The RBI has amended the Master Directions on Financial Services provided by Banks. This is a significant move permitting Banks to invest in Category II Alternative Investment Funds.

As of June 30, 2017, Alternative Investment Funds (AIFs) had raised the cumulative figure of Rs. 48, 129 crores, against aggregate capital commitments of Rs 96,000 crores. The AIF industry is thus growing at an exponential rate, raising monies from domestic and offshore investors.

Unfortunately, however, the Indian AIF industry, lags behind its western counterparts in terms of participation by domestic pools of capital. In western countries, long term or patient capital, such as pension funds, contributes nearly 40% of the capital raised by AIFs. In the Indian context, restrictions prescribed by sector regulators have inhibited fund managers from raising capital from the domestic financial services sector.

Hence, it was no surprise that one of the key themes in the 2016 reports of the Alternative Investment Policy Advisory Committee (AIPAC), chaired by Mr Narayan Murthy, was “unlocking domestic pools of capital”. The committee’s recommendation was premised on the argument that the domestic capital pools – pensions, insurance, domestic financial institutions, banks, and charitable institutions – need access to appropriate investment opportunities to earn risk-adjusted returns.

In fact, it is ironic that the K.B. Chandrashekar Committee report way back in January 2000 aired the same sentiment. The committee mused about augmenting the domestic pool of resources by increasing the list of sophisticated institutional investors in venture capital funds (VCFs) to include banks, mutual funds and insurance companies, and, as the industry matures, other institutional investors, such as pension funds. The committee observed that investing in VCFs could be a valuable return-enhancing tool for such investors while the increase in risk at the portfolio level would be minimal.

The AIPAC and industry bodies have been pursuing the Reserve Bank of India (RBI), Insurance Regulatory and Development Authority (IRDA), Pension Fund Regulatory and Development Authority (PFRDA) and other regulators to ease their respective norms to allow financial services industry participants to invest more in AIFs.

RBI-VCF-AIF journey

The RBI has, over the years, played its role in channelling banks’ investments into venture capital. A big fillip in this regard came through the RBI Monetary and Credit Policy announced in April 1999 when RBI made investments in venture capital a part of “priority sector lending”. Banks thus started allocating healthy commitments to VCFs. In 2004, the VCF regulations were amended and “real estate” was dropped from the negative list of sectors for VCFs. This led to several VCFs being set up as real estate funds and banks continued to participate in such funds. The RBI’s concern that increased participation by banks in the real estate sector could lead to an asset bubble implosion drove the RBI to revise the risk weightage for real estate investments and venture capital was dropped from the list of priority sector lending.

Thereafter, in 2012 the VCF regulations were replaced by the AIF regulations. Under these, AIFs could be set up under any of the three following categories:

  • Category I includes multiple sub categories such as VCFs, infrastructure funds, social venture funds etc.
  • Category III covers hedge funds and long-only funds.
  • Whereas Category II is the residual category i.e. funds that cannot be classified as Category I or III can seek registration under Category II. Hence, Category II comprises private equity funds, real estate funds, debt funds, etc.

In 2016, when the RBI issued the Master Directions setting out permissible financial services by banks (Master Directions), banks were restricted to participate in only VCFs and Category I AIFs.

Several representations were made to the RBI drawing its attention to the unintended consequence of leaving out Category II AIFs. It was pointed out that more than half the total number of registered AIFs and cumulative funds raised can be attributed to Category II AIFs. Hence, for banks to meaningfully participate in AIFs, it is imperative that the RBI recognises the need to channel domestic savings into Category II AIFs.

On September 25, 2017, the RBI amended the Master Directions stipulating the following regulatory regime for banks’ participation in AIFs:

  1. Category I and Category II AIFs: No bank shall, without RBI approval, make an investment of more than 10% of the paid-up capital / unit capital of a Category I or Category II AIF.
  2. Category III AIFs: No bank shall make any investment in a Category III AIF. However, a subsidiary of a bank can invest, in a Category III AIF, the minimum amount prescribed under the AIF regulations.
  3. Risk assessment: Banks must ascertain the risks arising on account of equity investments in AIFs made directly or through their subsidiaries, within the Internal Capital Adequacy Assessment Process (ICAAP) framework and determine the additional capital required, which will be subject to supervisory examination as part of Supervisory Review and Evaluation Process.
  4. Controlled deals: A subsidiary of a bank cannot make any portfolio investment in another existing company with an intention of acquiring controlling interest, without prior RBI approval. However, this restriction shall not apply to the investments made by a Category I or Category II AIF set up by a subsidiary of a bank.

This liberalisation move from the RBI will stimulate the AIF industry. It not only opens up an additional avenue for domestic fund raising by AIFs but also provides the banks an opportunity to improve their return on equity by taking an exposure to risk-adjusted superior return products.

We now have to wait and see whether (and how soon) IRDA and PFRDA will follow suit to unshackle the current restrictions applicable to insurance companies and pensions funds for investing into AIFs.