PRIVATE CREDIT FUNDS

 PRIVATE CREDIT FUNDS?

Private credit Industry has been recently expanding at an exponential rate over the past few years as per Preqin till June 2021 the assets under management of private credit managers was $1.2 trillion suggesting the fact that the industry is trying to outgrow its earlier small time business roots with a lot of money sloshing around searching for attractive returns as central banks all over the world are following a tightening monetary policy to tame soaring inflation levels. As per a S&P Global report the private debt industry was having assets of around $412 billion dollars at the end of 2020.

 

A Reuters article stated that there is a 76% jump in the number of private credit funds targeting Asia following regional and India specific strategies. According to Global Private Capital Association, in North America around %150.1 billion of private capital was raised and a total of at least $2.5 billion of new credit funds were launched targeting the various growth opportunities in the region.

 

What does the above growth of private credit hold for India and how can such funds contribute towards India’s goal of becoming a $5 trillion economy by 2025. To start with we first need to understand the concept of a Private credit Fund and what it does and what are its benefits over traditional sources of finance.

What is a private credit fund?

Private credit funds are basically a pooled investment vehicle where investors lend money to small or mid-sized firms in return for collateral. Such funds follow a range of strategies, like direct lending, venture debt, or special situations, offering different varieties of debt for example, senior, junior, or mezzanine securities to both listed or unlisted companies, as well to real assets classes like the real estates and infrastructure. The following graph shows the asset under management of private credit funds complied by PEQIN.

 

 Sources of Funds for Private Debt

Collateralized Debt Obligations (CDOs) these are basically derivative instruments which derive value from a pool of debt instruments. Suppose a bank has a number of loan accounts given to various companies belonging to different sectors, the bank can group these diverse loans into a portfolio and sells pieces of it to other investors through the help of some specialised organization. Such a strategy allows the bank to raise cheap funds by selling the pooled portfolio of loans to a private credit fund who specializes in attracting investors who are ready to buy tranches of the pooled portfolio for higher yields.

Business Development Companies: It is a type of closed-ended investment fund that invest in small and medium sized companies as well as distressed firms, they usually raise funds by listing themselves on the stock exchanges. In return for lending funds, they get a part of equity or subscribe to bonds of the borrowing company. BDC’s are closely engaged in developing and mentoring the companies in their portfolios during the initial stages since it is in BDCs best interest to help them become successful. So, a BDC usually lends funds to a private credit fund with an expertise in lending money to small firms or companies in a particular industry or situation.

Major Categories of Private Fund

Since credit funds follow different strategies to invest there can be a number of categories of private credit funds, such as based on structural features of the fund, the duration of funds, the type of asset classes invested in or the quantam of liquidity of the investment instrument. Broadly the main type of funds are as followed:

Distressed Funds: These funds invests in the securities of a company which is facing financial distress, such securities are purchased at a discount from other investors. These funds use different types of startergies to generate attractive yields the most famous one being the restructuring of the distressed firm’s capital structure to create value. The concept of fulcrum security is popular among such funds where the fund recieves the equity of the company upon emergence from the bankruptcy process.

Mezzanine Funds: These funds invest in hybrid securiites which contain the features of both debt and equity. Such funds have originating platforms of their own to source transactions in the form of proprietory bilateral negotiations between the lender and the borrowers. Such funds typically offer fixed rate loans which further allows for extra rates due to the inherent asset specific risks or soemtimes often include warrants or other equity linked securities.

Alternate Investment Funds: These are special investment funds which are destined to lend funds to companies with a particular niche or category distinguished on the basis of a number criterias. These funds are usally pooled portfolios raising money usually from HNIs family offices or institutions like sovereign wealth funds. The three broad category operational in India as per SEBI (Alternative Investment Funds) Regulation, 2012 are;

Category I AIFs => allowed to invest in venture capital funds, infrastructure funds, angel funds

Category II AIFs => allowed to invest in private equity funds, debt funds, funds of funds

Category III AIFs => allowed to invest in hedge funds

Since AIFs are not directly affected by stock market performance and due to the large amount of pooled assets these funds offer flexibility to fund managers to modify the trading strategies to maximize returns.

Features

Aiding the Growth of SMEs:

The main advantage of such funds is that they are able to lend those small enterprises which are served by the traditional banking sector. Also, banks are reluctant to do business with companies that rely heavily on private debt mainly due to:

v  Poor amount of assets acting as quality collateral

v  Lack of accounting standardization/ transparency

v  Small size of operations

Hence such firms turn to private credit funds due to relaxed financing constraints, more flexible covenant structures and quick execution of loan agreements.

Since private credit funds lend to small firms which carry higher risk of default, such funds ensure a strict and regular monitoring of their portfolio companies. The primary methods used by funds to analyze the growth of portfolio firms are covenant checks, scrutinizing financial statements and periodic meeting with the board of the companies. Such streamlined practices surely motivate small firms to maintain an efficient system of checks and balances to maintain good relationship with their non-bank creditors. As per Preqin around 50% of banks require borrowers to supply with continuous information on a monthly basis, this amount is less comparable to 87% of private equity funds having such information sharing mandates.

Due to rising geo-political risks due to Covid-19 imposed restrictions and supply chain disruptions because of war in Ukraine there has been an increase in worldwide inflation levels and adoption of protectionist trade policies by countries. Such adverse developments are going to impact the operations of businesses which rely on sourcing of materials or natural raw materials as their cost of production will surely rise making it difficult for them to raise funds at favorable rates from banks or traditional sources. As a result, companies have been shunning the public markets for funds and going for private credit, even large companies who can easily access public debts are going for direct private credit due to more flexible financing options offered by private credit funds.

Reduction of Insolvency cost

Since as mentioned above private credit funds focus mainly on direct lending which involves fewer number of creditors as compared to syndicated loans (Patrick Bolton, 2009), making it easier for such funds to avoid formal bankruptcy proceeding by having an out of court settlement during times of default. Since small firms faces a lot of challenges in liquidation once admitted to bankruptcy court which leads to further collapse in value of the firm’s leftover assets. So small firms usually go for private credit more as compared to bank debt.

 Floating Rates and illiquidity premium:

Since private credit funds usually offer illiquidity premium mainly because they offer senior unitranche loans to companies lacking sound financials and accounting practices. The following figure shows the growth of illiquidity premium for such funds in USA.

 

Also, private credit are usually given on floating rate basis which tends to increase their desirability by firms since fixed interest rates which aren’t affected by the market gyrations offer the following benefits:

• v  Income increases with a rise in interest income for the fixed income investors

  v  Assets of the lending company aren’t subject to mark-to-market volatility. Since such fixed rate private loans aren’t traded in the public markets, they are less correlated with the market movements.

Privately Negotiated Terms & Structure

Since private credit involve direct lending borrowers work directly with the lenders tweaking the loan agreement conditions as per the current scenario. For example, in 2020 when a lot of companies landed up in distress due to tougher business conditions, a number of private lenders stepped in with amendments to help their portfolio companies maintain liquidity by allowing for extra capital infusion, postponing amortization schedule and so on. For firms that face liquidity issues due which are unable to get public funding end up going to private credit funds, hence private debt sometimes referred to as bear market capital.

 

TWO TIPPING POINTS

After the Global financial crises there were a number of regulatory amendments enacted by governments all over the world to limit the risk-taking activities of commercial banks who mainly provided most of the capital to businesses, which resulted in funding gap during the post crises recovery period followed by world over Central Banks quantitative easing mechanisms, resulting in the following funding gap as shown in the diagram:

 Also, the rising demand for private credit during the current times is one of the potent reason for the growth of this industry which offers benefits such as flexibility, certainty of execution and critical support such firms can provide to their borrowers during time of distress, which has resulted in private credit market worth $1.2 trillion. Part of this growth have been due to the risk averse behavior of traditional sources of lending due to higher uncertainty engulfing the world, as many manufacturing companies faced difficulties due to disruption of supply chains resulting in financial distress leaving them financially exposed to the vagaries of cyclical business fluctuations.

The above two sources are the main push factors for the emergence of private credit funds as an attractive alternative to the orthodox sources of funds which has resulted in an ever-expanding universe of such funds as is evident from the following graph which shows the proportion of funds raised by different types of private credit funds since 2007.

 Credit Funds Structure used for Hedging:

The structure of private debt funds can be modified to shield the returns from a number of returns such as exchange rate risk, the withholding taxes or SPV taxes, etc. For example, in Europe credit funds are based on the limited partnership structure which deploy funds through a Special Purpose Vehicle (SPVs), so that such funds can access the tax treaties or domestic tax exemptions related to the investee jurisdiction. But recently OECD is lobbying for the BEPS rules which has prompted such funds to question the existing SPV structure as a way to benefit the lacunas of different tax regimes in different countries. The managers of a private credit fund to hedge against the exchange risks sets up currency sleeves which are structured as parallel partnerships alongside the main fund. The currency sleeves include all the investments which are made in currencies apart from the functional currency of the fund. The case of Luxemburg is very important since it’s the most preferred EU destinations to set up credit funds because of the three regulatory structures which foster the limited partnerships such as the Special Limited Partnerships, Common Limited Partnerships and the partnerships limited by shares, such structure tends to reduce the regulatory compliance and cost of administrating corporate governance by ensuring regulation at the managerial level rather than enforcing laws at the funds level.

 

CASE OF INDIA

The expansion of private credit funds in India will play a crucial role in addressing a number of issues. But first we need to account for the developments towards the industry in India. Recently seven credit funds under the AIF category were registered with SEBI in the first quarter of 2022, also lot of private equity and global funds are creating or already operate Indian focused private credit funds such as Avendus’s Structed Credit Fund II with a total corpus of $ 130 million or KKR’s Asia Credit Fund with dry powder of around $1.1 billion and many more each having its own unique credit strategy.

According to a survey conducted by EY of credit fund managers majority of these funds invest in sectors related to manufacturing, retail and real estates as the various schemes aimed at improving the capital expenditure such as the Production Linked Schemes or the Gati Shakti Scheme are going to create a lot of credit opportunities for such funds. Hence, these funds will help the economy to increase its infrastructure growth which will boost the efficiency in a number of industries such as automobiles, specialty steel, hydrogen-based plants, etc. The following graph shows the ranking of industries on the basis of funds deployed by credit funds in the next 12-24 months.

 

The legacy issues of non-performing assets at the Indian Banks can be solved with these funds as they promote out of the court solvency procedures along with reduced number of borrowers. Since the average time taken for resolution under the CIRP’s is about 561 days which doesn’t include the time taken for admitting the case in the court. Since private credit funds offer specially structured deals in case of default which can help the creditors in attracting as much as value from the assets of the distressed company during the resolution process. 

There has been a decline of funds deployed by banks and traditional NBFCs in the wholesale sector, an EY report mentions that for September 2022 the retail book for NBFCs increased by $11 billion whereas credit to real estate sector has grown by only $1.1 billion.

The above graph shows that investment of big-ticket amount draws less funds from private banks whereas small amount loans consisting of retail or personal loans attract good amount of investors. So private credit can help in closing this funding gap for the wholesale loans. Also, Emphasis of data localization along with government’s push towards capex investment in roads, railways, affordable housing, power infrastructure, etc. is going to create a lot of opportunities for credit funds.

The tighter liquidity conditions, geopolitical risks and the pursuit of protectionist trade policies by the west countries have negatively impacted the valuations of Indian startups, since only $3 billion of capital was raised by startups in Q1 of 2023 as compared to $12 billion in Q1 of 2022, the Indian Startups have been reeling under pressure of gloomy business prospects due to the war in Ukraine which is affecting their business models since these are small scale firms who are yet to achieve profitability. According to a report the Venture capital funding of startups fell to a 21-month low with only $2.8 billion raised across 387 deals, the private credit funds can help to plug this funding gap for these startups. Also, a lot of Indian startups lack proper guidance in terms of management, identification of markets and industry experiences as a result the startup ecosystem is limited to Tier-1 cities in India. As we already know that private credit funds do offer management and other consulting services to the borrowers helping them overcome the challenges of the business world, the following diagram shows the results of a survey of fund managers about the prospects of the industry in India. 

 

So private credit funds can be a potential tool towards realizing India’s goals towards economic development, according to the EY annual survey 76% of fund managers believes that the sentiment for the industry is positive mainly due to shift in focus of NBFCs from wholesale debt to retail loans. 

Since to promote economic growth India will be requiring a lot of credit supply but the shift in lending practices of traditional banks and NBFCs towards retail segment and the digital lending area have created a massive funding gap to firms with uncertain growth potential and higher risks this combined with a shortage of liquidity and mispricing of credit in today's scenario have created various opportunities for private credit funds to grow. And in India the growth of AIFs can be a door into the metamorphosis of the private credit industry as is shown below in the form of CAGR of the AIF industry in India.

Hence favorable government regulations like the initiation of GIFT city along with various tax incentives plus SEBI's various amendments towards the functioning of AIFs and the participation of more domestic players like Kotak real estate funds or Edelweiss Investment funds,etc,. will definitely help in the expansion of India's private credit sector.