Regulatory Updates on Investments in Alternative Investment Funds (AIFs) for Regulated Entities (REs)
Regulated entities (REs), which include banks and other financial institutions, often invest in units of Alternative Investment Funds (AIFs) as a part of their routine investment activities. Recently, regulatory authorities have observed transactions by REs that pose significant concerns, particularly involving the substitution of direct loan exposures to borrowers with indirect exposures through investments in AIF units. These practices have raised alarms about the potential for evergreening, where old loans are artificially extended to delay or avoid recognizing them as non-performing assets (NPAs).
To address these concerns, new guidelines have been issued. Firstly, REs are now prohibited from investing in any AIF scheme that makes downstream investments, either directly or indirectly, in a debtor company of the RE. For clarity, a debtor company is defined as any company to which the RE currently has or has had a loan or investment exposure within the preceding 12 months.
Furthermore, if an RE is already invested in an AIF scheme that subsequently makes a downstream investment in a debtor company, the RE must liquidate its investment in that AIF scheme within 30 days. This rule applies from the date of the downstream investment by the AIF. For existing investments, the 30-day period begins from the issuance date of this circular. REs are required to promptly inform the AIFs to comply with these regulations.
In situations where REs cannot liquidate their investments within the stipulated 30-day period, they must provision 100 percent of such investments. This measure ensures that REs account for the entire amount of their potentially risky investments, thereby safeguarding their financial stability and reducing the likelihood of undisclosed risks.
Additionally, the new regulations stipulate that investments by REs in subordinated units of any AIF scheme operating under a ‘priority distribution model’ will be subject to full deduction from the RE’s capital funds. A ‘priority distribution model’ refers to the distribution scheme where certain investors receive returns before others, as detailed in the SEBI circular dated November 23, 2022.
These instructions derive their authority from multiple legislative acts, including Sections 21 and 35A of the Banking Regulation Act, 1949, Chapter IIIB of the Reserve Bank of India Act, 1934, and Sections 30A, 32, and 33 of the National Housing Bank Act, 1987.
The new regulations take effect immediately, compelling REs to promptly adapt their investment strategies. This swift implementation underscores the regulatory commitment to ensuring transparency and mitigating risks associated with indirect exposure to debtor companies through AIF investments. The ultimate goal is to uphold the integrity and stability of the financial system by preventing practices that could potentially mask the true financial health of lending institutions.
