From Blanket Ban to Responsible Capital: Decoding RBI’s AIF Mandate

[Somya Sharma and Harshit Sharma are 2nd year students at Hidayatullah National Law University, Raipur]

INTRODUCTION

Recently, the Reserve Bank of India (RBI) issued the Reserve Bank of India (Investment in AIF) Directions, 2025(Directions), set to take effect from 1 January 2026. These directions aim to reshape the way banks, Non-Banking Financial Companies (NBFCs), and other Regulated Entities (REs) interact with India’s Alternative Investment Fund (AIF) ecosystem.

At the outset, the AIF Directions introduce specific quantitative thresholds aimed at strengthening financial discipline and risk containment. These include exposure caps to mitigate concentration risk, prudential provisioning to curb the indirect rollover of stressed assets, and capital treatment norms intended to prevent regulatory arbitrage through the use of layered fund instruments. This shift has come in less than two years after the RBI’s December 2023 crackdown, which imposed a blanket ban on REs having downstream exposures to debtor companies, investing in AIFs, aiming to curb the practice of evergreening of stressed assets.

Conversely, the recent Directions represent a measured recalibration of the regulatory framework. While the intent is to minimize systemic risks, the RBI simultaneously acknowledges that well-governed AIFs can serve as a source of patient, long-term capital for industries requiring sustained funding. Nonetheless, these measures are not devoid of challenges. Their efficacy in fostering stability will ultimately hinge upon the consistency of enforcement, the robustness of monitoring mechanisms, and the regulator’s capacity to anticipate and respond to the market’s ingenuity in exploiting regulatory gaps. Through this article, the authors discuss the evolving framework for AIF investments and the concept of evergreening, while exploring the possible implications of the current framework.

RBI’S EVOLVING FRAMEWORK FOR AIF INVESTMENTS

The circular of the RBI dated December 2023 reflected its clear stance on AIF investments, imposing a complete ban on REs' investments in AIFs that had downstream exposures to debtor companies. Such instances of loan evergreening and circumvention of other market regulations through different AIF structures were unveiled by the consultation paperreleased by the Securities and Exchange Board of India (SEBI).

However, a circular issued for clarification by the RBI provided some relief by adopting a less restrictive approach towards AIF. Pure equity instruments are exempt from this restriction, whereas hybrid instruments remain within its scope. Although the move was aimed at enhancing asset quality, it inadvertently revealed pressing operational and market challenges for institutional investors and the broader AIF ecosystem. Owing to the requirement of the circular that lenders exit their AIF investments, many leading banks incurred substantial provisioning losses.

The recalibration began in May 2025, when the RBI issued its Draft Directions (Investment by Regulated Entities in Alternative Investment Funds). This marked a clear shift from a blanket ban to more balanced limits. It suggests that no single RE should hold more than 10% of an AIF scheme’s total corpus, and that all REs together should not hold more than 15%. Departing from the 2023 blanket ban, the draft proposes a narrower provisioning rule applicable only if a regulated entity owns more than 5% of an AIF that has made non-equity investments in a company indebted to it.

The RBI finalized the Directions in May 2025, which have kept the balanced approach of the draft, including significant improvements. It has drawn firm boundaries around permissible exposure, permitting a single RE to contribute not more than 10% of an AIF scheme’s corpus, and collectively all REs together to not exceed 20% of the corpus. Furthermore, an RE that exceeds the 5% threshold in an AIF with downstream non-equity exposure to its debtor company must make 100% provision against that exposure, subject to the amount of its direct loan or investment. Additionally, it mandates that subordinated unit holdings must be deducted from capital funds, with the adjustment spread across Tier 1 and Tier 2. Therefore, this shift in RBI’s direction highlights its stance to maintain financial stability while also recognizing the way of working of capital markets.

EVERGREENING UNVEILED: AIF STRUCTURES AND SYSTEMIC RISK

According to banking parlance, evergreening refers to the practice through which banks/NBFCs utilize AIF as a tool to provide additional loans to the borrower to repay the initial principal amount, thereby preventing an existing loan from becoming a Non-Performing Asset (NPA). This trajectory highlights how these entities evade regulatory requirements by evergreening their loan portfolios, effectively concealing the true state of their asset quality and consequently misrepresenting their financial health to stakeholders.

The nexus between banks and AIF in evergreening loans was flagged by the SEBI in its consultation paper dated December 2023, discussing the role of the Probability of Default (PD) model in assisting evergreening of loans. Certain AIFs have implemented a waterfall distribution structure under which investors are divided into different categories, thereby leading to the non-uniform allocation of investment returns. Such a separation leads to the creation of junior and senior classes of investors, permitting the latter to avail priority in the distribution of investment returns. The lender invests in the junior units to mitigate potential NPAs through investing an amount in accordance with the expected loss. Subsequently, the AIF invests in the borrower’s non-convertible debentures, thereby facilitating the loan repayment. The lender, in effect, substitutes NPAs with repayment proceeds and junior units, thereby evading NPA classification and provisioning, along with the preservation of the borrower’s creditworthiness through structured repayment.

In this context, the RBI has issued stringent regulatory provisions for REs investing through AIF due to the evergreening of loans. It has become mandatory for REs to maintain provisioning for sub-standard assets and NPAs. However, to circumvent these requirements, REs began subscribing to the subordinate class of units of AIFs, which are designed to absorb losses ahead of senior tranches, thereby converting REs’ sub-standards or NPAs into investments. Furthermore, SEBI has imposed a blanket ban on AIFs raising investments through structures that prioritize distribution among investors; however, some of the REs have escaped this by categorizing themselves as sponsors. Therefore, the RBI, through its series of notifications, has restrained such REs from circumventing these requirements, even as sponsors, and from making investments in such debtor portfolio entities, unless they make 100% provisions for existing investments in AIFs in which the RE also has an exposure as a direct investor.

PRACTICAL IMPLICATIONS OF THE RBI FRAMEWORK

These recently issued directions reflect a paradigm shift for REs, as they have narrowed the leeway for using AIFs as methods of diversification, indirect lending, and higher yield generation. Furthermore, it has also mandated the REs to enforce stringent compliance oversight with meticulous monitoring to ensure that the exposures remain under the purview of prescribed limits. Entities having significant exposures to individual AIFs may need to reassess their portfolio compositions to ensure better diversification and mitigate concentrated risks. Additionally, investment in subordinate units has the potential to affect capital adequacy ratios owing to their loss-absorbing characteristics. This conundrum necessitates a recalibration of investment strategies to align asset selection with regulatory capital optimization and risk-assessed asset treatment. The prerequisite of 100% provisioning in instances where downstream exposures are intertwined with pre-existing debts is anticipated to reduce quarterly profitability and discourage such overlaps. Therefore, these measures are collectively expected to induce internal risk audits, reviews of capital planning, and reassessments of AIF investment strategies by financial institutions.

Furthermore, for AIFs and fund managers, the circular is expected to restrict capital inflows from banks and NBFCs, which previously used to be a significant investor segment, specifically in category II and III funds focused on debt or hybrid instruments. This modification also requires a more concerted effort to diversify the investor base, along with placing greater reliance on high-net-worth individuals, family offices, and non-regulated entities. At the same time, greater regulatory attention on indirect exposures will lead to increased scrutiny of fund deployment, particularly in schemes related to heavy debt, reinforcing the need for stringent governance mechanisms and greater transparency. It is also pertinent to note that downstream lending needs to be implemented with greater caution, specifically in instances where commitments from REs surpass 5% of the corpus. Thus, these developments in the long run are expected to closely align AIF strategies with both SEBI and RBI directions, thereby enhancing governance standards and confidence of investors.

CONCLUSION

The RBI’s Investment in AIF Directions, 2025, marks a clear shift in the existing approach. Earlier in 2023, the central bank had taken a firm stance by banning regulated entities from investing in AIFs with links to their debtor companies. While the ban aimed to block evergreening and improve asset quality, it also unsettled the market, leading banks and funds to face sudden losses.

The recent framework takes a more balanced approach, moving away from a complete ban and instead establishing clear limits and conditions. It permits REs to invest in AIFs, but only within specified boundaries. Furthermore, the RBI has also called for stronger governance, better due diligence, and clearer disclosures, thereby keeping risks under control.While AIFs continue to provide long-term capital to areas that regular bank lending often cannot reach, the real test of this framework lies in its implementation. Thus, there are chances of resurfacing of the risks, such as evergreening of loans and regulatory arbitrage, until proper enforcement, as its impact depends on proper monitoring, compliance, and enforcement.