Credit Solutions

Crystal gazing: how private credit can deliver on the investment promise

November 2023

Read Time: 5 minutes

Private credit is a rapidly growing asset class in India that is poised to bring transformative change to the credit market. This growth is driven by various factors including a thriving entrepreneurial ecosystem, a large universe of high-quality businesses, increasing investor awareness and confidence in this asset class, and consistent tax treatment across debt products. To ensure desirable and sustainable investment outcomes over multiple fund cycles, investment managers in the private credit space may need to evolve and adapt to changing market dynamics and emerging opportunities. As it matures, private credit is primed to transition from being solely a financial product to becoming a versatile capital solution that caters to the various capital requirements of established businesses.

Companies will typically have diverse capital requirements at different stages of their business journey. Since the global financial crisis in 2008-2009, as well as more recent events such as the IL&FS credit crisis and the pandemic, and increasing regulations, the credit market had become more focused on either bank debt-like traditional products or public market products available mainly for companies with AA- ratings and above. With fewer wholesale non-banking financial companies (NBFCs) operating today, private credit, facilitated through funds have come to the forefront as an important financing option, meeting the needs of Indian mid-market companies and their promoters.

Currently estimated to be at USD 4 billion in transaction value in 1H CY23 compared to USD 5.3 billion for CY22, the private credit market in India is experiencing strong demand from companies for bespoke financing solutions. There is also an increasing appetite for this asset class among domestic high-net-worth individuals (HNIs) and institutional investors. Initially, investors were attracted to private credit to offset the low returns in traditional debt products. However, recent tax changes for Market Linked Debentures and Debt Mutual Funds have created a level playing field for all debt products, including Credit Alternative Investment Funds (AIFs), resulting in the emergence of many new funds within a short period. A sudden influx of capital in this alternate investment asset class may put some pressure on yields in the near term until the market settles and the demand picks up.

Private credit funds are pooled investment vehicles that primarily engage in non-bank lending. These funds offer debt or debt-like instruments to companies or promoters to fulfill specific needs in appropriate structures for a particular situation that may not be met by traditional debt providers due to specific lending norms, regulations, or differing outlooks on industry/business and risk appetite. These needs may include promoter funding, acquisition financing, capital structure optimization, special situation funding, bridge loans for initial public offerings (IPOs), growth financing, distressing funding, and more. Most of these custom financings are directed towards private companies, with yields ranging from 12% to 18% for performing credit, 18 to 20% for special situations and 20%+ for distressed funding. Private credit financing commonly involves fixed contractual returns, and in certain instances, the structures are designed to optimize returns while also presenting upside potential. While potential for unlimited upside may not be available like in equity investments, downside risks are also mitigated through safeguards such as majority ownership of the operating business, charge on assets, promoter guarantees, etc. These measures grant the fund an ability to exert influence and control over the company and the outcomes, if deemed necessary.

As market cycles become shorter and more volatile, investment structures may have to evolve to enable investment managers to be agile in seizing market opportunities and navigating investment cycles over a 5 to 7-year period. Instead of solely relying on a single product strategy, investment managers may find it advantageous to explore the utilization of multiple financial instruments to enhance their investment strategies to capture the potential upside of equity-like participation while also managing risks via the security of debt-like instruments. By incorporating products such as convertibles, hybrid structures, and other innovative solutions that combine the unique characteristics of different instruments, investment managers can provide added flexibility and potential for superior investment outcomes over a fund cycle, while addressing complex funding needs of investee companies more effectively. While it may not be suitable for all situations like buyouts or early-stage funding where risk capital is required, private credit has the potential to serve a larger market need which might be currently served by traditional debt or in some cases pure equity. Institutional credit solution platforms with an understanding of different asset classes, deep sector knowledge and comprehensive coverage of the ecosystem will be better suited to understand and meet the requirements of businesses, optimize the capital structure by evaluating and selecting an optimal combination of instruments and control exit outcomes.

This comprehensive strategy is well-positioned to expand the scope of private credit applications, serving as an alternative solution in various scenarios for established businesses with predictable business models. Given its ability to supplant traditional and alternate pools of capital at both ends of the debt and equity spectrum and play anywhere in between, private credit has the potential to become the preferred choice for many private capital needs; and in the process of this transition, it can evolve from being a mere ‘Private Credit fund’ to truly becoming a ‘Private Capital fund’.

(This article was first published by Business Standard)

Author: Nilesh Dhedhi, Managing Director & CEO, Avendus Finance Private Limited and Niyati Tanna, Executive Director, Avendus Private Equity Investment Advisors

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