Today, a majority of private credit platforms are structured as Securities and Exchange Board of India Category II alternative investment fund (AIF) entities, with the ability to access both offshore and domestic capital. High net worth individuals (HNIs) and family wealth offices have emerged as the largest domestic investor pool in such platforms. Many HNIs find the higher risk-reward profile of private credit investments appealing and have committed large amounts of capital to this space. The changes in the taxation regime for debt mutual bonds (introduced in 2023) have also, in some part, caused HNIs to look at alternative opportunities for fixed income exposure. Fund managers today cut across a wide range of risk profiles, including performing credit, stressed assets, and special situations. HNIs have the risk appetite to invest in higher risk-reward exposures and have been responsible for much of the private credit capital supply in the stressed asset space.

Private credit occupies a unique space in India’s credit market, demand for which has been steadily increasing. The non-banking finance company (NBFC) crisis in 2018 triggered by the collapse of IL&FS led to a tightening of liquidity, reducing credit access for many borrowers in the mid-sized, slightly stressed, or high-risk segments. Private credit funds are able to offer solutions to borrowers not able to access traditional bank finance. Take M&A or acquisition finance, an end use that banks cannot support. Private credit funds, however, have the flexibility to structure an acquisition finance deal backed by shares (with no asset-level security) that may also include an equity-linked return. Similarly, several companies in need of growth capital, sponsors looking to increase equity holding, or firms in need of pre-initial public offering bridge funding have turned to private credit for capital. Private credit funds are also able to mobilise capital quickly and can lend against less traditional security packages, adding to the more flexible nature of such capital. Fund mandates cut across a range of sectors including real estate, technology, manufacturing, financial services, and infrastructure. Many structures involve an equity-styled return that accrues via an internal rate of return linked to the net worth of the borrower or target entity and/or convertible instruments. The AIF platform makes it easier for funds to participate in these structures, allowing investors to create unique solutions to meet specific credit needs of borrowers. Slightly mature growth-stage firms are tapping into private credit as a useful source of capital without having to dilute their equity holding.

The supply of private credit is essentially non-bank capital and therefore not subject to prudential regulation or close regulatory oversight. The increased “supply side” of private credit capital has also triggered, in some cases, more aggressive pricing and underwriting strategies, making regulators concerned about the “knock-on” systemic risk implications that private credit lending may have. The Reserve Bank of India (RBI), in its Financial Stability Report (2024), highlighted the risk stemming from private credit given its interconnectedness with banks and NBFCs, riskier credit profiles of borrowers, and complex deal structures. It also noted that because the secondary market for private credit exposure is limited, valuation of risk is more opaque than what is available for other debt markets. These concerns have prompted the RBI to require regulated entities (REs) to account for “pass through” exposure.

In December 2023, the RBI issued a set of rules aimed at regulating bank and NBFC exposure to AIFs to address concerns linked to evergreening of loans. REs are now restricted from investing in an AIF that has downstream debt investments in borrowers where such REs also have debt exposure. If there are any such downstream investments, REs must make a 100% provision on the pro rata exposure. As private credit grows as an asset class, we can probably expect greater supervision by financial regulators over lending.

Private credit has bridged a large gap in the Indian credit market, and is well-positioned to see continued demand and supply-side growth. Increased growth also potentially increases market risk, triggering higher regulatory scrutiny. The goal of private credit regulation should ideally be to find the right balance between containing systemic risks and enabling credit access.

This article was originally published in Financial Express on 26 November 2024 Written by: Shilpa Mankar Ahluwalia, Partner. Click here for original article

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