RBI DRAFT DIRECTIONS ON AIFS – SOUND IN PRINCIPLE BUT COMPLEX IN PRACTICE

Keywords – Financial laws, corporate jurisprudence and Companies Law

INTRODUCTION

Apart from traditional investment avenues, Alternative Investment Funds (AIFs) have gained significant traction in the Indian market over the years. AIFs have emerged as one of the most popular vehicles for both domestic and foreign investments and play a crucial role in fuelling economic growth. Indian regulators have made efforts to bring these funds under a robust regulatory framework. The recent draft directions issued by the Reserve Bank of India (RBI) concerning investments by Registered Entities (REs) have once again brought these funds into the regulatory spotlight.  This blog explores the recent RBI draft directions for REs (directions) and their impact on the domestic AIF ecosystem. It further examines the implications for foreign investment inflows through AIFs, along with the practical feasibility of the proposed framework.

UNDERSTANDING THE RBI’S DRAFT DIRECTIONS: LIMITS, PROVISIONING AND OVERSIGHT

The directions provide for caps on RE investments into the AIFs and mandate specific provisioning requirements. As per the directions, an individual RE’s investment is capped at 10 % of the total fund size of the AIF scheme (corpus), whereas REs on a collective basis are capped at 15% of the corpus. Additionally, oversight on downstream investments is tightened by requiring 100% provisioning for REs that hold more than 5% in an AIF fund, which in turn has downstream investments in a company qualifying as a debtor company of that RE.    

From a preliminary reading of the draft directions, it appears that provisioning requirements may not be triggered in cases where REs or AIFs hold equity shares, Compulsorily Convertible Debentures, or Compulsorily Convertible Preference Shares in the investee company, or where the RE’s exposure to the AIF scheme remains below 5% of its total corpus. However, as these are still draft directions, the final position may evolve based on regulatory clarifications and stakeholder feedback.

Additionally, the draft directions also require REs to put in place a clear investment policy that includes strong checks to identify and prevent potential evergreening of loans.

ANALYSIS

The earlier December 2023 circular issued by the RBI was seen as abrupt and overly stringent by market participants, as it imposed a blanket restriction on REs investing in AIFs that had downstream exposures to companies classified as their borrowers. This created widespread concern about its impact on market flexibility and legitimate investment structures. In response to industry pushback, the RBI issued a clarification in March 2024, which offered partial relief by carving out pure equity investments from the scope of the restriction. This was a much-needed move to prevent over-regulation of standard equity-linked transactions. Building on this, the current directions mark a shift toward a more risk-based regulatory approach, moving away from the blanket prohibition model.

The primary objective of the current directions seems to be curbing the evergreening of loans. However, a deeper regulatory concern lies in addressing the issue of cross-linkages between AIFs and traditional financial institutions such as NBFCs and asset management companies (AMCs) through complex and opaque investment structures. This includes the risk related to sponsor-level exposures, common investor bases and regulatory arbitrage arising from lighter oversight of AIFs compared to traditional lenders, as highlighted in the 2023 RBI report.  These directions aim to ensure a better balance between regulatory oversight and market flexibility.

The proposed 100% provisioning requirement is to prevent evergreening of loans and address the risk of cross-linkages between AIFs and REs. Specifically, when an RE invests in an AIF that further invests in a company already indebted to the same RE, it results in overlapping direct and indirect exposures, thereby concentrating risk in the same debtor company and weakening the credit discipline. The absolute provisioning requirement serves as a risk containment tool by putting a high cost on REs involving opportunity cost and reducing REs’ profits, which makes it unattractive for REs to over-reliance on or lend to stressed or overexposed borrowers. This encourages REs to strengthen their investment policies curbing evergreening while also helping in safeguarding investment security and overall market liquidity.  However, the practical viability of the directions is a bit concerning. An unprecedented challenge that arises is the high cost involved in provisioning which may prompt some REs to exist the AIF market. However, given that India’s AIF secondary market is still underdeveloped, existing the market itself becomes challenging as many REs face limited demand and liquidity. This often leaves their portfolios stuck or forces them to sell at steep discounts, making exit a difficult and value-eroding process.

Further, the 15% cap on an aggregate basis poses challenges and may hurt private capital in the short run itself, particularly in sectors where AIFs serve as a critical funding channel. Further, it is pertinent to note that since in a collective setup the risk is getting divided, there must be some relaxation regarding the investment cap; otherwise, strict enforcement of the 15% overall cap is likely to significantly restrict the inflow of substantial private capital into AIFs. This is particularly concerning for the Category-1 AIFs which fund the small and mid-size companies and startups. These startups and small companies rely heavily on AIFs since they often find difficulty in raising funds, which is why AIFs prove very helpful for them; however, now this cap of 15 % will restrict funding for these companies, thereby affecting their growth potential. Negative effects can particularly be seen in sectors like real estate, where AIFs provide structured finance, providing enough liquidity to finance the projects.

These caps will require the AIFs to diversify their portfolios to gather more capital, but such forced diversification may lead to increased risk and dilute focused strategies. Companies like Piramal Enterprises and IIFL Finance have already seen big hits in their share prices under 100% provisioning rules earlier. With the added burden of strict limits and heavy provisioning, REs are likely to scale back or exit their AIF investments. This could adversely impact funding availability for startups, potentially delaying or derailing upcoming IPOs, and ultimately eroding investor confidence.

IMPLICATIONS FOR FOREIGN CAPITAL AND GLOBAL INVESTOR PERCEPTION

AIFs serve as an attractive non-traditional vehicle for investors abroad, especially those who have confidence in the Indian debt markets and are seeking flexibility in restructuring. They are especially attractive to investors open to taking control of investee companies and navigating debt deals within a comparatively lighter regulatory framework.  By facilitating co-investments, AIFs enable Foreign Portfolio Investors (FPIs) to comply with the 50% diversification norm. This has further contributed to the growing AIF preference.

However, the proposed cap on aggregate RE participation may have a ripple effect on the incoming foreign investments. Domestic institutional support acts as an anchor for the AIFs, showcasing confidence in the funds’ quality and reducing perceived risk. Limiting RE’s participation could weaken this anchor effect, as the reduced domestic commitment increases the perceived risk, making it harder to attract offshore capital and thereby threatening private capital mobilisation even in the short term.

Another concern is the treatment of RE investments via intermediaries such as Fund of Funds (FoFs) and mutual funds. The RBI’s March 2024 clarification had exempted these from provisioning and exposure limits, recognising the impracticality of tracking downstream exposures in pooled structures. However, the current draft omits this exemption, implying that banks may now be expected to monitor indirect exposures across multiple AIFs and investee companies.

This is especially problematic since such granular downstream data is often inaccessible. Importantly, the very purpose of pooled structures like FoFs is to diversify risk and ease the due diligence burden by outsourcing portfolio management to expert intermediaries. Requiring granular tracking in these cases undermines that purpose, increases compliance costs, and can discourage REs from investing through these vehicles, thereby weakening portfolio diversification.

CONCLUSION AND SUGGESTION

While the RBI’s draft directions represent progress, especially in addressing concerns raised in the December 2023 Financial Stability Report( FSR), a more calibrated and practical approach is still warranted. The draft appropriately includes safeguards against evergreening, such as requiring capital deduction for RE investments in subordinated units under the Priority Distribution Model (PDM).

However, the proposed 15% cap on aggregate RE participation in a single AIF scheme deserves reconsideration. As the RBI itself has emphasised through its FSR that effective risk assessment and mitigation of evergreening require robust governance. Since AIFs are structurally closer to the investment risk and better placed to assess it, the regulatory focus should shift toward mandating robust investment policies within AIFs. These policies should specifically require detailed risk disclosures coupled with clear identification and reporting of cross-linkages with regulated entities.

This would allow for a more informed and objective assessment of risk, rather than presuming that all RE participation automatically contributes to evergreening. Such an approach ensures transparency and accountability while preserving the practical viability of AIFs as a funding channel.