RBI Modifies AIF Norms: How Beneficial Is It For NBFCs?

Over the past decade, Alternative Investment Funds (AIFs) have experienced significant demand in India. During the period spanning from 2019 to 2024, the AIFs showcased impressive growth, marked by a CAGR of 36%. This is attributed to the flourishing capital markets and the overall decline in interest rates, making India an appealing destination for investors.

Additionally, AIFs provide investors with attractive opportunities while addressing supply and demand imbalances, contributing to a positive trend in India's investment environment. AIFs serve a dual purpose by benefiting from and contributing to the nation's economic advancement. In the fiscal year 2022-23, there was a significant Y-o-Y increase of 30% in the number of commitments secured by AIFs, rising from INR 6.41 trillion to INR 8.33 trillion.

With this growth, ongoing discussions regarding AIF guidelines have garnered attention. In March 2024 release, the RBI (Reserve Bank of India) permitted banks and NBFCs (Non-Banking Financial Companies) to exclude AIF investments in equity shares of their debtor companies. Conversely, all other AIF investments, including those in hybrid instruments, remain subject to regulatory oversight.

Moreover, the RBI has granted an exemption for regulated entities (RE) to invest in AIFs through intermediaries such as fund of funds or mutual funds. This exemption may alleviate some of the regulatory burdens on banks and NBFCs, potentially mitigating the impacts on their performance in the third quarter ending December 2023.

On December 19, 2023, the RBI directed lenders to refrain from investing in AIFs with direct or indirect downstream investments in companies that had been borrowers within the previous 12 months. Additionally, existing investments in such AIFs must be liquidated within 30 days or fully provided for this directive aimed to combat the practice of evergreening loans. The regulator instructed banks and NBFCs to provide 100% of their entire investment in such AIF schemes.

Following the revised guidelines in March 2024, the RBI specified that banks and NBFCs are only required to allocate provisions based on their investment in the AIF scheme, which is subsequently invested by the AIF in the debtor company rather than on the lender's total investment in the AIF scheme.

Let's decode this with an example: suppose a lender invests Rs 15 crore in a Rs 150 crore AIF scheme, which then invests Rs 2 crore in the debtor company of the lender. Under the previous provisioning guidelines, the lender would have to provision for the entire Rs 15 crore investment in the AIF scheme. However, under the revised guidelines, the provisioning requirement would only be on the Rs 2 crore exposure to the debtor company.

This adjustment aims to align provisioning requirements more closely with associated risks, ensuring more effective risk management practices for lenders investing in AIFs. Additionally, it seeks to reduce the burden on NBFCs, which previously had to provision 100% of their total investments in AIFs. Since some entities have already made provisions, there can be a provision write-back in the current quarter.

The circular offers operational and regulatory clarity while also posing new inquiries. The provision where REs' provisioning aligns with downstream investments in portfolio companies by the AIF is accepted. The exclusion of investments through mutual funds and Funds of Funds will enhance capital participation in AIFs.

However, excluding equity shares from downstream investments only applies to listed companies overlooking Venture Capital and Private Equity investments, often in the form of compulsory convertible instruments like CCPS and CCDs. This addresses a significant concern for venture capital and private equity funds that were inadvertently impacted by the previous circular despite having equity exposure in portfolio entities.

Although quantifying the number of AIFs benefiting from this circular is challenging, it's presumed that a substantial number should now be able to attract investments from banks and REs.

To sum up, India's burgeoning alternative investment funds industry represents a significant boon for the economy, attracting heightened foreign investment and bolstering the growth trajectory of Indian enterprises. With the increasing population of domestic investors from tier-II and -III cities, there exists the potential for AIFs to rival the size of the $ 481 billion mutual funds sector in the coming years.

As of the June 2023 quarter, AIFs had amassed commitments totalling $102 billion, with investments exceeding $42.1 billion for the first time. The AIF industry in India is positioned for ongoing expansion, providing investors with a wider choice of possibilities within an open and technologically advanced investment environment as long as these driving forces persist in reshaping the landscape.