Use Of 'Preferential Distribution Model’ By Alternate Investment Funds(AIFs) to Hide Bad Loans And SEBI's Plan To Address It

The Securities and Exchange Board of India (SEBI) recently came out with a consultation paper highlighting the use of alternative investment funds (AIFs) by finance companies to hide bad loans. 

AIFs are investment vehicles that pool money from investors and invest them into assets. Usually, the profit or losses are divided among investors based on their proportion of the fund (on a pro-rata basis). However, a loophole allows AIFs to create two classes of investors (different tranches) – a junior tranche and a senior tranche. 

As the name suggests, investors in the senior tranches are given preference when distributing profits, while junior tranche investors are only given the leftovers after payments are made to senior investors. Hence, the model is called a preferential distribution model. 

According to SEBI, the model is being misused by lenders to hide their bad loans.

How Are AIFs Used to Hive Off Bad Loans?

Once a lender notices that one of its loans might be about to go bad, it asks external investors to form an AIF with the external investors holding the senior debt. 

For instance, if the lender expects a Rs 100 crore loan to go bad, it asks an external investor (often private equity funds) to put Rs 80 crore into a fund while it puts in Rs 20 crore. 

The fund then extends the Rs 100 crore loan to the borrower, who accepts the loan and uses the same money to repay the lender. 

As a result, the loan is extinguished in the lender’s books with no loss of capital that needs to be shown – despite the company taking a Rs 20 crore haircut on loan. 

IThe lender can show the investment in the AIF under its investments section while not having to show any provisioning for the loans. 

If the borrower does well later, the lender can recoup its money through the AIF. 

If the loan goes bad permanently, the lender only needs to show a loss on its investments – which prevents its lending practices from being scrutinised. 

From the AIF investor’s perspective, the seniority position allows it to secure returns before other investors. It might also let them get better deals since lenders might be desperate to get bad loans off their books.

Why is SEBI Against the Practice?

The practice has several dangers, which SEBI believes could create a systemic risk. 

Firstly, the bad state of the borrower is hidden by extending another loan, which distorts knowledge about the borrower’s true creditworthiness. Further, the creation of tranches is a cause of concern. 

Before the financial crisis of 2008, banks would give loans to buy houses (mortgages), and then hundreds of mortgages would be bundled up by banks and would be divided into tranches. 

The senior tranches would receive payments first, followed by the junior tranches. The tranches would then be sold to different investors based on their risk appetite. However, the introduction of tranches only added to the product’s complexity, with investors being unable to understand the true risk-reward of their investments. 

Lenders, too, can walk away from bad loans without having to account for it in their books, making it difficult for regulators or investors to track the lending track record of these players.

SEBI Might Do Away With the Senior Junior Structure Completely

SEBI is looking to do away with these differing tranches to reduce incentives for outside investors to strike such deals. 

The consulting paper also has some arguments by the working committee to allow a priority distribution model in some cases rather than implementing a blanket ban on the structure. 

The working group has suggested that there should not be any related party transaction when AIFs buy assets. However, SEBI seems to be focused on ending the PD structure completely. 

“It is necessary to explicitly prohibit adopting of differential distribution model by AIFs and any such practice providing differential rights to investors which affect the pooling requirement of the investment vehicle,” the SEBI paper said. 

SEBI also is against any special economic rights granted to some investors over others and wants all investors to have the same economic rights. Whether the move would help lower the misuse of the priority distribution models remains to be seen.