The Reserve Bank of India (‘RBI’) had issued a Circular on December 19, 2023 (‘December Circular’) regulating investments by all commercial banks (including small finance banks, local area banks and regional rural banks), primary (urban) co-operative banks / state co-operative banks / central co-operative banks, all-India financial institutions and NBFCs (including HFCs) (‘Regulated Entities’ or ‘RE(s)’) in any scheme of Alternative Investment Funds (‘AIFs’) which has downstream investments either directly or indirectly in a ‘Debtor Company’ (‘Debtor Company (ies)’) of the RE.^[1] Existing investments by REs in AIFs that have such investments in a Debtor Company (of the RE) were required to be liquidated by the RE within 30 days, failing which RE was required to make a 100percent provision on such investments.

In response to concerns flagged in various stakeholder representations, the RBI has issued a Circular on March 27, 2024 (‘March Circular’)^[2], to provide certain clarifications on interpretation of the December Circular.

In the March Circular, the RBI has clarified that REs are required to provision only to the extent of their investment in the AIF, which has been invested by the AIF in the Debtor Company (as opposed to the RE provisioning for the entire investment made by the RE in the AIF).

The RBI’s decision has received mixed reactions from market participants, in view of certain operational drawbacks in giving effect to the March Circular’s intent.

The extent of an AIF’s investment which has been invested in Debtor Companies may be dynamic, especially in open-ended and/or open schemes. Moreover, operationally, the portfolio-company-wise break-up (of investments) is not typically reported to investors – making estimating the scope of provisioning even in close ended and open-ended schemes complicated (even if ascertainable).

Absent documents identifying the actual amount of investment made by the AIF in the Debtor Company which is solely to be ascribed to the investment from the RE, REs have been recommended by auditors to provision for the entire amount of the REs investment in the relevant AIF scheme or the investment of the scheme in the Debtor Company (whichever is less) in order to provision for the full risk of the investment of the AIF in the Debtor Company.

To illustrate the practical difficulty, we can consider the following scenario:

If an RE invests INR 200 (approx. US$ 3) in an AIF, which in turn invests INR 100 (approx. US$ 2) in a Debtor Company. Of this INR 50 (approx. US$ 1) can be identified as the investment in the AIF made by the first RE and the other INR 50 (approx. US$ 1) can be ascribed to an investment in the AIF made by another investor.

In this case, the March Circular has now clarified that the amount to be provisioned by the RE would be INR 50 (approx. US$ 1) and not INR 100 (approx. US$ 2). However, there would be practical difficulties if the extent of the investment of the RE in the AIF scheme for the Debtor Company cannot be identified.

As above, a potential mitigant would be for the RE is to procure certification from the AIF manager certifying the amount of the RE’s investment which has been invested in the relevant Debtor Company. Appropriate market practice in this regard can be evolved, especially in the case of close ended and open-ended schemes.

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[1] RBI circular RBI/2023-24/90 dated December 19, 2023

[2] RBI circular RBI/2023-24/140 dated March 27, 2024