Introduction
A concerning tactic called evergreening is resurfacing in India, where lenders are using Alternative Investment Funds (“AIFs”) to mask bad loans. This involves banks and NBFCs shifting struggling borrowers’ debt to AIFs, keeping the original loan afloat, and avoiding classification as a non-performing asset (“NPA”). While this maintains the lender’s financial health on paper, it’s a deceptive practice. The underlying debt burden remains, potentially leading to defaults down the line. Recognizing this risk, the RBI recently implemented regulations to curb this practice and ensure transparency within the financial system. However, the regulations faced concerns from the industry for being too stringent and discouraging genuine transactions. Following consultation and representation from the industry, the RBI consequently relaxed some of the provisions of the regulations.
This article delves into the deceptive practice of evergreening loans via AIFss. It analyzes the RBI’s recent actions aimed at curbing this practice and explores the potential long-term impacts of these regulations on the financial ecosystem.
Evergreening of Loans: why is RBI concerned?
Evergreening of loans is a deceptive practice employed by lenders, primarily banks and NBFCs, to maintain the illusion of financial health. It involves issuing new or additional loans to borrowers who are already struggling to repay existing ones. This tactic prevents the existing loans from being classified as non-performing assets (NPAs), which would expose the lender to stricter regulatory oversight, potential loss provisioning, and increased capital requirements.
The motivations behind evergreening are primarily driven by regulatory concerns. By keeping existing loans afloat, lenders can avoid the stricter scrutiny and potential penalties associated with a high NPA ratio. Additionally, evergreening allows them to postpone setting aside funds to cover potential losses on bad loans, thereby inflating their profitability in the short term. Finally, maintaining a lower NPA ratio can help lenders meet capital adequacy requirements set by regulators, ensuring they have sufficient funds on hand to absorb potential losses.
However, evergreening creates a facade of financial well-being, masking the true health of both the borrower and the lender. Borrowers with underlying financial weaknesses are simply adding to their debt burden, potentially delaying an inevitable default. For lenders, evergreening postpones the inevitable reckoning of dealing with bad loans, creating a ticking time bomb that could destabilize the financial system if it explodes.
RBI’s Crackdown on Evergreening of Loans through AIFs
Both the RBI and SEBI, are concerned about the use of AIFs by regulated entities to mask bad loans (evergreening). SEBI, in a consultation paper, highlighted these concerns and stated they identified over 40 cases involving a significant amount of money (over $3.6 billion) where AIFs were potentially used to circumvent financial regulations.
To tackle the same, the RBI circular implements a multi-pronged attack to curb the evergreening of loans through AIFs. It targets both new and existing instances of this deceptive practice.
Firstly, the circular restricts future investments by Regulated Entities (REs) like banks and NBFCs. REs are prohibited from investing in any AIF scheme that has downstream investments, either directly or indirectly, in companies they have loaned money to within the past 12 months. This effectively closes the loophole that allowed REs to offload bad debt onto AIFs, keeping their books looking healthier.
Secondly, the circular addresses existing instances of evergreening. If an AIF scheme, where an RE has already invested, makes a downstream investment in a company indebted to the RE, the RE is mandated to divest its holdings in the AIF within 30 days. This provision ensures that ongoing attempts to mask bad loans through AIFs are rectified.
Finally, the circular discourages non-compliance through a hefty penalty. If an RE fails to divest its investment within the stipulated timeframe, they are forced to make a 100% provision on the investment. This essentially treats the investment as a non-performing asset on the RE’s books, significantly impacting their financial health. This strong disincentive encourages REs to adhere to the new regulations and discourages future attempts at evergreening loans through the AIF route.
The Challenges posed by RBI’s Strategy
While the RBI’s efforts to curb illegitimate practices in the financial ecosystem were well-intentioned, some unintended consequences of the strategy are evident.
Firstly, the RBI’s circular throws a wrench into legitimate refinancing strategies. Companies often look to consolidate high-interest debt with lower-cost loans from AIFs. This financial maneuver helps them manage their debt burden more effectively. However, the current regulation restricts RE investment in any AIF that has exposure to companies the RE has loaned to in the past year. This inadvertently hinders even these credit-positive activities.
Secondly, the current approach is a blunt instrument that fails to differentiate between genuine transactions and evergreening practices. This can be understood from a hypothetical situation where the RE invests in a debtor company’s equity as part of a long-term growth strategy, not for refinancing purposes. In such scenarios, the loan exposure to the debtor remains unchanged, yet the RE is prevented from participating in a potentially valuable strategic investment. This stifles legitimate business activities and hinders the development of a healthy financial ecosystem.
Thirdly, the new regulation has the unintended consequence of stifling the growth of AIFs. A significant portion of AIF funding comes from REs like NBFCs. With the new rule, NBFCs become wary of investing in AIFs due to the potential overlap with their existing loan portfolios. This creates a funding crunch for AIFs, hindering their ability to function and invest in the market.
RBI Eases Restrictions on AIF Investments
In response to the feedback and concerns raised by the Regulated Entities regarding its previous circular, the RBI tweaked the directions with a continued focus on curbing evergreening practices through its revised circular.
In the revised circular, the RBI has firstly, acknowledged the concerns raised by stakeholders regarding the previous circular’s broad scope. They’ve clarified that equity investments by REs in a debtor company’s shares won’t be considered as “downstream investments” under the regulation. This distinction allows REs to participate in the debtor’s long-term growth strategy through equity holdings without triggering restrictions.
Secondly, the provisioning requirement has been refined. Previously, REs faced the possibility of provisioning for their entire investment in an AIF scheme if any part of it went to the debtor company. Now, provisioning is only required for the specific portion of the AIF scheme’s investment that directly flows into the debtor company. This targeted approach reduces the financial burden on REs.
Thirdly, the RBI provides further clarity on subordinated debt and capital deductions. The requirement for full capital deduction on subordinated AIF investments now applies only if the AIF has no downstream exposure to the debtor company. Additionally, the deduction itself is split between Tier-1 and Tier-2 capital, offering REs some financial flexibility. The definition of subordinated exposure is also expanded to include sponsor units, ensuring consistent treatment across all forms of subordinated investments in AIFs.
Finally, the RBI has clarified that investments made by REs in AIFs through intermediaries like fund-of-funds or mutual funds are not subject to the circular’s restrictions. This exemption offers REs greater flexibility in managing their AIF investments. These clarifications demonstrate the RBI’s commitment to finding a balanced approach that curbs evergreening practices while allowing for legitimate business activities involving AIFs.
Way Forward
The RBI’s relaxed norms for AIF investments offer a promising path for the financial ecosystem, but some hurdles remain. While the changes encourage capital flow into diverse asset classes like venture capital and private equity, potentially fuelling innovation and growth, they also raise concerns about systemic risk if AIFs pursue aggressive strategies. The RBI faces a delicate balancing act between fostering investment diversity and managing this risk.
The revised provisioning norms offer some relief. NBFCs now only need to provision for the portion of their investment that directly flows into the debtor company, easing their financial burden. Additionally, AIFs, particularly VCs and PE funds, are expected to benefit from attracting more capital from REs due to the relaxed regulations. Fund-of-funds structures are also exempt from the circular’s restrictions.
However, unresolved issues persist. The classification of hybrid instruments like CCPs remains unclear. While equity investments are exempt, the lack of clarity on CCPs, which are quasi-equity, creates ambiguity. Ideally, these investments should also be exempt. Furthermore, the RBI hasn’t addressed existing capital calls made by REs to AIFs. Uncertainty exists regarding whether REs can continue honoring these calls if the AIF doesn’t fully meet the new criteria.
Moving forward, the RBI needs to explicitly address these issues. Clarifying the treatment of hybrid instruments and providing guidance on existing capital calls would provide much-needed certainty. Additionally, developing a robust risk management framework for AIFs would help mitigate potential risks associated with increased exposure to these alternative investments. By addressing these concerns, the RBI can ensure its relaxed norms achieve the desired outcome of fostering a vibrant AIF ecosystem without compromising financial system stability.
This article is authored by Shubham Sharma. The author is a 4th Year B.B.A., LL.B. (Corp. Hons.) student at Chanakya National Law University. He may be contacted at 2636@cnlu.ac.in
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