Loan Evergreening Via AIFS: RBI's Regulatory Clampdown And Its Significance

Understanding Loan Evergreening

Evergreening of loans means substituting outstanding loans with new or incremental loans to those borrowers who are not in a position to pay the outstanding loan, thus hiding the actual position of NPAs. RBI guidelines state that a loan can be considered an NPA if the payment of interest or principal is overdue for 90 days or more. NPAs put pressure on REs' cash flows, lower profitability, undermine market confidence, and raise the cost of capital, which, if not checked, can disturb the financial system. Evergreening in AIFs means that REs deploy these investment products to artificially lengthen the repayment period of defaulted loans. Consider the scenario of an NBFC lending ₹100 crore to Company X, which fails to repay. In order not to classify the loan as an NPA, the NBFC has lent ₹100 crore to an AIF, which in turn buys ₹100 crore of bonds of Company X. Company X utilizes these funds to repay the original loan, giving the impression of repayment on time. In reality, the loan tenure has simply been extended through the AIF, masking the underlying financial stress. The practice, which goes against transparency, has been in the crosshairs of RBI as well as the Securities and Exchange Board of India (SEBI). SEBI's May 2023 Consultation Paper noted how priority distribution (PD) structures in AIFs enable evergreening, leading to regulatory intervention. RBI's Regulatory Response In a bid to combat loan evergreening, the RBI issued two significant notifications: one on December 19, 2023, and another on March 27, 2024. These instructions are intended to limit the misuse of AIFs by REs, enhance financial transparency, and lower systemic risks. The Initial Announcement (December 2023) The RBI's first notification excludes REs from directly or indirectly making investments in AIFs pertaining to companies to which they've made loans or investments within the previous 12 months. This tackles the very mechanism of evergreening by filling loopholes for indirect exposure via AIFs. For existing AIF investments, REs are given a grace period of 30 days to dispose of their holdings if the AIF makes an investment in a debtor company. Failure to comply requires REs to make a 100% provision for the investment, giving it the accounting treatment of a potential loss to discourage non-compliance. The notice also deals with AIFs having priority distribution arrangements, wherein junior investors suffer disproportionate losses over senior investors. Investments in such AIFs are completely deducted from the capital funds of REs, ensuring healthy financial discipline. The 30-day period of divestment, however, has been criticized as being unrealistic, especially for Category I and II AIFs, which are close-ended with redemption and transfer restrictions. The exposure-finding, investment manager approval-finding, and buyer-finding process within 30 days is laden with operational challenges, and compliance would be challenging.

The Second Notice (March 2024)

The March 2024 notification removes the uncertainties in the first directive and provides relaxations to facilitate ease of compliance without watering down safeguards. It makes it clear that provisioning would be needed only for the exposure of an RE's AIF investment to debtor companies. Illustratively, if an RE invests ₹100 crore in an AIF in which ₹50 crore is exposed to a debtor company, provisioning would be needed only for the ₹50 crore, decreasing the cost burden on lenders. The notification also excludes equity-based downstream investments, alleviating private equity and venture capital funds, especially Category-I AIFs such as the National Investment and Infrastructure Fund (NIIF). The exemption facilitates long-term investments in MSMEs and startups without triggering provisioning or liquidation issues. Apart from that, investments by the intermediaries like FoFs or mutual funds are not covered under the notification, thereby encouraging authentic investment in Alternative Investment Funds (AIFs). Leaving out hybrid products, i.e., CCDs and CCPS, is confusing regarding their regulatory categorization. It is unclear whether regulated entities (REs) are excluded from investment in AIFs having any non-equity investments or from investment in specific non-equity categories. A Critical Examination of the Notifications RBI guidelines are a stern response to evergreening, with emphasis on financial transparency and accountability. The time-neutral nature of the first guideline, to be applied across all past, current, and future investments, has it all covered. The 12-month limit on new investment in AIFs of companies that are debtors blocks REs from hiding NPAs, while the 30-day window for unwinding outstanding investments is intended to cut short artificial inflation of financial health. But the stringent timeline does not consider the complexity of AIF structures, including lock-in periods and approval requirements from the investment manager, rendering compliance unfeasible. The second notice addresses some of the concerns by clarifying provisioning requirements and excluding equity-based investments. The amendment allows genuine investments with a focus on risk management. The enforceability of the notices is diluted, however, by the ambiguity of non-equity investments and undefined penalties for non-adherence. The application of a more sophisticated approach differentiating genuine investments from evergreening activities can enhance efficacy without discouraging legitimate AIF operations. Commercial Implications RBI guidelines have significant commercial implications for REs, AIFs, and the financial system in general. By assuming that concurrent investment inherently constitutes evergreening, the notices create a huge compliance burden. REs have to go through elaborate due diligence to determine the debtor company exposure, coordinate with AIFs, and fulfill divestment or provisioning obligations. The assumption robs AIFs of operational autonomy, since it suggests lenders make investment choices, which is not always the case. The notices threaten to skew capital inflows by discouraging REs from investing in the AIF market. AIFs, which are dependent on domestic capital from NBFCs and banks, could suffer dwindling fund inflows, restricting the scope of their ability to fund growth projects such as infrastructure or startups. The lack of a strong secondary market for the units of AIF makes the situation worse, as REs would be compelled to sell units at a loss, attracting tax liabilities under Section 56(2)(x) of the Income Tax Act, 1961, where the difference between fair market value and cost of acquisition is taxed as income. NBFCs, given their reliance on wholesale financing and bond markets, remain most exposed. NBFCs, unlike banks, are not able to accept demand deposits and are, hence, more prone to financial stress from NPAs. The provisioning requirement and limited access to capital under the notifications may precipitate stock sell-offs, credit rating downgrades, and increased cost of funds, undermining the financial solvency of NBFCs. Banks, though better placed to absorb such stresses, also have their ability to service liquidity and access to capital impaired in an illiquid AIF market. The broader financial system may suffer from drift towards the utilization of foreign institutional funds, negating the purpose of India's effort to mobilize domestic funds for growth. Over-regulation may stifle growth in the AIF industry, depriving economic development of its potential contribution. The imposition of dual compliance whereby AIFs must notify REs before investing in debtor companies and REs must notify AIFs before lending introduces procedural complexity, further discouraging participation. Moving Towards a Balanced Regulatory System While RBI's notices are a step towards averting evergreening, their blanket nature and operational shortcomings highlight the need for fine-tuning. A more nuanced course could involve distinguishing legitimate from evergreening investments through improved due diligence and governance reforms. Holding REs' management and boards liable for non-compliance and ordering periodic audits and high-risk lending disclosure could purge the sources of evergreening without penalizing legitimate investments. Requiring clearly defined penalties for non-adherence would enhance enforcement, whereas increasing the duration of divestment or establishing a systematic secondary market for AIF units would reduce operational costs. Promoting self-policing in REs, backed by stringent corporate governance norms, would introduce accountability and disclosure, as the RBI would desire for a sound financial system.

The RBI initiative to address loan evergreening via AIFs is appreciable but needs a more subtle touch to balance the regulatory framework with commercial imperatives. The December 2023 and March 2024 notifications are addressing a crucial issue but carry heavy compliance costs and the threat of derailing capital flows. By sharpening these regulations to specifically address evergreening, increasing governance standards, and removing ambiguities, the RBI can safeguard financial stability while facilitating the growth of the AIF industry. A collaborative framework that encourages transparency, accountability, and operational adaptability will provide a robust and efficient financial ecosystem in India.

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