There are many high-performing private investment vehicles in India, but the handful that are being set up for questionable objectives may subject the country's most quickly rising asset class to further regulatory scrutiny.
So far, nonbank finance organizations have made the most egregious use of these so-called alternative investment funds, with numerous employing these bespoke structures for pure regulatory arbitrage. When it appeared that their large-ticket debtors, particularly real-estate projects, were about to default, some bankers turned to new funds tailor-made for them by Wall Street corporations. Investors who pooled their funds were issued senior securities, which earned them interest. The lending business also contributed, albeit in a smaller junior tranche that ranks lower in the repayment pecking order and absorbs any losses first.
The private funds subsequently loaned money to the same stressed-out debtors, who repaid their initial loans and avoided bankruptcy. Finance firms were also pleased because any mark-to-market losses on the assets they currently held would be substantially less than the provisioning load they would have had to endure in the event of bad credit. At least some Indian shadow lenders have "evergreened" their loan books in order to escape being detected by the Reserve Bank of India, their regulator. The Securities and Exchange Board of India, India's stock-market watchdog, has caught on to the ruse. According to a Reuters article from October, the SEBI has discovered at least a dozen incidents totaling $1.8 billion to $2.4 billion in which alternative investment vehicles were utilized to avoid other financial authorities, including the RBI.
Although the quantities involved are minor, the difficulty with such shady practices is that they usually result in strict regulation. And this could halt the explosive rise of alternative funds, which include venture capital, private equity, real estate funds, and private credit. A prominent Mumbai-based private equity investor pointed out to me that the charming structures were largely funded by Wall Street businesses. The same marquee buyout specialists will be the first to whine if, as a result, regulation in India becomes stricter. Lawyers who advised on these transactions would wash their hands of them.
International investors currently dominate the alternative-asset sector in the world's most popular emerging market. However, an increasing number of rich Indians are looking to them for higher profits than they can earn from public stock, debt, and residential real estate. For an increasing class of high-net-worth individuals, the minimum ticket price of Rs 1 crore ($120,000) is not a deal breaker.
However, the game will not end with the wealthy. Domestic institutional participation will rise as insurance and pension corporations are allowed more freedom to participate in alternative assets. Because this will indirectly draw the average Indian saver into the rich person's playground, the SEBI cannot afford to overlook the shady structures. A worldwide private equity sponsor purchasing a riskier piece of a fund is standard practise, but a local nonbank finance company that isn't the sponsor providing a loan-loss cushion to make its balance sheet appear good? Or a major international store employing a fund to circumvent New Delhi's foreign direct investment restrictions? The regulators are growing impatient.
The tide is turning in SEBI's favor. In August, the US Securities and Exchange Commission, chaired by Gary Gensler, issued rules tightening its hold on hedge funds and private equity. Their trade associations have filed a lawsuit against the SEC, claiming that the agency has gone too far and that the new rules "would fundamentally change the way private funds are regulated in America."
That is possibly why SEBI wants to act quickly. In India, the alternative-asset business is booked by venture capital and hedge funds. The primary body, on the other hand, is made up of private equity and private credit. Previously a $200 million sideshow, these two asset classes today attract $83 billion, or more than four-fifths of the $100 billion committed by investors to private funds.
If past expansion is any indication, it won't be long until the business can flex its lobbying muscles – both in New Delhi and Washington – to oppose any attempt to rein it in. Even now, SEBI's job is not easy. According to the Economic Times, a battle between the regulator and the fund lobby has been going on for more than a year.
On both sides, the stakes are rising. According to CRISIL, an associate of S&P Global Inc., alternative funds will continue to be the fastest-growing section of India's investment environment. Light-touch regulation has enabled this expansion: The industry has had a lot of leeway as a conduit for foreign wealth into the country. But, now that the local saver is involved, expect private funds' freewheeling methods to come to an end. Because of the dubious deals conducted by global private equity groups, this conclusion was unavoidable.
