limited capacity to absorb losses.
Such practices may result in building up systemic risks on REs balance sheet and the financial market in general. Moreover, with reduced efficiency in the market due to such practices, it may lead to the emergence of unviable “zombie firms.” Amidst financial distress, one of the bakers of the debtor is likely to provide credit to a related party right before the default. Alternatively, they can make indirect debt or equity investment in the debtor company through structures like AIFs. Such recipients of shadow loans or indirect investment transfer the benefits to the initial borrowers to facilitate the repayment of the initial loans and circumvent its classification as stressed assets. Prior to the impugned circular in absence of a regulatory framework even if the regulator was suspicious of such evergreening of defaults there wasn’t any liability on part of the concerned RE.
Alternate Investment Funds as the Hidden Closet of Defaults
The utilization of AIFs as a mechanism for evergreening defaults and evading regulatory frameworks, notably in contravention of the RBI’s stipulated guidelines for stressed assets, represents a complex financial engineering that intertwines regulatory arbitrage, opaque maneuvering, and potential conflicts of interest. The REs (particularly NBFCs) infuse funds in debtor companies who are on verge of default through AIFs to enable them to repay the outstandings and avoid the classification of their loan exposure as non-performing or sub-standard assets.
According to SEBI the modus operandi involves REs, particularly NBFCs, subscribing to the junior class units of AIFs specifically structured for this purpose. The subscription is ostensibly based on the anticipated loss (haircut) on the loan portfolio slated for transfer. Subsequently, the AIF engages other investors who subscribe to the senior class units, thus establishing a priority distribution model. In this intricate arrangement, the AIF then invests in non-convertible debentures (NCDs) of borrower companies. These funds, received from the senior-class investors, are utilized by the borrower-investee companies to repay the loans extended by the RE. Consequently, the RE replaces the distressed loan portfolio on its books with the amount repaid by the borrower, accompanied by an investment in units of the AIF’s junior class. This enables REs to circumvent direct loan exposure regulations to borrowers by introducing an intermediary layer through AIFs. The AIF structure, with its dual-class units, facilitates the segregation of risk, wherein junior-class investors (usually the REs) absorb the losses beyond their proportionate holdings. However, profits are disbursed first to senior-class investors, fostering a peculiar risk-distribution model.
SEBI has reportedly detected transactions amounting to INR 150 billion to INR 200 billion involving such models which circumvent regulations governing stressed assets and has restrained AIFs operating using priority models from accepting any new investment till further notice.
RBI’s Circular and future of AIF-NBFC Partnerships
To prevent the perpetuation of this practice, the RBI came up with a circular restraining REs from making any investment in Alternate Investment Funds which have either direct or indirect downstream investment in any of their debtor companies. The intent of the central bank is to effectively close the regulatory loophole enabling evergreening of defaults. However, the restrictions may jeopardize availability of funds for AIFs where REs remain key institutional investors. This would in turn affect segments like startups that rely on AIFs for investments. As the restrictions are also applicable on Development Finance Institutions (DFIs) like SIDBI and EXIM Bank they would also affect the availability of funds for key developmental goals earmarked by the government. Consequently, jeopardizing the growth of the AIF industry.
While it is important to close the regulatory loopholes it must also be considered that reportedly detected instances of use of AIFs for evergreening represents a relatively small portion of the total investments by REs in AIFs. A sweeping prohibition on REs investing in AIFs with downward investments in its lenders appears to ignore the fact that many such investments may be on arm’s length basis without the intent of evergreening defaults. In case of REs with a large base of debtors, investments made in AIFs may subsequently flow down to debtors with sound financial condition or the quantum of investment and debt may be so disproportionate that evergreening would not be practically possible.
Concluding remarks
This analysis posits that RBI has grasped the gravity of the prevalence of evergreening. While closing the regulatory loopholes and instituting stringent measures, the RBI endeavors to preserve the integrity of financial institution’s balance sheets, ensuring that short-term gains do not compromise long-term financial stability. Nevertheless, such sweeping restrictions on participation of REs (particularly NBFCs) in AIFs can have an unwarranted impact on the availability of finance for critical sectors.
Moreover this action could ensue in becoming a counter-productive measure. Research indicates that internal capital markets have a pivotal role to play in propelling the flow of capital to firms that are cash strapped. Fetters on the functioning of internal capital markets may result in the deterioration of investment and employment. Consequently, the drawbacks of limiting evergreening practices may surpass the associated benefits.
To effectively plug the regulatory loophole and address the practical realities of the AIF industry in the long term accommodative midways should be explored. The RBI may consider extending the existing regulation restraining the commercial banks from contributing more than 10% of an AIF’s capital to all regulated entities including the NBFCs. Additionally, an alternative framework with stringent disclosure and due diligence thresholds may be prescribed to maintain checks and balances.
