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Under existing regulations, banks and financial institutions may invest in alternative investment funds (AIF), which then deploy funds into investee companies. However, recent developments show increasing scrutiny by the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI) of investments by regulated entities (RE), such as banks and non-banking financial companies, in AIFs.

To enforce compliance and tighten the management of stressed assets through AIFs, the RBI issued a circular on 19 December 2023, which was amended by a circular dated 27 March 2024 (RBI circulars). They stipulated that REs cannot invest in any AIF scheme which has direct or indirect downstream investments in a debtor company of the RE. However, it was clarified that the downstream investments would exclude investments made by the AIF in the equity shares of a debtor company. If the AIF subsequently invests in a debtor company of the RE, the RE will have to liquidate its holdings in the AIF or make a 100% provision.

The SEBI, referring to the RBI circulars, amended the AIF regulations and introduced a new circular on 8 October 2024 (SEBI circular). This required AIF management to undertake specific due diligence to prevent evergreening of stressed loan/assets of REs through AIFs and to ensure compliance with RBI restructuring and provisioning standards. Such due diligence must follow the Standard Setting Forum for AIFs (SFA). The SEBI circular forbids every AIF scheme whose manager or sponsor is an RE or in which an RE has significant influence, either by virtue of contribution or its relation with the manager or sponsor or because the RE has majority or veto voting power on investment decisions, investing in a way that would lead to the RE holding an interest in or exposure to the investee company indirectly that it could not hold directly.

AIFs must ensure that none of the schemes make any equity investments in an investee company that would lead to a breach of the regulations prescribed by the RBI for the relevant RE. For example, under the Master Direction-Reserve Bank of India (Financial Services provided by Banks) Directions, 2016, no bank may hold more than 10% of the paid-up capital of a company, not being its subsidiary, engaged in non-financial services or 10% of the bank’s paid-up share capital and reserves, whichever is less. This limit may be extended to 30% in certain cases.

Under the SEBI circular, any scheme of an AIF over which a bank exercises significant influence according to the criteria specified in it, cannot make any investment in excess of the thresholds applicable to banks. No such scheme of an AIF will be able to make debt investments, the end use of which is such, for which the bank could not have lent directly under RBI guidelines.

The SEBI circular will impact the security structure of a debt investment made by a scheme of an AIF over which a bank exercises significant influence according to the criteria in the SEBI circular. Pledges created to secure debt investment by such an AIF scheme cannot exceed 30% of the paid-up share capital of the investee company or any other relevant entity to ensure that the bank exercising influence or control over such scheme continues to comply with RBI requirements for pledges created in favour of banks.

Additionally, the RBI, in its 4 October 2024 draft circular said it was considering re-examining investment thresholds for all scheduled commercial banks, apart from regional rural ones. Any downstream investment by AIF schemes in which banks exercise significant influence will have to comply with revised limits.

The RBI and SEBI clearly aim to demarcate REs’ core financial activities from riskier non-core ventures through AIFs. Their regulations reinforce the integrity of the financial system by preventing REs evading direct regulatory restrictions by using AIFs. New and existing investments by RE-influenced AIFs are under scrutiny, with close examination of their structures and potential penalties for non-compliance. This will likely reduce the flexibility for REs in deploying capital through AIFs.

These changes are a significant tightening of the regulatory environment for REs and AIFs and will have far-reaching effects on the financial sector’s investment strategies.

Devyani Dhawan is an of counsel and Aniket Sawant is an associate partner at SNG & Partners.