RBI CIRCULAR ON AIF

On December 19, 2023, the Reserve Bank of India (“RBI”) issued a circular (“Original Circular”) on investment in AIFs to address regulatory concerns w.r.t. investments made by banks, financial institutions, nonbanking financial companies (“Regulated Entities”/“REs”) in units of AIFs, during its regular investment operations. In order to address concerns on the possible evergreening through AIF route, the Original Circular aimed at clarifying that REs shall not invest in any scheme of AIF which has downstream investments either directly or indirectly in a debtor company of RE, and accordingly introduced further clarifications. However, many businesses in the industry raised concerns regarding difficulties in implementation of the Original Circular. Resultantly, some RE’s felt compelled to sell their interests in AIFs prematurely.

In an attempt to recognize these concerns, RBI issued a circular on March 27, 2024 (“Revised Circular”) to ensure uniformity in implementation among REs as follows:
i. Downstream investments shall exclude investments in equity shares of the debtor company of RE, but shall include all other investments, including investment in hybrid instruments.
ii. REs that are not able to liquidate their investments within 30 days from the date of such downstream investment by the AIF, it was clarified that provisioning shall be required only to the extent of investment by RE in AIF scheme which is further invested by AIF in the debtor company, and not on the entire investment of the RE in the AIF scheme.
iii. Investment by REs in subordinated units of any AIF scheme with a ‘priority distribution model’ shall be subject to full deduction from RE’s capital funds (as in the Original Circular). However, it was clarified that this shall only be applicable in cases where the AIF does not have any downstream investment in a debtor company of the RE.
iv. In line with (iii) above, deduction was proposed from RE’s capital funds, which shall now take place equally from both Tier-1 and Tier-2 capital.
v. Reference made to investment in subordinated units of AIF scheme shall include all forms of subordinated exposures, including investment in the nature of sponsor units.
vi. Investments made by REs in AIFs through intermediaries viz., fund of funds or mutual funds are not included in the scope of the Revised Circular.

While Revised Circular provides operational/regulatory clarity, especially relating to clarifications in RE’s provisioning mechanism, the exclusion of equity shares from the definition of 'downstream investment' fails to address investments in the PE/VC space, which are usually in the form of compulsory convertible preference shares/debentures. Thus, an underlying question which remains to be addressed is whether conversion of all hybrid instruments into equity instruments is mandated, in order to allow REs to remain invested in such funds.