New AIF regulations: Boon for growth or risky rebound

AIF, investment,
The RBI's relaxed AIF regulations seek to boost investment diversity, but raise concerns about potential systemic risks.

The Reserve Bank of India has eased regulations governing investments in alternative investment funds following the recommendations from stakeholders. In December 2023, the RBI had tightened investment rules for lenders in AIFs to address concerns over the potential evergreening of distressed loans. Banks and financial institutions were barred from investing in funds that had stakes in companies with outstanding loans from these banks, aiming to prevent the extension of bad loans.

An alternative investment fund is an investment vehicle that privately pools funds to invest in various assets beyond traditional stocks and bonds. Typically requiring substantial investments, these investment pools are predominantly patronised by high net-worth individuals (HNIs), operating under the SEBI (Alternative Investment Funds) Regulations, 2012, and can be established as a company, limited liability partnership, or trust.

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By December 2023, over 1,200 AIFs were registered with SEBI, attracting investors with their potential for high returns, low volatility, and diversification. Regulated entities (REs) often invest in AIFs as part of their routine investment activities. However, the RBI highlighted regulatory concerns with certain RE transactions involving these funds.

Initially, lenders were prohibited from investing in AIFs that had downstream investments in their debtor companies. Now, the RBI permits investments in AIFs with downstream equity investments, excluding those involving hybrid instruments like convertible debentures. 

Implications of relaxed AIF norms

The RBI’s relaxed norms for AIF investments could have wide-ranging implications for the financial ecosystem. By allowing lenders more freedom to invest in AIFs, the central bank is encouraging capital flow into diverse asset classes, which could stimulate innovation and growth in sectors previously underfunded. However, this increased exposure to alternative investments may also heighten systemic risk, especially if AIFs pursue high-return, high-risk strategies. The balance between fostering investment diversity and managing systemic risk is delicate, and the RBI’s regulatory adjustments aim to navigate this complexity.

The RBI has also relaxed provisioning norms, excluding investments in AIFs through intermediaries like funds of funds or mutual funds from the circular’s scope. Moreover, the RBI had required banks and non-banking financial companies (NBFCs) to provision the full amount of their investment in such AIFs. Now, provisioning is necessary only for the lender’s investment in the AIF scheme that the fund further invests in the debtor company. This change, welcomed by experts, eases the financial strain on NBFCs, allowing them to reserve only for the portion invested in the indebted company. Some NBFCs may even reverse previous full reserves in the current financial quarter, alleviating financial pressure.

While AIFs offer attractive returns, they also come with higher risks compared to traditional investments. These include liquidity risks, as AIFs often invest in less liquid assets, making it challenging to exit positions quickly. Additionally, the lack of transparency and regulatory oversight in some alternative investment markets can expose investors to higher operational and counterparty risks. Therefore, while the RBI’s easing of investment restrictions in AIFs may boost short-term financial performance for lenders and investors, it necessitates careful monitoring and management of the associated risks to prevent potential market disruptions.

The revised rules address industry concerns: they permit equity investments, considered less risky, and introduce more reasonable provisioning norms, reducing lenders’ financial burdens.

However, the initial tighter norms were praised for addressing unethical practices where AIFs rerouted funds to borrowers, aiding them in loan repayment and maintaining creditworthiness. This behaviour, deemed a severe regulatory violation by SEBI, was under investigation for transactions worth Rs 15,000-20,000 crore. The practice mainly benefited borrowers, enabling them to shed the NPA label and secure new credit. It also revealed that some businesses were diversifying borrowing strategies to manage debt, especially after the relaxation of lending norms and risk weightages post-COVID-19.

Prompted by rising loan defaults in retail and some commercial sectors, the RBI’s stringent December directive aimed to curb such practices. The recent easing of regulations raises questions about the RBI’s motives and the wisdom of this decision.