For years, ‘evergreening of loans’ – throwing new loans to help a stressed or delinquent borrower repay old loans – has worried the regulator. Since rules prohibit lenders from doing this blatantly, some of them, mostly non-banking companies, had figured out a different way some years ago. They cut special deals with foreign credit funds, which bet on comparatively lower-rated bonds, to set up local alternative investment funds (AIFs). These AIFs (an umbrella term for PE, VC, infra, special situation funds etc) became the new conduits for half a dozen non-banking finance companies (NBFCs) to evergreen their loans.
Sharp Deals
It was a complex deal: The NBFC in question and its overseas PE partner invested (in a 20:80 ratio) in the AIF which issued them units. AIF lent the money to stressed companies (many of them real estate firms) with borrowings from the NBFC. These borrowers used the new debt to repay the old loans it had taken from the NBFC. There was a reason why foreign credit funds struck such deals. The AIF, holding the debentures issued by the borrowers of the NBFC, was not a blind pool – here, the foreign investor enjoyed a ‘senior’ status while the NBFC held ‘junior’ units, which meant the latter would be paid only after the overseas investor was paid off. Thousands of crores of loans, which would have turned into non-performing assets, were moved from the books of such NBFCs. This wasn’t a permanent solution, but only a ploy to buy time and airbrush the asset books. For months, the deals escaped the regulatory radar.
A year ago, capital market regulator Sebi (which regulates AIFs and has been tensely watching the 30% year-on-year growth of AIFs) was the first to sense it. Soon, the AIFs were told to stop the ‘junior-senior’ structures. On Tuesday, RBI clamped down on banks and NBFCs (entities regulated by RBI) with sweeping dos and don’ts: no bank or NBFC can invest in any AIF having investments in any company which has borrowed from the bank/NBFC; if a bank/NBFC is already an investor in such an AIF it has to liquidate the investments, or make 100% provisioning – in other words. take a straight knock on its books – if it can’t get rid of the investment; no bank/NBFC can hold ‘subordinated’ or ‘junior’ units of AIF. The last rule puts an end to the ‘priority distribution model’ under a junior-senior arrangement with AIFs.
Tossing the Baby with the Bathwater
RBI’s intention was probably to splash cold water on the dodgy, ‘priority’ deals involving AIFs directly sponsored by the lenders themselves. But the directives – covering all kinds of AIFs with retrospective effect impacting existing exposures – will hurt many lenders, mostly banks, which had put money in AIFs as part of asset diversification, better returns, and contributed just 5-10% of the corpus of funds which has invested in a dozen companies. At times, banks after investing approach AIFs to ask portfolio companies to become their clients. No bank or NBFC would prefer a fire sale to sell off the investment in 30 days. And, if a bank or NBFC is a sponsor to an AIF, it may be forced to wind up the fund.
Goodbye AIF… Hello trust
Whether banks or NBFCs should at all invest in AIFs is a question that surfaced in the US with the Volcker report in the wake of the 2009 meltdown. Leading banks shut the funds they had sponsored. But the context here is different: RBI’s recent strictures are driven by fears of lenders dressing up sticky loans, not because such investments are perceived to be speculative.
By the time RBI has come out with the rules, the sharp practice of book-cleaning through AIFs is largely over, largely due to SEBI’s restrictions. Today, some of the finance companies are believed doing similar deals by sponsoring trusts with a large overseas investor, like a credit fund. The trust buys out the loans (which are showing early signs of stress) from the NBFCs with the money it receives from the investments by the NBFC and its foreign partner. In such a deal, the trust issues ‘junior’ pass through certificates (PTCs) – instruments that are similar to bonds – to the NBFC while the overseas investor gets ‘senior’ PTCs. Instead of AIF, it’s the trust that does the same job of housing the loans; and instead of ‘junior units’ of an AIF, the NBFC now holds ‘junior PTCs’ of the trust. New rules, new game.