The supply of credit remains an undeniable catalyst for the growth of the Indian economy. In its journey to becoming a US$5 trillion economy, India requires a credit supply that amounts to ~50% of that targeted economy size. Meeting that supply size could be a daunting task unless private credit markets mature in India. This is because banks and NBFCs have been increasingly shifting their lending mix towards retail over the last few years due to the advent of technology-led lending models as well as risk aversion towards corporate lending.
The perennial need for private credit has already been realized, not only in India but across the world. Globally, private credit accounts for 10-15% of assets under management under private capital, which includes private equity, venture capital, real estate, etc. Post the pandemic, the surge in liquidity in the global market has shifted a lot of investment in private credit towards emerging markets, including India, where it gained major traction due to favourable economic and administrative reforms.
Private credit opportunities in India
The opportunities for private credit in India emanate from structural issues in the debt market. Following the global financial crisis, the banking sector became increasingly risk averse towards the mid-corporate space. Asset managers sharply cut down their allocations to the mid-corporate segment since 2018-19, following defaults by IL&FS, and the freeze of withdrawals in the credit schemes managed by Franklin Templeton. On the other hand, non-bank lenders in corporate lending largely migrated to retail / MSME credit, after facing a liquidity crunch in 2018. As a result, the mid-market enterprises (comprising privately owned companies majorly located in tier 2/3 cities) have faced a pronounced lack of access to debt.
The opportunities are also arising out of asymmetry in the credit market and mispricing of risks causing much lower growth in lending to companies with a credit rating of A and below compared to the same in the AA and AAA rated universe.
The above factors have resulted in a massive gap in the private credit market and consequently significant opportunities for private credit to grow. With a shortage of liquidity and mispricing of credit, the universe of corporates rated below AA offers rich risk-adjusted returns to discerning lenders.
Shift towards AIFs
When it comes to the type of structure that is needed for the growth in private credit, Alternative Investment Funds (AIFs) fit the bill. The surge in the industry’s commitments raised, which denotes the amount clients are willing to invest in AIFs, in recent years strongly depicts the phenomenon of AIFs playing that vehicle of growth for private credit. Thanks to their flexible structure (with respect to investment in unlisted entities, etc) and regulations supporting the investment vehicle.
AIFs have been able to take care of the supply side for private credit by raising funds from HNIs, family offices, corporate treasuries, and institutions in the domestic market over the last few years. Despite the recent surge in interest rates, the segment still looks attractive.
Performing Credit as a segment within Private Credit
Within the private credit space, India has witnessed the highest attention towards real estate funds, special situation funds, venture debt funds, and distressed funds. While these funds meet the specific needs of the market, these funds typically seek IRRs of more than 16%.
This leaves a large gap in the market, as evidenced in the graph below.
With MFs typically lending at finer rates, and venture/distressed/RE/special situation funds above 16%, the space between 8% – 16% is quite wide open. This space consists of cash flow-based lending to operating companies, focusing on growth, long-term working capital, capital expenditure, etc.
What’s in it for investors?
The above chart depicts that as we move away from AAA to AA rated bonds down to BBB rated companies, a lucrative opportunity for investors exists in a white space, known as the Performing Credit, which lies between mutual funds and distressed debt funds & others at the two extremes. Investment opportunities in this space are expected to go up to $100 billion in the next 3 to 5 years.
The environment for growth in the private credit space including the performing credit is favourable from the demand side. Mid-corporates that are unrated, or rated in the range of BBB and A, are growing well at a pace higher than witnessed by large corporates. Our analysis indicates that 15,000+ such companies exist that are profitable at an OPBITDA level (Operating Profit before Interest, Tax, Depreciation, and Amortisation).
Fresh capital has been drying up due to the tightening of markets. Hence, private credit funds get more advantage to negotiate for higher rates as a provider of scarce capital to enterprises. India’s excellent rating and data coverage offer non-linear opportunities compared to any emerging market. Given these, it is possible to build a truly diversified and stable performing credit portfolio.
Risks in the space
In the private credit space, investors face risks, arising from governance standards, poor disclosures, management capability, operational performance, financial situation, etc. However, with some of the recent regulatory steps and professional fund management, such risks can be mitigated ensuring stability and predictability of returns.
The Insolvency and Bankruptcy Code, enacted in 2016, imparted confidence to lenders about the covenants getting adhered to if the borrowing entity turns insolvent or sick. Secondly, the introduction of the Account Aggregator framework in 2021 created Account Aggregators to act as intermediaries between financial services providers and facilitate sharing of financial information. The framework enabled transparency and the scope for efficient decision-making about borrowing entities. Information asymmetry has been reduced in the recent past with such measures – providing lenders with access to related party information, GST data, bank statements, financial disclosures, etc., for detailed governance checks.
Choosing a highly professional fund manager is extremely useful while investing in the space. Investors should look at fund managers that leave no stone unturned for strict due diligence, comprehensive business monitoring to reduce information asymmetry, excellent sourcing ability, tight quarterly monitoring, and accurate pricing of risks, among several factors.
GIFT City – a new window of opportunity
International Financial Services Centre Authority (IFSCA), the regulator at GIFT City, Gujarat was set up to undertake financial services transactions that are currently carried outside Indian soil by overseas financial institutions and foreign subsidiaries of Indian financial institutions. New regulations issued by IFSCA in April 2022 could aid the next level of growth for private credit funds by providing a framework comparable to Singapore and other global asset management centres for setting up funds.
AIFs set up within IFSC have been granted special dispensations to provide them with higher operational flexibility. The regulatory and tax framework set up within the GIFT City has the potential of unlocking access to large global pools of capital. For meeting a US$ 100 billion need, the infrastructure provided by the GIFT City is much needed for private credit managers to scale and meet the need of the market.
The article has also been published in Mint (Online) on February 4, 2023. You can read it here:
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Disclaimer:
The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.
