AIFs reject early exit pleas from banks, plan for 'defaults'

AIFs reject early exit pleas from banks, plan for ‘defaults’

Hurt by new rules, the alternative investment funds (AIFs) in India have turned down ‘early exit’ requests from banks and finance companies, and are now exploring ways to deal with these investors as they default on ‘capital calls’ from funds.

Will AIFs impose a penalty on banks and non-banking finance companies (NBFCs) which, following the Reserve Bank of India’s recent dos and don’ts, fall short of their original commitments to the funds? Will a fund forfeit the amount already invested? Or, will funds simply cap the investment with contributions made so far, make an exception for banks and NBFCs caught in the new regulations, and move on to preserve relationships with these large investors?

While the third appears more likely, it could all depend on each fund and multiple factors: the size of commitments by affected investors, how aggressive a stance a fund manager takes, and whether the absence of future drawdowns could unsettle a fund’s investment plan and dynamics. A bank or NBFC which stops contributing can be technically categorised as ‘defaulter’, but a fund may think twice before doing it, said AIF circles who, however, were unanimous on the denial of early redemption to select investors.

According to Tejesh Chitlangi, senior partner at the law firm, IC Universal Legal, “The Category I and II AIFs in which RBI’s governed Regulated Entities (REs) primarily invest, are all closed-ended funds with investors not permitted preferential redemption rights in terms of SEBI AIF Regulations. This is keeping in view the blind pool nature of such funds with a defined tenure and timing of pro rata payout to each investor rightly considered at par under Sebi Regulations. The priority distributions to any investors are also subject to SEBI restrictions under the said Regulations.”

The RBI notification is in conflict with the AIF regulatory regime since under SEBI laws the AIFs are not legally obliged to honour the REs redemption requests made under said notification, said Chitlangi. “This was clearly avoidable by RBI as concerned REs in the absence of priority redemption payout will continue to be subject to full provisioning of their AIF investment positions unless they transfer their otherwise illiquid units. This avoidable regulatory conflict therefore needs to be urgently resolved by RBI,” he felt.

In a directive on December 19, RBI banned a bank or NBFC from investing in any AIF which, in turn, has invested in a company that has borrowed from the investing bank or NBFC. In cases where such investments already exist, lenders must either liquidate the investment in 30 days (from the date of issuance of the circular) or make 100% provisioning on such investment.

Investors in an AIF make an initial commitment and subsequently contribute in tranches as and when a fund calls for capital. The RBI circular has put a question mark on the fate of future contributions of banks and NBFCs impacted by the directive.

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Escaping the blow

Meanwhile, investors and AIFs are trying out ways to escape the regulatory diktat. For instance, some investors (like NBFCs) have transferred the units issued by an AIF to group companies that are not regulated by RBI to sidestep the restrictions – with money and units being simply transferred from one group entity to another. In a few cases, investors have sold units to family offices which sometimes bet on unlisted ventures.

Industry circles said two debt AIFs were planning to sell the debentures issued by companies which had borrowed from banks/NBFCs that are investors in the funds.

“However, an investment manager needs to assess such transactions (exiting an investment that is triggering a regulatory concern for a particular investor) from the viewpoint of the fiduciary structure of the fund, and the interest of all investors. The exit may also affect the value, liquidity, or diversification of the Fund,” said Richie Sancheti, founder of the law firm Richie Sancheti Associates.

Fund industry officials are expected to meet RBI soon to plead for possible relaxations that would discourage sharp practices like loan evergreening without hurting all AIFs.

“While the circular represents RBI’s response to emerging concerns as a regulator such as preventing potential conflicts of interest, ensuring transparency and accountability, it presents several challenges for both limited and general partners of AIFs. Firstly, the notification has the impact of classifying all such AIF investments as done for the purpose of evergreening. Then there are other challenges like ‘no deminimis’ in terms of the quantum of a lender’s exposure in an AIF vis-à-vis its lending to the borrower, ability of close-ended AIFs to redeem the units of a particular investor, ability of impacted LPs to sell units to another investor, challenges in new fund raise and squeezing profitability of lenders,” said Tejas Desai, senior partner, private equity & financial services (tax and regulatory) at EY.

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