The Indian alternative investment funds (AIFs) space has been buzzing with activity albeit kept in check by the trammels of Securities and Exchange Board of India's (SEBI) circulars.
To add to it, India's apex bank, the Reserve bank of India (RBI), also issued a circular in December 2023 (December Circular) appended by another clarification in March 2024 (March Circular) (together, the Circulars) with a view to troubleshoot concerns around evergreening of debt through the AIF route by banks and non-banking financial companies (NBFCs). We focus on the effect these Circulars have on private equity / venture capital (PE / VC) investments by AIFs with bank and NBFCs as their investors / limited partners.
Background
By way of quick background, SEBI in a consultation paper dated 23 May 2023 had expressed concerns that certain AIF structures may be used to facilitate probable evergreening of loans extended by certain regulated lenders (essentially where a Regulated Entity1 which intends to remove loans from its books from a prudence and provisioning perspective, invests in an AIF along with other investors, which AIF then in turn invests in the debtor company and the debtor company uses the proceeds received from the AIF to repay the debt taken from the Regulated Entity). RBI did indeed agree with SEBI and identified substitution of direct loan exposure with indirect exposure through investments in units of AIFs as an issue.
The December Circular, therefore, restricted all Regulated Entities from making investments in any scheme of an AIF which in turn invests (directly or indirectly) in any company which is a debtor of the relevant investing Regulated Entity2. Existing investments too were not spared and the December Circular in fact went a step ahead and provided that if an AIF scheme, in which a Regulated Entity is already an investor, makes a downstream investment in any debtor company of the Regulated Entity, then the Regulated Entity shall be required to either liquidate its investment in the scheme within a period of thirty days from the date of such downstream investment by the AIF or if they are unable to do so, make a100 per cent. provision on such investments. The estimated impact of the December Circular was pegged to be in the range of USD 7 to 8 billion with five private banks alone having made provisions of INR 23.34 billion (approx. USD 280 million) as a consequence of the December Circular.
Having said that, some respite for the stakeholders came through the March Circular basis the various stakeholder representations that were made, where RBI clarified that (i) the restriction on investment in the December Circular shall not include downstream investments by impacted AIFs in "equity shares" (but will continue to apply to all other investments including investment in hybrid instruments); (ii) provisioning by the Regulated Entity will only be required to the extent of the Regulated Entity's investment in the AIF which is ultimately invested in a debtor company and not on the entire investment of the Regulated Entity; and (iii) investments by Regulated Entities in AIFs through intermediaries such as fund of funds or mutual funds are not included in the scope of the December Circular.
Issue
AIFs are increasingly becoming a vital part of the PE / VC deal activity and have picked up momentum in the past five years (reports suggest that as at the end of 2023, commitments received by Indian AIFs have crossed INR 10 trillion (approx. USD 120 billion)) with Regulated Entities being an active group of AIF investors accounting for circa 10 to 12 per cent. of the total commitments made to AIFs.
It is typical in minority PE / VC type investments for investors to receive minority protection economic rights relating to anti-dilution, liquidation preference, etc. To bolster the enforceability of such rights, these are usually baked into the terms of the compulsorily convertible preference shares (CCPS) and compulsorily convertible debentures (CCDs) upfront. Moreover, CCPS / CCDs are also commonly used to bridge any valuation gaps, and valuation ratchets etc., linked to certain events are also incorporated into the terms of such instruments.
The key issue being faced with the Circulars is that whilst RBI has clarified in the March Circular that investments can be made in a debtor company by an impacted AIF by way of equity shares, it has now created a conundrum in its own right as to what falls in the realm of "equity" and "non-equity". It is well settled under the Indian foreign exchange regime (also governed by the RBI) that "equity instruments" include, in addition to plain vanilla equity shares, CCPS and CCDs as well. However, the March Circular makes a specific reference to "equity shares" and not "equity instruments" therefore raising the question whether the impacted AIFs can invest by way of acquisition of CCPS / CCDs as they would have typically done.
Moreover, the restrictions being applicable to all AIFs where a Regulated Entity is an investor without any ownership, monetary or other thresholds for bona fide investments (for instance, the Circulars being applicable only to AIFs where the Regulated Entity was the majority investor or where the investment manager was an affiliate of the Regulated Entity) has had an obvious effect on deal making. The impacted AIFs are scrambling to fulfil their commitments towards companies while excusing the Regulated Entities (where the funds had not already been drawn down) or are being forced to restructure their investments to comply with the Circulars. This may also lead to fund managers who manage funds backed by a wide category of investors (to whom these Circulars do not apply) to have difficult conversations with the non-impacted investors.
It would of course be preferable if the Regulated Entities take a more liberal view and attribute the expansive "equity instruments" definition for interpreting the Circulars as well. There is, however, hesitation at their end in doing so perhaps given that from RBI's perspective the onus to comply with these restrictions is on the Regulated Entities. The sleight of hands in terms of the wording in the Circular may also be seen as deliberate.
SEBI, has, in the last few weeks, also come up with various memorandums which make a specific reference to a critical need for the AIFs and their managers to ensure that a circumvention of the Circulars does not occur / recur through layering of transactions and that it is the duty of the investment managers of domestic funds to carry out a specific due diligence on its investors and investments. Going forward, it is likely that the onus of compliance with the Circulars may be shared by both, the Regulated Entities and the impacted AIFs (and their managers).
Way Forward
Whilst Regulated Entities (as well as the AIF managers) are waiting with bated breath for any further clarifications / relaxations from the RBI, it may be prudent to consider alternative structuring in the meanwhile.
If the investments have already been made by the AIFs, to the extent these are in the form of instruments convertible into equity, a seemingly simple fix would be to give effect to the conversion such that the investments fall in the permitted category and to rely on contractual protection for the economic protection rights.
For fresh investments, the impacted AIFs could explore subscribing to a separate class of equity shares with differential rights, such that these can give effect to the economic protection rights that would have been offered through CCPS / CCDs such as anti-dilution, by way of say a bonus issuance.
However, as mentioned above, in case of multi-investor funds, fund managers may have to rally support for such alternative structuring from other non-impacted investors of the AIFs as well which would understandably not be an easy sell as no investor would prefer to dilute the enforceability of their rights on account of restrictions that do not apply to them.
The Circular seems like a classic case of a good intentioned regulatory action leaving unexpected collateral damage in its wake. It would be to no one's benefit if the momentum AIFs have gained is lost due to this and one can hope this is recognised sooner rather than later by the regulators.
Footnotes
1. Means all commercial banks (including small finance banks, local area banks and regional rural banks), primary (urban) co-operative banks / state co-operative banks / central co-operative banks, all-India financial institutions and Non-Banking Financial Companies (including Housing Finance Companies).
2. The debtor company of the Regulated Entity, for this purpose, means any company to which the Regulated Entity currently has or previously had a loan or investment exposure anytime during the preceding twelve months.
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