Sebi questions ‘senior-junior’ fund deals by non-bank lenders

Over the past two years, some of the large non-banking finance companies (NBFCs) have transferred real estate and other wholesale loan exposures at the first hint of stress to new alternative investment funds (AIFs) that they set up in partnership with PEs and asset managers.

The transaction works in a way where the money is chipped in by the NBFC and the PE goes in cleaning up the former’s loan book, while the PE earns a better return.

What lures a PE fund to walk into such a deal is the unique ‘senior-junior tranche’ arrangement: while both the PE and the NBFC invest in the AIF, the PE has a ‘senior’ status – as the stipulated returns from the AIF’s investments are first paid to the PE. Only after the PE is paid, the AIF distributes the balance to NBFC (the junior tranche, having a second lien).

The Securities & Exchange Board of India (Sebi), in a recent communication to several funds, has questioned the senior-junior mechanism, three persons aware of the development told ET.

The regulator, said a fund manager (requesting anonymity), is categorical in its letters that only investment managers or sponsors can incur higher losses. However, in most AIF structures involving PE-NBFC, the PE is the sponsor but the NBFC which is an investor in the fund is exposed to possible losses and lower returns. Sebi, said the person, has also stalled a proposal to set up an AIF (structured in senior-junior tranches) by a large Mumbai-based NBFC and a global asset manager.

According to a senior banker, such deals boil down to ‘loan evergreening’ – a sharp practice of giving more loans to salvage an existing loan to a troubled borrower who is on the verge of default.

KICKING THE CAN DOWN

Here’s how an NBFC-PE deal works: Say, an NBFC invests ₹300 crore while a PE puts in ₹700 crore in the newly-formed AIF which issues units to both the investors.

The AIF then lends ₹1,000 crore it receives (from the PE and NBFC) to a set of stressed borrowers of the NBFC by subscribing to debentures these borrowers issue. The borrowers (who are part of the entire deal) then repay the NBFC. Post such a deal, the NBFC has no exposure to these borrowers; instead, it holds units of the AIF in its investment book. The result: the finance company’s loan book looks cleaner and it avoids higher provisioning in the event of default. The loss from mark-to-market accounting of the units is far lower than the provisioning on loans that turn into non-performing assets.

Thus, the NBFC uses the money to refinance (or even restructure) its loans through the AIF which serves as an intermediary vehicle.

According to a senior source in the fund industry, such deals have also drawn the RBI’s attention. “The NBFC simply kicks the can down the road. The central bank would probably like to know whether the NBFC is making adequate provisioning and what the terms of such transactions are.”

GENUINE DEALS MAY BE IMPACTED

However, the senior-junior tranche, said Tejesh Chitlangi, senior partner at IC Universal Legal, has been a key structuring aspect for several AIFs, particularly for funds investing in debt securities.

Many such deals are driven by commercial reasons – with a set of senior investors in AIFs, paying a higher fee, receiving their periodic payouts (say principal as well as a hurdle/rate of return) in priority over the other junior investors who pay a lower fee.

“This can be considered as an informed decision on part of all investors where higher risk brings better returns and vice-versa without violating Sebi’s blind pool principle that requires proportionate participation by investors in all the underlying investments. However, Sebi does not seem to be in favour of such structures for a variety of reasons. While there is no express prohibition in the AIF Regulations restricting such structures, the regulatory view seems to be in favour of permitting the same only where the junior or in some cases the first loss class belongs to the sponsor/manager and not to a set of third-party investors,” said Chitlangi.

“It appears to be a stance to discourage certain intra-group debt investment transactions carried out by a few AIFs. But, this would end up restricting routine commercial structures deployed by many AIFs. Therefore, it warrants permissibility of the same albeit with any requisite checks and balances as deemed fit by the Regulator,” said Chitlangi.

Sebi’s objections to these structures come after at least four large NBFCs have refinanced loans of close to ₹10,000 crore through them in the past two years.