Why Private Credit Funds Need Careful Watch
Non-Banking Financial Companies (NBFCs) are steadily shifting their focus toward retail loans, although some are now in the process of rebuilding their wholesale loan portfolios. Simultaneously, several startups are veering away from raising equity capital at discounted valuations. The world of debt mutual funds has witnessed net outflows, as its once-favourable tax treatment was levelled with other fixed-income products due to the removal of indexation benefits. The influx of fresh capital has dwindled, courtesy of tightening market conditions. Consequently, private credit funds find themselves in a more advantageous position when negotiating for higher interest rates, given their status as a scarce source of capital for businesses. These private credit entities continue to tap into opportunities created by the shifting strategies of NBFCs, mutual funds, and conservative banks.
Typically, private credit funds (PCF) invest in the debt or hybrid securities of unrated and lower-rated companies. They offer debt financing to startups and early-stage businesses. While it's worth noting that private credit comes at a cost, this funding avenue imposes fewer stringent conditions than traditional lenders, providing an alternative for startups that wish to avoid significant valuation reductions through down rounds.
Private credit activity in India is experiencing robust growth momentum, with over Rs 30,000 crores deployed across selected transactions in the first half of 2023. With Non-Performing Assets (NPAs) of scheduled commercial banks currently at historic lows, the distressed asset investment pipeline is displaying signs of deceleration. As a result, fund managers are increasingly pivoting toward structured solutions for special situations, such as acquisition financing, bridge-to-IPO funding, and capex solutions. The National Asset Reconstruction Company Limited (NARCL) faces challenges and struggles to scale as originally envisioned.
India's financial landscape bears a resemblance to a AAA battery mindset. In this environment, mutual funds and non-bank lenders fiercely compete for credit-worthy "AA" and "A" rated businesses. Meanwhile, those rated "A-" and "BBB" find themselves turning to private credit for solutions. This shift is driven by disparities within the credit market, where mispricing of risks has led to significantly slower lending growth for companies holding a credit rating of A and below, in contrast to their counterparts in the AA and AAA rated segment.
Private credit funds step in to lend to these businesses at rates ranging from 12 per cent to 18 per cent, often dividing transactions into tranches. For the riskiest credit, returns can climb as high as 20 per cent to 24 per cent. However, this comes with a caveat: the risk of default is elevated, and exiting such investments can prove challenging owing to the illiquid nature of these securities. The structuring of credit varies, encompassing revenue-based financing, venture debt, special situations financing, real estate financing, among others. Some innovative funds are adopting creative strategies to cater to investor demands for enhanced returns. Particularly in credit funds, investments are structured in a manner that allows for risk to be staggered over time, enabling investors to select credit opportunities aligned with their individual risk appetites.
Yet, within this burgeoning private credit market, transparency and illiquidity are formidable risks. Lenders often enter these transactions with the intent of holding the debt until maturity, as private debt loans tend to lack the liquidity of broadly syndicated loans. Unlike publicly traded securities, where information flows relatively freely, private credit transactions occur in the shadows, granting investors only limited insight into the underlying risks. In the Indian context, where concerns over corporate governance and disclosure norms have previously arisen, this opacity raises particularly worrisome questions.
The emergence of a new asset class is undeniably exciting for a growing economy. Private credit can be a rewarding pursuit, but its allure often conceals the risks that lurk in the shadows of high returns. However, it raises important questions for regulators like the Reserve Bank of India (RBI) and the Securities and Exchange Board of India (SEBI). They must closely monitor the rapid growth of this industry, characterised by a lack of transparency both to regulators and the broader marketplace. Recollections of the 1992 stock market scam, with its convoluted handling of illiquid assets and various debt instruments like BRs (Bank Receipts) and SGLs (Subsidiary General Ledger) passing through multiple hands without actual cash in the account, serve as a stark reminder. Today, it's not uncommon to find the promoters who own lending institutions, also have stakes in Asset Reconstruction Companies (ARCs), or access to private credit funds. This situation creates the potential for activities that, to put it politely, could facilitate accounts moving within different entities.
Regulators must urgently establish comprehensive guidelines for fund managers to effectively manage liquidity risk. The financial services sector is known for its intelligence and creativity in packaging financial products, often giving the appearance of innovative solutions. It's at times like these that one must scrutinise the market intelligence and overall supervisory competence of financial regulators to ensure that these emerging asset classes do not become breeding grounds for misconduct and systemic risks. In the realm of private credit, investors confront various risks linked to governance standards, inadequate disclosures, management competence, operational performance, financial stability, and more.
However, it is also imperative for regulators to recalibrate their understanding of private credit funds, particularly if they had concerns about Asset Reconstruction Companies (ARCs) and Alternative Investment Funds (AIFs) being instruments for potential evergreening. This understanding is crucial, especially for licensed lending entities such as banks, NBFCs, and AIFs that operate their own private credit funds. These entities must uphold the highest standards of transparency to dispel any doubts. One might rightly question why regulators would permit existing lending institutions to establish their own ARCs or PCFs in the first place. But only the regulators know the answer.
The question that looms large is: What happens if a PCF, particularly one dealing in mezzanine funds or special situation funds (which are not obligated to hold assets against potential losses), needs to write off its exposure? Would regulators then demand disclosures to address systemic concerns should the credit quality of the companies that have availed these private loans start to deteriorate? These are vital questions that need thorough consideration and proactive measures from the regulatory authorities to safeguard the integrity of the financial system.
It's reasonable to assume that many of these private credit funds originate from various private equity firms. These firms frequently install highly capable managers, but these managers may encounter conflicts of interest when it comes to ensuring timely exits, maintaining a portfolio exposure that constantly incorporates mergers and acquisitions for improved returns, or mitigating losses. This can result in their portfolio entities being burdened with unwanted private debt. Furthermore, a significant issue arises concerning the potential conflicts of interest within private credit funds. These funds often extend loans to companies in which they hold equity stakes or possess other vested interests. This situation raises valid concerns regarding equitable treatment for all investors. Effectively managing these conflicts is paramount to preserving trust in the financial system.
Additionally, the risks tied to leverage in private credit funds should not be underestimated. In the quest for yield amidst a low-interest-rate landscape, these funds have turned to leverage as a means to boost returns. Although leverage can indeed amplify profits, it also has the potential to exacerbate losses, presenting systemic risks to the wider financial system. This concern is particularly pronounced in markets with underdeveloped debt markets, as is the case in India.
While proponents of private credit funds may argue that their sector offers valuable alternatives for investors seeking higher returns and that the flexibility they provide to borrowers can stimulate economic growth, it is crucial to recognise that these benefits do not negate the need for vigilant regulatory oversight. The opaque nature of private credit transactions, coupled with the potential for conflicts of interest and excessive leverage, can pose significant risks to financial stability. It's not about stifling innovation but rather about striking a balance between fostering investment and ensuring the integrity and resilience of the financial system. For example, Monetary Authority of Singapore (MAS) has adopted a proactive regulatory approach to oversee private credit funds. Private credit funds operating in Singapore are subject to licensing and regulatory requirements, which include stringent criteria for fund managers. Monetary Authority of Singapore ensures compliance with anti-money laundering and counter-terrorism financing regulations, promoting transparency and accountability. It also mandates fund managers to employ robust risk management practices and maintain adequate liquidity to manage potential risks effectively.
On a global scale, private credit constitutes approximately 10-15 per cent of the assets under management within the realm of private capital, encompassing private equity, venture capital, real estate, and more. However, the Indian debt market paints a different picture, characterised by its shallowness, with a significant portion of available funds channeled into government entities. This situation reflects a pronounced imbalance in India's banking landscape. Indian banks have long relied heavily on extending credit to large corporations and government entities as their primary client base. In contrast, in more developed debt markets around the world, both corporations and governments turn to bond markets for borrowing needs. This shift allows banks to redirect their focus towards retail banking, mid-sized enterprises, and smaller businesses, thereby diversifying their lending portfolio.
Hopefully, private credit, where risk often hides behind closed doors and creative finance, won’t become like walking through a financial minefield blindfolded. Transparency and vigilance are the cornerstones of a resilient financial system. In the realm of private credit, we must shine a relentless light on the shadows of risk, for ignorance is not an option. Regulators can’t say “I didn’t know”. Not again.
