[Aditi Kanoongo is a 5th year law student at NALSAR University of Law, Hyderabad]
The Reserve Bank of India (‘RBI’) recently released draft directions on Regulated Entities (‘REs’) in Alternative Investment Funds (‘AIFs’). The proposed rules follow the earlier circulars issued in December 2023 and March 2024, marking a continued effort by the RBI to strengthen oversight over REs’ indirect exposures through AIFs. This regulatory move aligns with the RBI’s broader objective to curb the practice of evergreening of loans by introducing greater transparency and financial discipline in such investment structures.
This post critically examines the evolving regulatory landscape governing Res’ investments in AIFs, assesses the impact on financial institutions and AIFs, and offers suggestions for a more balanced approach that deters evergreening without impeding legitimate capital deployment and innovation financing.
Understanding Evergreening and Regulatory Arbitrage
Evergreening refers to the practice wherein REs, such as regulated banks, financial institutions and non-banking finance companies, utilize AIF as a vehicle to avoid the classification of stressed loans as Non-Performing Assets (‘NPA’). Through this mechanism, these entities circumvent regulatory requirements and evergreen their financial performance, thereby obscuring the true state of their asset quality and thereby misleading stakeholders regarding their financial health.
In its consultation paper dated May 23, 2023, the Securities and Exchange Board of India (‘SEBI’) addressed concerns reading the misuse of AIF by RE. While acknowledging the existence of pari passu and pro-rata investment structures, SEBI rejected the proposal to introduce distinct classes of co-investments. In this context, a significant concern identified was pertaining to the Priority Distribution (‘PD’) model. Under this model, senior classes of investors are given preferential rights to profit, whereas the residual capital of junior class investors absorbs losses incurred. SEBI observed that the PD model is being utilized by certain AIFs by investing in the junior class, allowing RE to route funds to stressed borrowers without recognizing the loan as NPA. By bearing losses through their investment in the junior tranche, these entities avoid regulatory requirements, thereby facilitating the practice of the evergreening of loans.
To address regulatory risks, the RBI, through its circular on December 19, 2023, prohibited RE from investing in AIFs that have downstream investments in companies to which REs currently have, or had in the preceding 12 months, given any loan or investment exposure (‘Debtor Companies’). In such cases, the RBI mandated that REs must liquidate their investment in the AIF within 30 days, failing which they are required to make a 100% provision on the total investment made in the AIF.
Impact and the Need for Regulatory Nuance
Although intended to strengthen regulatory oversight, this move led to considerable practical concerns. First, the circular was anticipated to reduce around 20-30% of funding in the AIFs, thereby reducing the available investment corpus for target companies. Second, several stakeholders had raised concerns about the lack of practical options available to comply with the circular. Many REs were forced to exit hesitantly owing to the limited compliance window, incurring financial losses. For example, a major NBFC had to liquidate 40% of its investment at par, 20% at a discount and make a provision for the remainder. Third, not only did REs struggle to honour their capital commitment, but it disrupted the growth of AIFs. This development is especially troubling, considering that AIFs play a critical role in fostering start-up growth and supporting the broader innovation ecosystem.
In response to these concerns, the RBI issued a circular in March 2024, clarifying and relaxing the above-mentioned regulatory norms. The provision requirement previously applied to the entire investment made by REs in AIF is now limited to only the extent of RE’s investment in the AIF that is further invested in Debtor Companies. It is also clarified that downstream investment by AIFs in the equity shares of Debtor Companies is excluded from the scope of the restriction. However, hybrid investments remain regulated, posing a significant concern for private equity and venture capital funds, as they typically depend on such investment structures.
Notably, SEBI, by way of its notification in April 2024, inserted regulation 20(20) in the SEBI (AIF) Regulation, 2012, imposing the requirement of specific due diligence on AIF, managers of AIF and Key Management Personnel to ensure prevention of circumvention of laws as introduced by SEBI time to time. Consequently, while certain norms are relaxed, the compliance burden on AIFs continues to intensify.
A Shift Towards Balanced Approach
In a significant policy shift, the RBI, through its draft directions issued on May 19, 2025, proposed new investment thresholds for REs in AIF schemes. Under the proposed framework, a single RE would be permitted to invest up to 10% of the corpus of any AIF scheme, with a collective cap of 15% applicable to the total investment by all REs in that scheme. This marks a welcome departure from the earlier stance of prohibition to moving towards a calibrated regime that allows RE participation within defined limits. However, it is suggested that REs should be permitted to invest up to 25%, rather than restricting them to 10%. This recommendation is premised on the view that a 25% investment ceiling would still prevent REs from exerting substantial influence over AIF investment decisions while at the same time would not constrain legitimate investment activity.
Moreover, the draft circular exempts REs from compliance requirements where their exposure to an AIF scheme is limited to 5%. This is a welcome relaxation, as it encourages smaller and diversified exposure to continue without compliance burden. The RBI has also proposed exceptions for strategic funds, thereby enabling targeted investments in critical sectors such as infrastructure, national development, and security. These measures reflect a more nuanced approach that seeks to balance regulatory safeguards with the need to facilitate growth-oriented capital deployment through AIFs.
Conclusion
The regulation of RE investments in AIFs is primarily based on the premise that any RE investment in an AIF, which subsequently invests in Debtor Companies, signals an intent to engage in evergreening. However, this assumption risks overlooking legitimate investment strategies and may discourage genuine capital deployment. While the RBI’s interventions seek to curb evergreening and strengthen financial discipline, the regulatory framework must carefully balance these objectives and the need to support authentic capital flows that are vital for innovation and start-up growth. Therefore, the proposed calibrated investment limits alongside exemptions for smaller exposures and strategic funds signify a more nuanced and pragmatic approach. Such a balance is crucial to achieving regulatory goals without undermining the essential role AIFs play in driving economic development and maintaining financial stability.
– Aditi Kanoongo