Actionable insights on equities, fixed-income, macros and personal finance Start 14-Days Free Trial
Actionable investing insights Get Free Trial

No more evergreening through AIFs, says RBI to NBFCs


RBI has a new rule: NBFCs cannot use AIFs to evergreen loans. Let me explain. This is going to take some time.

NBFCs have seen increased regulation over time, mostly because they tried silly stunts. So RBI forces them to recognize bad loans after 90 days of non payment etc. NBFCs don’t like this because it looks bad and needs higher provisioning etc. For the uninitiated, NBFCs are Non-Banking Financial Companies which can lend you money, but don’t have the word “Bank” in their name. AIFs are Alternative Investment Funds, which is a SEBI regulated investment vehicle that takes a minimum of Rs. 1 cr. per investor and then can buy just about anything.

Let’s say there’s this builder who is about to default. No matter how much houses are selling for, brokers are queuing up, and all the drama, there will always be builders nearing default, after taking loans from an NBFC. The NBFC knows. NBFC is like hello uncle, wait, I have an idea.

So, enter the AIF. The NBFC usually has some group link with a Cat 2 or 3 AIF, which can invest in debt. NBFC makes the nearly defaulted builder issue bonds. These bonds are bought by the AIF. Where does the AIF get money? From investors. Who is the stupid investor that wants to buy nearly defaulted debt? Uhem.

The NBFC itself subscribes to units of the AIF. Here, take my money, it says and buys between 25% and 40% of the AIF corpus. That money goes to buy the bonds of the near-defaulter, which takes the money and gives it back to the NBFC. So, magically, no default.

But, you say, won’t the builder default to the AIF? Well, sure, but the AIF can hold defaulted debt, and wait long times for recovery, because hey, rich people’s money etc. This doesn’t even translate to a much lower NAV for the AIF, mostly. Round trip the money, the NBFC has no NPA, the AIF gets time to keep this opaque, the NBFC’s exposure to the AIF doesn’t even show the default.

Also, as it turns out, the AIF needs other investors. Not just an NBFC. Now people who have minimum 1 cr. to give, are usually not stupid. So the NBFC says, don’t worry boss, if there is a default, my units, which are “subordinate” units, will take all the blame and the financial hit if indeed they default. That way the first 25% or 40% of any default gets absorbed by an NBFC, and only beyond that is where an external investors is hit. In reality, of course, another AIF can be used similarly to further evergreen this default, and in any case, an AIF gets like 7-10 years before they have to call it a completely unrecoverable thing. Meanwhile the NBFC owns the AIF units and can keep them as “investments” without needing to recognize impairment until the eventual default, many years away. Evergreening.

This is a problem because the risk is hidden.

Let me first state that this is why NBFCs were regulated in the first place. Banks had this problem and dumped their bad loans on their own (or friendly) NBFCs. RBI was like hello, you think I’m dumb? (but after many years of such evergreening) Then came tighter and tighter RBI regulation. So now, NBFCs are going to the AIF. AIFs are regulated by SEBI. So instead of telling the AIF to stop doing this shit, RBI is like imma tell you NBFCs what you gonna do.

So RBI comes in heavy. Says this:
– If an NBFC makes any investments into an AIF, then that AIF cannot lend money to (i.e. buy bonds of) any company that the NBFC has lent to in the last year.
– If the NBFC has already invested, and after this investment if the AIF innocently buys bonds of such a company, the NBFC has to dump the AIF units within 30 days.
– Current investments have to be dumped in 30 days too, if there is such a situation
– If they don’t dump ’em units, then there’s a 100% provision of the entire amount invested in the units

Example: NBFC owns 100 cr. worth units of an AIF that has been used to evergreen an NBFC loan to a stressed company. NBFC now has 30 days to sell those units. Or, they have to take 100 cr. worth provisions.

Higher provisions reduce equity (since profits may turn to losses) and take away Tier 1 capital. Provisions are essentially like an expense. If your expenses are higher, you will have losses (or lower profits) and your “shareholder equity” reduces. That makes the NBFC more vulnerable, since there’s a minimum capital adequacy ratio of around 15% needed.

RBI’s gone one step further. It could also be that one NBFC invests in a different NBFC’s AIF units, and do a quid pro quo the other way. They both usually will own subordinated units of each others AIF. (Because I really like you but you’re still taking the hit on any default) In the new rules, the NBFC has to take 100% provision on all subordinate units they own in any AIF regardless of where the AIF has invested in.

Since this is effectively immediately, certain NBFCs will have to scramble to dump their units or see a pretty big hit to their results. This could trigger a ratings downgrade of these NBFCs and then, bank exposures will also see higher capital hits (some of which has already happened with the RBI changes in risk-weights for retail loans). In effect, this will result in a funding crunch for a few NBFCs.

Btw, there’s some history: last year, SEBI said to AIFs that there will be no more “priority distribution” in AIFs (meaning one class of units can’t say they will take a loss to provide a better exit for other units)

Direct impact is to the NBFC sector as a whole, and to the few NBFCs that are doing this regularly. There will be some impact on debt markets, where these NBFCs borrow, where credit spreads will widen. Any NBFC who sees much higher debt costs is probably in trouble. Some companies that are actually close to default but were looking to be evergreened, will probably have to default or restructure. This is also a warning sign for small and midcaps that have lots of debt – the cost of debt will increase.

This is a good regulation. We shouldn’t have NBFCs investing in units of AIFs to evergreen loans. You should of course have junk bond AIFs that can take bad assets off NBFCs but buy them at a super low price so that a recovery can be profitable for the AIF. The new rules don’t stop that, just that the investors into that junk bond AIF cannot be NBFCs at all.

India does need a proper junk bond market, not one that evergreens bad loans buying them at full price. Banks and NBFCs hate taking losses, but a proper junk bond AIF market will force the biggest loss on the banks or NBFC first by selling loans at a low price, and then the AIF will make a profit from any recovery. RBI is wary of hidden risk, and it’s eliminated one more source of it.



Like our content? Join Capitalmind Premium.

  • Equity, fixed income, macro and personal finance research
  • Model equity and fixed-income portfolios
  • Exclusive apps, tutorials, and member community
Subscribe Now Or start with a free-trial