In an exclusive interview with Sanjeev Sinha, Punit Shah, Partner, Dhruva Advisors, shares his views on the Reserve Bank of India’s recent circular on AIF investments, and what challenges and unintended consequences might arise due to the blanket ban on investments in units of AIFs. Excerpts:
What is the primary objective of the recent circular issued by the Reserve Bank of India regarding regulated entities’ investments in Alternative Investment Funds (AIFs), and how does it aim to prevent certain financial structures?
The primary objective of the RBI circular is to prevent “evergreening” of the loans given by the regulated entities to its borrowers. The RBI suspects that some regulated entities are routing their additional investments into the borrowers through the AIFs where direct landing may be not possible due to defaults etc. By restricting the regulated entities as above, the RBI wants to prohibit further exposure to defaulting borrowers, indirectly through AIFs.
What challenges and unintended consequences might arise due to the blanket ban on investments in units of AIFs with downstream investments in debtor companies, as outlined in the circular? How could this impact the classification of AIF investments and hinder the investment process by regulated entities?
Unfortunately, the circular can have several adverse unintended consequences. It is intended to apply in a situation of evergreening of bad loans; however, it will now apply to every situation, including the cases of standard loans and investments. Also, the circular does not provide for any monetary threshold of the exposure, hence, the circular would apply to any transaction, even of an immaterial amount. These unintended consequences could lead to tremendous hardship to the regulated entities by way of provisioning or premature divestments and also to AIFs, as it requires them to redeem such investments to such regulated entities immediately, which may not be regulatorily possible at all.
The above challenges could have severe negative impact on the financial services industry, particularly for the concerned regulated entities and AIFs. It would be appropriate for the RBI to relook at the circular and provide for exceptions for situations such as for cases of good loans and investments, materiality thresholds for the applicability of the circular etc.
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Are there any local regulatory requirements that apply to investing in particular investments, such as derivatives or loans, when investing in AIFs?
The investments in an AIF shall be in accordance with SEBI (AIF) Regulations, 2012.
Further, only Category-III AIF is permitted to make investments in derivative instruments. With respect to borrowings, Category-III AIF may engage in borrowing subject to consent from investors. Category I and Category II AIFs may borrow only to meet the temporary funding requirements subject to conditions.
How do regulated entities ensure compliance with the AIF Law and other regulatory requirements when investing in AIFs?
The circular provides that the regulated entities should advise the AIFs suitably. Accordingly, it appears that the regulated entities will have to provide the details of their debtor companies to the AIFs to comply with the circular. Further, with respect to the other laws relating to AIF, the AIF shall abide itself with the SEBI (AIF) Regulations, 2012.
What are the key changes in the AIF regulations in 2024?
The AIFs are mandated to hold all their investments in dematerialized form w.e.f. 1 October 2024 i.e. investments made on or after 1 October 2024. However, where the investee company is mandated to facilitate dematerialization of securities and the AIF exercises control over the investee company (either by its own or together with intermediaries), such investments even if made prior to 1 October 2024 shall also be held in dematerialized form on or before 31 January 2025.
Further, as per recent SEBI Circular, issued in January 2024, the investor (along with their ultimate UBO) shall be from a FATF compliant jurisdiction. Any further investments by an existing investor who is not from FATF-compliant jurisdiction shall be prohibited.
Also, SEBI has released a consultation paper recently inviting for public comments which provides for prevention of circumvention of FEMA regulations through setting up of an AIF by foreign investors.
