Balancing Relaxation And Risk: A Critical Analysis Of Gaps In Reserve Bank Of India (Investment In AIF) Directions, 2025

Alternative Investment Funds ("AIFs") have emerged as a crucial component of India's economic growth as they channel funds into private equity, real estate, venture capital, and also distressed assets. For financial institutions, investing in AIFs allows them to diversify risks by gaining exposure to a pool of borrowers and benefit from professional fund management expertise. However, these very attributes have also created opportunities for "evergreening", which is the practice of lenders using fresh funds to mask their bad loans and avoid recognition of stressed assets. Recognising the systemic risk of such practices, the Reserve Bank of India ("RBI"), over the past few years, has taken steps to regulate investments by financial institutions such as Non-Banking Financial Companies, All India Financial Institutions, various commercial banks and co-operative banks ("Regulated Entities") in AIFs.

To curb the practice of evergreening, the RBI issued a notification on December 19, 2023, to introduce stringent restrictions:

• Regulated Entities were prohibited from investing in AIF schemes which had downstream investments, either directly or indirectly, to debtor companies of the Regulated Entities.
• If a Regulated Entity had invested in an AIF that later makes a downstream investment in the Regulated Entity's debtor company, then the Regulated Entity must liquidate its investment in that AIF within 30 days. If that was not possible then the Regulated Entity was required to make 100% provision for such investments.

To address the concerns of stakeholders, on March 27, 2024, the RBI issued a notification to relax the stringent restrictions laid down by the erstwhile notification. The provisioning requirement was limited to the portion of the Regulated Entity's investment in the AIF scheme which is actually invested in its debtor company and not on the entire investment of the Regulated Entity in the AIF scheme. Moreover, equity instruments were an exception that was carved out from the ambit of "downstream investments".

Further on July 29, 2025, RBI the released the Reserve Bank of India (Investment in AIF) Directions, 2025 ("Directions") to issue revised guidelines for regulating the investments into AIFs by Regulated Entities. Some of the provisions of the Directions include:

• A Regulated Entity cannot invest more than 10% of the total corpus of an AIF scheme.
• The combined investments of all Regulated Entities cannot exceed more than 20% of the total corpus of an AIF scheme.
• If a Regulated Entity invests more than 5% of the corpus of an AIF scheme, and that AIF in turn makes downstream investments in a company that is a debtor of the Regulated Entity, then the Regulated Entity must make 100% provision to the extent of its proportional investment in that debtor company via the respective AIF scheme. This provision is capped at the amount of the Regulated Entity's direct loan and/or investment exposure in the same debtor company.

Although the Directions introduce several relaxations, they also introduce potential loopholes which mitigate the effectiveness of these Directions. For instance, the introduction of the 5% threshold for triggering the provisioning requirement appears to limit a Regulated Entity's indirect investment in its own borrowers, however, the manner in which the threshold is structured allows for easy circumvention without technically breaching the Directions.

The first method of avoidance arises when investments are split across different Regulated Entities within the same banking group. For example, a bank may directly invest up to 4.9% in an AIF scheme, while its NBFC subsidiary, housing finance company, and asset management arm each also commit 4.9% to the same scheme. Although no single entity crosses the 5% threshold, the group as a whole could funnel nearly 15–20% into the scheme. If that AIF then invests in non-equity instruments of a borrower that has also taken direct loans from the same banking group, the net effect is that the banking group has indirectly increased its exposure to that borrower far beyond what the Directions intended to permit. Thus, enabling evergreening while remaining fully compliant with the text of the Directions.

A second loophole arises as the threshold is applied scheme-wise rather than manager-wise. A single Regulated Entity can invest 4.9% of the corpus in Fund I and another 4.9% in Fund II, even if both funds/schemes are managed by the same AIF manager, ultimately pooling into the same portfolio of investments. On paper, each investment remains below the regulatory ceiling, but in substance the Regulated Entity is able to channel nearly 10% or more of financing into the same borrower through different schemes. The Directions do not explicitly aggregate investments across schemes, leaving scope for structuring multiple schemes of the same AIF to target the borrower/debtor company while staying within the prescribed thresholds. This undermines the very rationale of the restriction, which was to prevent Regulated Entities from using AIFs as conduits to fund the borrowers they already lend to.

Both of these examples highlight the tension between the form and substance of the Directions. The aforementioned loopholes weaken the effectiveness of the Directions, as Regulated Entities can restructure their commitments across group entities or across multiple schemes to bypass the prescribed thresholds, defeating the purpose of the restriction, while still appearing to follow it.

One of the major shortcomings of the Directions lies in their ambiguous treatment of indirect investments to a borrower facilitated by the Regulated Entity's investment in an AIF scheme. The RBI explicitly prohibits Regulated Entities from investing in AIFs that, in turn, have downstream investments in companies to which the Regulated Entity already has loan exposure, as a Regulated Entity should not be lending to a company on one hand and then simultaneously funding it through an AIF structure on the other. However, the Directions remain vague when it comes to multi-layered investment structures. For instance, a Regulated Entity invests in an AIF which then invests in a holding company, which in turn funds its subsidiary, and that subsidiary is the debtor company/ borrower of the Regulated Entity. In such a situation, it is not clear whether the Regulated Entity's investment in the AIF scheme and the downstream investment to the subsidiary/debtor company would come under the ambit of the Directions. Thus, this lack of clarity provides a loophole, where financial institutions may structure transactions through holding companies, subsidiaries, or associated companies to comply with the letter of the Directions while still channelling funds to borrowers they already finance.

A possible solution to address the shortcomings of the Directions lies in strengthening disclosure norms, monitoring mechanisms and adopting a substance-over-form approach. While the 5% exposure cap is aimed at curbing concentration risk, its effectiveness is undermined if Regulated Entities and AIFs can structure their investments to stay just under the threshold, thereby still maintaining significant aggregate exposure to the same borrower via the AIF. To remedy this loophole, the RBI should mandate consolidated exposure reporting across both direct and indirect holdings, including layered or structured investments, so that the true extent of financing to a borrower is visible. Therefore, enhanced disclosures by AIFs to RBI regarding their portfolio composition, particularly where Regulated Entities are investors, would allow RBI to detect circumvention attempts. Thus, although the Directions provide relaxations which promote investments in AIFs, it remains essential to address the existing loopholes to ensure the effectiveness of the Directions is not compromised.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.