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.
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.
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
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
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.
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.
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.
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