Tailor Made Credit Solutions

Such funds have the flexibility to create bespoke credit solutions creating products that meet the specific commercial requirements of borrowers, for example, linking returns to operating cash flow, or extending capital for equity investor exits. A slow down in private equity capital has led to growth stage companies looking to private credit as a source of growth capital, which has the added advantage of “no sponsor dilution”.

Private credit has also become the “go to” source to finance end-use cases where banks may have regulatory restrictions from lending such as leveraged buy outs and sponsor backed credit structures. Historically, much of the private credit deal flow has been from offshore foreign portfolio investors, however, today, many investors invest via SEBI regulated category II alternative investment funds (AIF) set up in India.

Market & Regulatory Enablers

The development of a strong insolvency law ecosystem (under the framework of the Insolvency and Bankruptcy Code 2016) (IBC) has been an important factor that has contributed to the growth of the private credit space in India. While many lenders still hope for shorter resolution timelines (from the average 18-24 month time period), the IBC has played a key role in changing borrower behaviour and reducing enforcement risk. Many of the other enforcement avenues such as debt recovery tribunals and the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 are not available to unlisted AIF investments, making the IBC regime the anchor platform for private credit recovery. Several special situations and distressed debt funds rely on the IBC regime for their core recovery strategies.

Deal Structures

Private credit funds in India have invested across multiple asset classes, including real estate, infrastructure, manufacturing and technology covering special situations, performing credit, pre-IPO financing and growth stage investments. The underlying asset class determines pricing and deal size and the market has seen a wide range for both. Returns may be structured as a combination of cash coupon, redemption premium, capitalized interest and in some cases can also include equity linked returns.

Private credit investments are typically unlisted, not rated, highly negotiated and tend to be relatively illiquid. There isn’t much of a secondary market for private credit exposure. The pricing therefore is higher than the cost of traditional finance which makes it an attractive asset class for sophisticated investors able to take on riskier exposure.

A deal would typically involve a “deep dive” legal and financial diligence on the borrower, detailed covenants, tight security packages and for the more stressed situations could also include some level of operating and cash flow control via escrow and other account arrangements.

Regulations

The rapid increase in private debt capital has prompted regulators to look at solving for regulatory and systemic risks triggered by investment structures. In December 2023, the RBI issued a set of rules aimed at regulating bank and NBFC exposure to AIFs to address concerns linked have downstream investments in borrowers where such RE also has an exposure (Debtor Company). REs are required to either liquidate existing investments within 30 days from the date the AIF makes the downstream investment or make a 100% provision on such exposure. The RBI subsequently (in Marh 2024) clarified that equity investments by AIFs in Debtor Companies are permitted and that the provisioning requirement only applied to that part of the REs investment in the AIF which was then further invested in the Debtor Company. As the private credit market grows, we can expect greater regulatory scrutiny on investment structures. Unlike public bond markets aimed at protecting retail investors, the goal of private credit regulation will be geared more towards addressing market and systemic risks.

Conclusion

Regulators are focussed on creating an enabling regulatory environment for private credit recognizing the unique space it occupies in India’s debt ecosystem. Sovereign wealth funds, institutional investors, pension funds and family offices have all been key investors in the private credit space and will likely continue to commit capital to this asset class. Private credit is well positioned for year on year growth and the Indian credit market is expecting a continued increase in private credit deal flow.

This article was originally published in The Economic Times on 25 May 2024 Written by: Shilpa Mankar Ahluwalia, Partner. Click here for original article

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