Since the beginning of 2023, the global financial system has been facing significant challenges with respect to high interest rates and inflation. Recent failures of Silicon Valley Bank, First Republic Bank and Signature Bank in the U.S. and loss of market confidence in Credit Suisse are some examples which show that the world is still adjusting to a tighter monetary policy.
Despite this, the private credit sector, particularly in India, is expanding due to robust economic growth, rising middle class, continuous business increment and development, and the present state of the macroeconomic cycle. The current regulations applicable to banks in India have made it challenging for them to lend to middle-market companies, leaving a funding gap that is being filled by the private credit providers. Private credit funds typically invest in debt or hybrid securities of unrated and lower-rated companies. Besides the holding company, there is an increasing trend of operating companies approaching private credit providers for capital growth.
What is private credit?
Simply put, private debt or private credit investments are in the form of non-banking lending in high yielding and illiquid investment opportunities in debt-like instruments and can include equity-like features such as preferred shares or hybrid capital. In India, the private debt investments are typically in the form of structured debt instruments, which are tailored as per the requirements of the issuer and the investor. Generally, these instruments are issued in the form of listed / unlisted NCDs subscribed to (a) under the FPI route (simple route and voluntary retention route) or (b) at a domestic level by NBFCS or SEBI registered alternative investment funds or other entities, or (c) by way of redeemable debentures or shares (under the FVCI route).
Key drivers behind the boom in the private credit market
As mentioned above, private debt or private credit investments are generally offered to mid-market firms, which are under served through traditional sources of finance such as bank loans. Various forms of private credit include distressed credit, senior debt, mezzanine finance, specialty finance etc. Private credit also provides flexibility to corporate borrowers on account of it being structured credits which provide debt servicing through various features including back-ended premiums, options and warrants. This stands in contrast to conventional commercial banks, which typically do not provide such structured credit options.
Certain key factors which are driving the growth of private credit market in India are:
Customised financing and end use
Unlike Indian banks, which are bound by tight regulations and can often be rigid with their financial terms - providing loans to selected sectors on a project basis etc. Private debt players not only provide highly tailored funding which helps issuer to grow in their capital structure, wherein coupons are linked to profits of the issuer or certain events/ dates, flexible repayment terms (unlike EMI), and also investments are made in all industry segments where banks may have end-use restriction or significantly higher exposure limits. Private credit can provide acquisition financing or capital for a company to get through financial challenges, sponsor financing, real estate development, business expansion, bridge to IPO, capex solutions, stress-related or special situations, refinancing of high-cost borrowing made available as a part of an out of court structuring.
Structured investments
Return of capital is a huge challenge in case of equity or instruments mandatorily convertible into equity. However, private debt investors can structure their investment as quasi-debt or quasi-equity or both. Such private debt investors can structure their investments in such a way that they have an option to protect their downside and to link their upside to the profits, share price, EBITDA of the issuer.
Raise funds quickly/ less time consumption
In case there are multiple banks/ lenders, raising of funds can become a time-consuming process. However, small and medium-sized enterprises are generally leaning towards private credit funding as the process is often faster since there is usually only one private credit provider at a time.
Covenants strong
Private debt is a corner of the loan market where covenants are still common. Most deals have at least one financial maintenance covenant, and this provides some protection to the investors. It often has covenants that provide greater structural protections to the investors as compared to covenant-lite structure (broadly syndicated loans or unsecured high-yield bonds).
Impediments or risks associated
Under the private debt market, the businesses of the issuers are characterised by opaque structures, valuations are untested, debt securities are illiquid in nature, yields are volatile due to the uncertain interest rate in the market. Consequently, the risk of default is higher and exiting from the investments may be challenging for the investors.
As investors continue to search for higher yields, the private debt market is expected to grow significantly in India, and it will help to broaden India's debt market. The sector has demonstrated consistent performance and appealing returns over the last decade. Family offices and high-net-worth individuals are also keen to augment the Indian private credit market through cheaper funds versus US dollar denominated foreign capital. The size of the Indian private debt market is currently at an early stage and small to demonstrate any large structural or systematic issues/ risks yet.
