Private credit is one of the most rapidly emerging asset classes in India over the last decade as an alternative investment option. It is growing as a medium of debt financing for startups, performing companies and other special situations.
Talking about the growth of the sector, Karthik Athreya, Director and Head of Strategy, Alternative Credit, Sundaram Alternates, mentions that India is moving in the direction of North American markets where alternate credit is 75-80% of all risk financing versus exactly the opposite in India.
“Proof of the pudding as far as private credit is that the AIF Cat II industry has grown from zero in 2013-14 to ₹6 lakh crores today! The AIF industry as a whole is approx. 20% of the MF industry in such a short span of time,” he said.
Anuj Kapoor, MD & CEO, Private Wealth and Alternatives Asset Management, JM Financial said that investment in private credit in India is estimated around USD 15 billion at the end of FY22 and continues to grow rapidly.
Also Read: Three Private Credit Funds Get Moody’s Warning on Problem Loans
Importance of private credit as an asset class
Investors have increasingly added private credit to their portfolios as a potentially higher-yielding alternative to traditional fixed-income strategies.
Tailored solutions: “Private credit is a significant asset class for investment portfolios, offering several key benefits that enhance and diversify financial strategies. Unlike public market assets, private credit allows for tailored solutions that can specifically meet investors’ individual needs and preferences,” said Prashant Mishra, Founder & CEO, Agnam Advisors.
Anuj added that the variety of private credit strategies, each with their unique proposition, means that a private credit portfolio can be structured to target a wide range of objectives and can be tailored to an investor’s individualised goals.
Yield enhancement: Private credit often offers higher yields compared to more traditional investments like public bonds or bank deposits. This is partly due to the illiquidity premium associated with private lending, as these loans are not as easily sold or traded as publicly listed securities.
“Private credit may provide a yield spread above public corporate bonds to compensate for the “illiquid” or non-tradeable nature of the investments,” said Arpita Vinay, MD & Co-CEO, Spark PWM.
The private credit universe often entails investments in relatively riskier market segments.
“However, investors typically measure performance based on risk-adjusted returns. For example, investing in AAA or AA bonds in India usually yields spreads of 0.5% to 1% more than government of India bonds. When investing further down the credit spectrum, the differential—or spread—over GoI bonds can increase substantially, ranging from 4% to as much as 10%.
Despite the higher risk associated with these investments, our long-term market observations support the viability of investments in this asset class. For instance, when compared to more established markets such as the U.S, the probability of default among lower-rated corporations is significantly lower in India as per default statistics published by Indian and Global credit rating agencies). This lower default rate, combined with the high yields offered by investing in private credit, more than compensates for the perceived higher risk,” said Raghunath T, Head – Credit at Vivriti Asset Management.
Arpita said that private credit has been less correlated with public markets than other asset classes, such as equities and bonds. This can help reduce portfolio volatility and improve risk-adjusted returns.
Different from public debt instruments: “Public debt instruments are often rated, listed and with some ability to exit through secondary markets versus private credit opportunities which are mostly unrated, unlisted and often closed-ended fund structures that require a higher risk threshold but with better returns to investors,” said Karthik.
Rohit added that the nature of risk & return of traditional public debt is very different from private credit investments.
“While traditional public debt is highly liquid, strongly rated and assumes mainly interest rate or reinvestment risk to generate inflation-like returns, private credit is thinly traded and assumes mainly credit risk to deliver double-digit returns. An efficiently managed portfolio of private credit investments can deliver superior risk adjusted returns as compared to traditional public debt. Unlike traditional public debt, investments in private credit can be tailored to meet specific investment criteria, such as loan duration, credit risk level, and covenants,” said Rohit, Co-Founder, Client Associates.
Risks associated with private credit investments
“Private credit looks at bespoke situations and drives specific outcomes. Apart from the credit risk, depending on the strategies employed, various other risks like market risks, security risks, legal and enforcement risks etc. come into play,” said Anuj.
Credit risk: The primary challenge in managing credit risk arises from the nature of the investments themselves — private companies often lack extensive public information.
“Investment managers must therefore engage deeply with these companies to understand their business models and perform a comprehensive analysis of their governance structures before committing capital. This due diligence is crucial as it helps mitigate the inherent risks of investing in less discovered and tracked entities,” said Raghunath.
Liquidity risk: Unlike more liquid investment avenues such as public debt, private credit does not offer the ability to quickly exit positions.
Investments are typically locked in for extended periods, ranging from three to five years, depending on the fund’s stipulations. This lack of liquidity requires investors to be prepared for a longer-term commitment, during which they may need to navigate periods of volatility or underperformance without the option to readily divest.
Dependence on key personnel: Arpita said that dependence on key personnel can also be a key risk component.
“The success of any private credit fund is highly dependent on the general partner and its management team who play a critical role in identifying, vetting, and structuring investments, and determining the appropriate time to either exit or realise the payoffs for those investments. The loss of one or more key individuals may have a material adverse effect on the performance of the fund,” said Arpita.
Operational risks: Operational risk in lending encompasses a variety of challenges, primarily focusing on the execution capabilities of lenders and regulatory compliance. “First, lenders must proficiently manage tasks such as underwriting, servicing, and the collection process. Effective execution in these areas is critical, as poor management can lead to loan defaults and financial losses. Additionally, lenders face risks associated with adhering to a myriad of regulations. Non-compliance can result in legal penalties and reputational damage, both of which can severely impact a lender’s business,” said Prashant.
How private credit funds manage risks
Prashant said that active due diligence, diversification between instruments and geographical locations and active management are some risk management strategies. In certain cases, investors can add covenants in terms by adding protective clauses in loan agreements.
Rohit believes that the default risk is the key risk which a private credit fund manager has to manage. “They do this by way of mitigating the default risk through two approaches – A) Diversification – this limits the exposure towards each borrower and therefore limits the impact of the default risk on the total portfolio. B) Adequately securing the credit by way of establishing an escrow account on the cash flows from the business which ensures visibility of the cash flows and channelizing the same towards repayment commitment. Secondly, securing key assets of promoters of the business in the favour of the fund with a clear and unencumbered path to monetise them in case of default,” said Rohit.
Arpita also said that having a diversified fund is recommended to manage these risks. “This strategy effectively spreads the risk across various sectors and borrowers, significantly reducing the potential impact of any single borrower default. Emphasising senior secured loans within this diversified strategy further safeguarded against capital loss, demonstrating the critical role of risk management in private credit investment. The structuring of the payment terms is also done in a way to match the operating cash flows,” said Arpita.
In conclusion, overall, experts believe that this asset class is here to stay. “With time and with the rapid growth of Indian investors, due diligence standards, transparency through SEBI instituted disclosures and a longer vintage and track record of fund managers will make it a highly sustainable asset class that is here to stay,” said Karthik.
Talking about future growth of this asset class, Anuj said that private Credit AUM in India is expected to reach USD 60-70 billion by 2028, which would be around 1-1.2% of the country’s GDP. In contrast, in more developed markets, such as the US, private credit is closer to 4% of the GDP.
Padmaja Choudhury is a freelance financial content writer. You can reach out to her at padmaja@padmajachoudhury.com.
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Published: 28 Apr 2024, 10:39 AM IST