Introduction

In the past few years, the Reserve Bank of India (“RBI”) has issued directions to regulate investments by banks, non-banking financial companies and other regulated entities (collectively, “REs”) in alternative investment funds (“AIFs”). These regulatory measures have been primarily intended to curb evergreening of loans by REs, where REs substitute their direct exposure to debtor companies with indirect exposure by investing in AIFs that, in turn, have investments in such debtor companies. The RBI’s efforts to prevent evergreening have been supplemented by the Securities and Exchange Board of India (“SEBI”) in its circular, dated October 8, 2024 (“SEBI Circular”). The SEBI Circular requires certain mandatory due diligence checks for AIFs that have an RE as their sponsor, manager or controlling investor, to ensure that REs do not, through investments in AIFs, indirectly invest in debtor companies to which they cannot have direct exposure.

Recently, on July 29, 2025, the RBI introduced the Reserve Bank of India (Investment in AIF) Directions, 2025 (“New Directions”), which increase regulatory oversight over REs’ investments in AIFs while also relaxing some of the prohibitions of the prior regime. The New Directions are to come into effect from January 1, 2026 (or an earlier date as decided by an RE) and will supersede the RBI’s prior circulars, dated December 19, 2023 (“Circular 1”) and March 27, 2024 (“Circular 2”) on this subject, in relation to new investment commitments made by REs in AIFs.

This note analyzes the New Directions, the improvements from the prior regulatory framework and the concerns that remain to be addressed.

A Snapshot of the Prior Regime

Prior to the introduction of the New Directions, investments by REs in AIFs were regulated by Circular 1 and Circular 2. Circular 1 prohibited any form of investment by REs in AIFs that had direct or indirect downstream investments in debtor companies of the RE. A debtor company is defined as any company to which the RE has, or previously had, a loan or investment exposure in the preceding 12 months. Circular 1 required REs to liquidate their investments in AIFs within 30 days of the date of the downstream investment by the AIF or the effective date of Circular 1, if the RE had already invested in an AIF with downstream investments. In the event the RE was unable to liquidate its investments within 30 days, the RE was required to make 100 percent provision on such investments. Circular 1 also mandated that the full value of the investments by REs in subordinate units of AIFs having a priority distribution model be deducted from the RE’s capital funds.

Based on stakeholder feedback, the RBI subsequently introduced certain relaxations to these requirements through Circular 2. First, Circular 2 permitted REs to invest in AIFs which had directly or indirectly invested only in the equity shares of the debtor company of the RE (and not in debt or hybrid instruments of such debtor company). Second, the requirement to create 100 percent provision in the event of failure to liquidate the RE’s investment in the AIF was limited to creating a provision over 100 percent of the AIF’s investment in the debtor company instead of over 100 percent of the RE’s investment in the AIF. Third, Circular 2 clarified that the requirement for capital deduction in case of investments in subordinate units of AIFs was limited to instances where the AIF did not have any downstream investment in the RE’s debtor company.

The New Directions

The New Directions provide REs with some leeway to invest in AIFs that have downstream investments in their debtor companies. However, at the same time, the New Directions also put in place caps on all investments by REs in AIFs and not only on investments in AIFs with downstream investments in debtor companies.

The key features introduced by the New Directions are set out below:

Permissible thresholds for investments in AIFs

The New Directions restrict investment by an individual RE to 10 percent of the total corpus of the AIF and the total investment by all REs in an AIF to 20 percent of the AIF’s total corpus. These threshold-based permissible investment limits are wider than the restrictions under Circular 1, read with Circular 2. Circular 1 regulated only investments by REs in AIFs with downstream investments in debtor companies and in subordinate units of AIFs. By contrast, the New Directions are applicable to all RE investments in AIFs, irrespective of the investment pattern and unit structure of the AIF.

Investments in AIFs with downstream instruments in debtor companies

Unlike Circular 1, the New Directions do not contain a blanket prohibition on REs investing in AIFs having downstream investments in debtor companies. Under the New Directions, REs are permitted to invest up to five percent of the AIF’s corpus in such AIFs without any consequent compliance obligation on REs. However, in the event the RE’s investment in an AIF with downstream investments crosses the five percent threshold, the RE is required to make 100 percent provision of its proportionate investment in the debtor company through the AIF, subject to a maximum of the direct investment exposure of the RE to the debtor company.

This obligation for an RE to maintain 100 percent provision does not apply where the AIF’s downstream investment in the debtor company is only through equity instruments. In this regard, the New Directions have expanded the scope of equity instruments (which, under Circular 2, was limited to equity shares of debtor companies) to also include compulsorily convertible preference shares and compulsorily convertible debentures. It should also be noted that, unlike Circular 1, the New Directions do not provide REs the option of liquidating their investments above the five percent threshold within a specified time period to avoid the provisioning requirement.

Exemptions

The threshold restrictions of 10 percent and 20 percent as discussed above, are not applicable to outstanding investments or commitments made by an RE made with the prior approval of the RBI under the RBI (Financial Services provided by Banks) Directions, 2016. However, for investments and commitments made from and after the effective date of the New Directions, REs would need to comply with the threshold caps in relation to their investment in AIFs.

Further, the RBI may, in consultation with the Government of India, exempt certain AIFs from the scope of the New Directions. This means that if an RE invests more than 10 percent, or two or more REs invest more than 20 percent, in a notified AIF, the RE would not be in breach of the New Directions. However, even in such cases, the RE would need to have an investment policy governing its investment in the AIF.

Continued relevance of Circular 1 and Circular 2

The framework provided under Circular 1 and Circular 2 will continue to govern all outstanding investments of an RE in an AIF that were made before the issue date of the New Directions. In respect of investments made by an RE based on an existing commitment as on the issue date of the New Directions or a new commitment entered into before the effective date of the New Directions, the RE has the option of following either the New Directions or Circular 1, read with Circular 2. Thus, an RE that makes an investment in an AIF after January 1, 2026, pursuant to an investment commitment made before January 1, 2026, may choose to comply with Circular 1. This might be commercially advantageous for an RE that is investing in an AIF which has no downstream investment in a debtor company, as the RE would not be restricted by the investment caps provided in the New Directions.

However, the New Directions would have to be mandatorily complied with for all investment commitments made after the effective date of the New Directions.

Conclusion

The New Directions will bring some respite to REs in relation to their investments in AIFs. Marking a shift from a blanket prohibition, the New Directions permit investments by REs in AIFs that have downstream investments in debtor companies, subject to certain compliance obligations. REs would also benefit from the optionality that the New Directions provide for investment commitments made prior to the effective date of the New Directions.

However, the New Directions have also expanded the scope of regulation from regulating only investments through AIFs having downstream investments to regulating investments by RE in AIFs more generally. This raises questions regarding the intent behind the New Directions as they now go beyond the initial stated purpose of preventing evergreening of loans. AIFs and REs should also keep in mind that the due diligence requirements prescribed by the SEBI Circular would have to continue to be complied with.

While the practical effect of the New Directions remains to be seen, they are likely to affect financing plans of AIFs that rely on REs for their funding requirements. The New Directions may also lead REs to diversify their portfolio of investments in AIFs in light of the investment thresholds and to avoid provisioning obligations.

This insight has been authored by Aparna Ravi and Divyanshu Sharma from S&R Associates. They can be reached at [email protected] and [email protected], respectively, for any questions. This insight is intended only as a general discussion of issues and is not intended for any solicitation of work. It should not be regarded as legal advice and no legal or business decision should be based on its content.