In scaling up any business, the initial hurdle often revolves around the requirement for collateral, particularly daunting in the realm of brick-and-mortar businesses. However, the landscape shifted significantly with the rise of technology-driven ventures, where innovative concepts and ideas could swiftly translate into tangible valuations.
Responding to this demand, investors united their resources, pooling capital into structured vehicles and capable funds. This collective effort ushered in a new era where skilled managers took charge, ensuring the highest governance and compliance standards.
This evolution has not only transformed the investment landscape but also sparked a renaissance in recent decades, reshaping how capital is deployed to nurture and elevate promising ventures.
A New Avenue for Investment: The Rise of AIFs
AIFs have emerged as a potent force in recent years, offering investors avenues beyond traditional stock markets. Catering to high-net-worth individuals and institutional investors, AIFs provide opportunities for portfolio diversification and potentially higher returns.
Evergreening: A Shadow Over AIFs
Evergreen loans pose a systemic risk to the financial system. These are essentially loans that are perpetually renewed, preventing genuine repayment and masking potential defaults.
The RBI’s investigations, along with those of the Securities and Exchange Board of India (SEBI), revealed instances where AIFs were allegedly used to evergreen problematic loans. This misuse undermined financial stability and raised concerns about circumventing foreign investment caps and insolvency regulations.
RBI Steps In – Navigating the Changes in AIF Regulations
In December 2023, the RBI issued a notification that significantly impacted the relationship between AIFs and regulated entities, primarily banks and Non-Banking Financial Companies (NBFCs).
This notification restricted regulated entities from investing in AIF schemes that had portfolio companies in which a bank or other regulated entity already had a position. However, the RBI recently issued a revised circular relaxing some provisions.
- Relaxation in Provisioning: Previously, REs had to make a 100% provision against their entire investment in an AIF. The new guidelines clarify that the provisioning will only be based on the portion of the AIF’s investment that goes into the RE’s debtor company. This offers REs more flexibility to manage their portfolios and potentially avoid significant provisioning requirements.
- Direct/Indirect Investment Definition: Earlier guidelines prohibited RE investments in AIFs with any downstream investments (direct or indirect) in the RE’s debtor companies. The revised definition clarifies “downstream investment” to exclude equity shares held by the AIF in the RE’s debtor company. However, all other investments, including hybrid instruments, are now considered downstream investments.
- Priority Distribution Model: Previously, RE investments in subordinated units of AIFs with a priority distribution model (high-risk, high-return structure) were deducted entirely from the RE’s Tier 1 capital. The new guidelines allow for a split deduction between Tier 1 and Tier 2 capital, catering to investors with varying risk appetites. However, further clarity from SEBI on differential return structures within these models remains necessary.
- Investments Through Intermediaries: It’s important to note that investments in AIFs through intermediary vehicles like Fund of Funds and mutual funds remain outside the scope of these amendments.
Fostering a Responsible AIF Ecosystem
- Strengthened Disclosure and Reporting: As an industry, we believe enhanced reporting requirements from AIFs to the RBI could provide greater transparency. This could include details on bank participation, portfolio company investments, and relevant financial metrics.
- Focus on Investor Education: Improved investor education around responsible investment practices would promote transparency and discourage practices like evergreening.
- The entire Alternative Investment Fund (AIF) ecosystem, along with IVCA, stakeholders, banks, and RBI, is actively engaged in discussions to reach a mutual solution. The regulator, known for its responsible and pro-growth stance, prioritises safeguarding against systemic risks. This approach has earned our regulators a stellar reputation globally. Now, the industry seeks support to unleash capital while emphasising the importance of a robust self-regulatory governance framework, ensuring accountability among industry bodies.
Conclusion: A Balancing Act for Long-Term Sustainability
The challenges posed by evergreening practices and the resulting regulatory interventions highlight the need for industry-wide collaboration and dialogue. By coming together, sharing insights, and exploring innovative solutions, we can navigate these challenges effectively and pave the way for a resilient and sustainable financial ecosystem.
The recent announcement by the Reserve Bank of India regarding Alternate Investment Funds is a welcoming move. It sets a positive tone and showcases regulators’ agility and openness to ground realities while remaining vigilant.
This move allows banks to write back certain provisions, offering much-needed flexibility. However, clarifications around hybrid instruments and debt instruments are still awaited.
Alternate investment funds (AIFs), focusing on granular opportunities like MSMEs & startups, play a crucial role in debt and equity markets. They have been instrumental in fuelling growth at both ends. AIFs facilitate capital creation within India’s dynamic economic landscape.
The industry eagerly awaits support and comfort from regulators to ensure the country’s growth trajectory remains strong. Startups have emerged as propellers of Indian growth, turning dreams into reality, and catering to the aspirations of a determined young India shaping a new global order.
(The author is Founder and Managing Partner, ValuAble; Views are personal)
