Opinion
Alternate investment funds could face harsher regulation in India
Summary
- Not long ago, AIFs were found to have helped shadow lenders evergreen their loan books. The questionable deals of global private equity firms have made stiffer rules more or less inevitable.
There are plenty of high-performing private investment vehicles in India, but it’s the few set up for dubious purposes that may bring harsher regulatory scrutiny. So far, the most egregious use of alternative investment funds (AIFs) has been by non-bank finance companies (NBFCs), several of which employ bespoke structures for regulatory aRBItrage.
When it looked like their big-ticket borrowers like real-estate projects were going to default, some financiers took recourse to new funds tailor-made for them by Wall Street firms. Investors who pooled money were issued senior securities, earning them interest. The finance company also contributed but in a smaller junior tranche that ranks lower down in the repayment order and is the first to absorb any losses. These private funds then lent money to the same stressed borrowers who, in turn, repaid their original loans and avoided bankruptcy proceedings. Finance companies were pleased, since any mark-to-market losses on the securities they now held would be far lower than the provisioning burden they would have had to bear in case of soured credit. This is how at least some shadow lenders ‘evergreened’ their loan books to avoid being on the radar of the Reserve Bank of India (RBI), their regulator. But the Securities and Exchange Board of India (Sebi) has cottoned on to that sleight of hand. According to a Reuters report, Sebi detected at least a dozen cases involving $1.8 billion to $2.4 billion where AIFs ave been misused to sidestep other regulators like RBI.
The amounts involved may be small, but the problem with such shady practices is that they invariably lead to stiff regulation. And that could slow down the blistering growth of AIFs, a broad category that includes venture capital, private equity, real estate funds and private credit. A Mumbai-based PE investor pointed out to me that it’s mostly Wall Street firms that sponsored these cute structures. The same marquee buyout specialists will be the first to complain when, as a direct consequence, regulation in India takes a sterner turn.
Currently, it’s international investors who dominate India’s alternative-asset landscape. But a rising number of affluent Indians are also looking at them for returns superior to what they can get from public equity, debt and residential real estate. For a growing class of high-net-worth individuals, the minimum ticket size of $120,000 is not a showstopper.
However, the game will not stop with the rich. Domestic institutions’ participation will increase, too, once insurance and pension firms are given more leeway to invest in alternative assets. Since that will indirectly bring the regular Indian saver to the rich person’s playground, it’s one big reason why Sebi cannot afford to ignore dodgy structures. A global PE sponsor buying a riskier portion of a fund would be par for the course, but a local NBFC that’s not the sponsor providing a loan-loss cushion to make its balance sheet look good? Or a big international retailer using a fund to get around foreign direct investment limits? Regulators are losing their patience.
The zeitgeist is in Sebi’s favour. The US Securities and Exchange Commission (SEC) came out with rules in August to tighten its grip on hedge funds and private equity. Their industry associations have sued the SEC, alleging that the agency has gone too far and that the new rules “would fundamentally change the way private funds are regulated in America." Which is perhaps why Sebi wants to act early. The alternative-asset industry in India has venture capital and hedge funds as its two bookends. The main body, however, consists of private equity and private credit. Whereas just a decade ago these two asset classes were a $200 million sideshow, now they command $83 billion, or more than four-fifths of the $100 billion committed by investors to private funds.
If past growth is any guide, it won’t take too long for the firepower to grow to a point where the industry can flex its lobbying muscles—both in New Delhi and Washington—to thwart any attempt to rein it in. Even now, it isn’t exactly easy for Sebi. A tussle between the regulator and the fund lobby has been playing out for more than a year, a newspaper reported in July.
The stakes are increasing on both sides. Alternative funds will continue to be the fastest-growing segment of India’s investment landscape, Crisil, an affiliate of S&P Global, noted in a report last year. That growth has been made possible by light-touch regulation: As conduits of foreign capital into the country, the industry has enjoyed a lot of latitude. But now that local Indian savers are getting entangled, expect an end to private funds’ freewheeling ways. The questionable deals of global private equity firms have made that outcome more or less inevitable. ©bloomberg
