While AIFs serve as pooled investment vehicles for high-net-worth individuals, requiring a minimum investment of INR 1 crore, there is also an element of elevated risk management which needs to be kept in mind. The regulators have usually encouraged the industry and have gone to the extent of providing regulatory sandboxes for innovative ideas. It is incumbent on the industry, however, to ensure that they are not perceived as being walking to close to the line.

Recognising the size of this opportunity and the magnitude of their economic vibrancy is essential. We stand on the brink of a transformative moment over the next couple of decades, one that demands our immediate attention and urgent action

Recent regulatory developments underscore the importance of caution and due diligence in managing AIFs to mitigate risks and ensure compliance with financial regulations.

Regulatory developments and what they imply:

Undoubtedly, AIFs essay a crucial role in capital formation, providing risk capital to enterprises, including unlisted companies, and facilitating the growth of the economy. From that point of view, today AIFs have started occupying a similar status as to what NBFCs and banks did a few years earlier.

Not surprisingly, the regulators are keen to make sure that the industry grows without making the commensurate errors which have transpired in the ecosystem earlier.

On December 19, 2023, the Reserve Bank of India (RBI) issued a directive to banks and Non-Banking Financial Companies (NBFCs), referred to as Regulated Entities (REs), to liquidate their investments in AIFs that had downstream investments in debtor companies of the REs, failing which the REs would have to make 100% provisions for their investments in these AIFs.

Subsequent clarifications by the RBI on March 27, 2024, refined these guidelines – key points included the exclusion of equity investments in debtor companies from downstream investments, provisioning requirements only for the portion of investments in debtor companies, and the exclusion of investments through intermediaries like fund of funds or mutual funds from the scope of the directive.

The intention clearly was to give a heads up to the industry to be judicious rather than impetuous in their approach to manage money. It clearly was a red flag to any potential concerns on likely evergreening of loans, among other transgressions

These measures are designed to ensure uniformity in implementation and address stakeholders' concerns.

Challenges and risk areas for AIFs

If one were to read the tea leaves, it is reasonably clear as to where the regulator is nudging the industry to move towards. They are doing this with robust guardrails created through dialogue, data analysis and discretion in equal doses.

Emphasising prudence in fund management

The key to managing AIFs prudently lies in comprehensive due diligence, robust risk management frameworks, and adherence to regulatory requirements. Accordingly, fund managers should implement stringent due diligence processes to assess the credibility and regulatory compliance of their investments, including verifying the background of investors and ensuring investments do not facilitate regulatory circumvention.

Additionally, establishing robust risk management frameworks that include regular monitoring and evaluation of portfolio performance is crucial - these frameworks should be designed to identify potential risks early and take corrective actions promptly. It is advisable that AIFs adhere to all relevant regulatory requirements, including those related to investment limits, disclosure norms, and provisioning. This includes staying updated with regulatory changes and implementing necessary adjustments in fund operations.

Further, maintaining transparency in fund operations and providing regular reports to investors and regulators can build trust and enhance the credibility of AIFs. This involves clear communication of investment strategies, risks and performance metrics. Finally, fund managers should avoid complacency by continuously reassessing their strategies and adapting to changing market conditions and regulatory landscapes as this proactive approach can help mitigate risks and enable fund managers to capitalise on new opportunities.

While the landscape of AIFs is fraught with opportunities and challenges, a prudent approach can go a long way towards navigating these issues effectively. Emphasising caution and avoiding complacency are essential for ensuring the long-term sustainability and credibility of AIFs, ultimately contributing to the stability and growth of the financial market.