SEBI's Regulatory Crackdown will Add to Liquidity Woes of AIFs

Key Takeaways:

1. SEBI has identified at least 40 cases involving AUM over Rs 30,000 crores where AIFs were used to circumvent financial regulations.

2. The regulator proposes a "general obligation" for AIFs, their managers, and key personnel to conduct due diligence on investors and investments.

3. Concerns include evergreening of loans, circumvention of FEMA norms, and exploitation of QIB regulations.

4. The AIF industry faces potential regulatory tightening, following RBI's earlier restrictions on regulated entities' investments in AIFs.

5. SEBI is piloting a Standards Forum for AIFs to further enhance regulatory oversight.

Detailed Narrative:

The Alternative Investment Fund (AIF) industry in India has been experiencing significant growth, with assets under management (AUM) reaching an impressive 3.88 lakh crores by September 2023. This substantial increase from the 13,000 crores recorded in September 2015 highlights the sector's rapid expansion. However, this growth has not gone unnoticed by regulatory bodies, particularly the Securities and Exchange Board of India (SEBI).

On January 19, 2024, SEBI released a consultation paper that brought to light several concerns regarding the use of AIFs for regulatory arbitrage. The regulator's ongoing thematic check on the AIF industry has uncovered at least 40 cases, involving AUM exceeding Rs 30,000 crores, where AIFs were allegedly used to circumvent existing financial regulations.

One of the primary concerns raised by SEBI is the practice of "evergreening" loans through AIFs. This involves regulated lenders using AIFs to artificially maintain non-performing assets as performing ones. The consultation paper describes a scenario where a lender makes a subordinated investment in an AIF, which then invests in a borrower on the verge of default. This circular flow of money allows the borrower to repay the lender, keeping the loan performing on paper. Meanwhile, the potential loss is allocated to the lender's subordinated investment in the AIF, leaving other investors unaffected.

The Reserve Bank of India (RBI) had already taken action on this issue. On December 19, 2023, the RBI issued a notification prohibiting all regulated entities, including banks, cooperative banks, NBFCs, and All India Financial Institutions, from investing in AIFs that have investments in their debtor companies.

SEBI's consultation paper also highlighted concerns about the circumvention of Foreign Exchange Management Act (FEMA) norms. Under the FEMA Non-Debt Instruments (NDI) Rules 2019, an AIF's downstream investment is determined by the domicile of its manager or sponsor. This has created opportunities for regulatory arbitrage, with some foreign investors setting up AIFs with domestic managers or sponsors to invest in sectors prohibited for Foreign Direct Investment (FDI) or to exceed allowed FDI sectoral limits.

Another FEMA-related issue is the use of AIFs by foreign investors to channel funds into debt or debt securities, bypassing the Foreign Portfolio Investment (FPI) or External Commercial Borrowing (ECB) routes typically required by RBI norms.

The consultation paper also addressed the exploitation of Qualified Institutional Buyer (QIB) regulations. Some AIFs, despite being concentrically held by a single or limited number of investors, qualify as QIBs and receive preferential treatment in Initial Public Offerings (IPOs). This practice potentially undermines the spirit of QIB regulations.

SEBI noted several other areas where AIFs might be exploited for regulatory arbitrage. These include:

1. Concealment of Significant Beneficial Owners (SBOs) in companies, as current rules under Section 90 of the Companies Act allow the trail of SBO detection to stop at an AIF.

2. Escaping RBI registration requirements for Non-Banking Financial Companies (NBFCs) by investing in structured debentures that resemble loans.

3. Avoiding Core Investment Company (CIC) registration for group holding companies by using AIFs for intra-group investments.

4. Circumventing Related Party Transaction (RPT) regulations, as AIFs are currently not subject to such controls.

To address these concerns, SEBI has proposed imposing a "general obligation" on AIFs, their managers, and key management personnel. This obligation would require them to carry out specific due diligence on their investors and investments before making any investment decisions. The proposed insertion in the regulations states:

"Every Alternative Investment Fund, Manager of the Alternative Investment Fund and Key Management Personnel of the Manager and the Alternative Investment Fund, shall carry out specific due diligence, as may be specified by SEBI from time to time, with respect to their investors and investments, before each investment, to prevent facilitation of circumvention of extant regulations administered by any financial sector regulator."

SEBI is also piloting a Standards Forum for AIFs, which is expected to further enhance standard-setting in the industry.

The regulator acknowledges that many instances of regulatory arbitrage through AIFs result in "in spirit" breaches of regulations, rather than explicit violations. Therefore, the proposed general obligation would require AIFs, their managers, and key personnel to affirm that they are not causing a breach of regulations by purpose and effect, not just on the face of the transaction or structure.

These developments come at a time when AIFs are already under liquidity strain due to regulated lenders having to divest their existing investments within a narrow timeline. SEBI's consultation paper signals a shift towards stricter regulatory oversight of the AIF industry, and further developments in this area will be closely watched by industry participants and observers alike.

FAQs:

1. Q: What are Alternative Investment Funds (AIFs)?

A: AIFs are SEBI-regulated investment vehicles in India that pool funds for investing in private equity, venture capital, hedge funds, and other alternative investments.

2. Q: Why is SEBI concerned about AIFs?

A: SEBI has identified cases where AIFs are being used to circumvent financial regulations, including evergreening of loans and bypassing FDI norms.

3. Q: What is "evergreening" of loans through AIFs?

A: It's a practice where lenders use AIFs to artificially keep non-performing loans as performing assets by circularly lending or investing money.

4. Q: How does SEBI propose to address these concerns?

A: SEBI proposes to impose a "general obligation" on AIFs, their managers, and key personnel to conduct due diligence on investors and investments.

5. Q: What action has RBI taken regarding AIFs?

A: RBI has prohibited regulated entities from investing in AIFs that have investments in their debtor companies.

6. Q: How might these regulatory changes impact the AIF industry?

A: The industry may face stricter oversight and potential challenges in structuring investments, which could affect its growth and operations.

Key Precedents:

1. SEBI Consultation Paper dated January 19, 2024: Proposed enhanced trust measures and due diligence requirements for AIFs.

2. RBI Notification dated December 19, 2023: Prohibited regulated entities from investing in AIFs with investments in their borrowers.

3. FEMA Non-Debt Instruments (NDI) Rules 2019: Determines AIF's downstream investment based on manager/sponsor domicile.

4. Companies Act, Section 90: Current rules on Significant Beneficial Owner (SBO) detection in relation to AIFs.

5. SEBI (Issue of Capital and Disclosure Requirements) Regulations: Provisions related to Qualified Institutional Buyers (QIBs) in public offerings.

These precedents form the regulatory framework within which the current concerns about AIFs are being addressed, highlighting the evolving nature of AIF regulation in India.