Private credit 2.0 expands beyond traditional uses, set for growth in India

Private credit solves two gaps in the market: It helps where the banking system is unable to and offers bespoke solutions to corporate borrowers' specific needs

Private credit investments in India were close to $10 billion in FY24; it is projected that total assets under management in this space will touch $60-70 billion by 2028, according to an EY report. Such credit has historically been driven by global capital investing in non-convertible debentures via the foreign portfolio investment route. However, a large part of its growth is now fuelled by domestic funds, which are mostly structured as Category-II alternative investment funds (AIF) registered with the Securities and Exchange Board of India and target a mix of offshore and domestic capital. High-net worth individuals and family wealth offices have found the higher risk-reward profile of such investments appealing and contributed to its growth.

 

Private credit has been able to solve two unique gaps in the market. First, the ability to fund use cases where the banking system is unable to lend due to regulatory restrictions and more stringent lending norms. Acquisition finance and leveraged buyouts being one example. And second, the ability to offer bespoke lending solutions that meet the specific requirements of corporate borrowers.

 

Restrictions under the Companies Act, 2013 prohibit public companies from providing any security or financial assistance in connection with the purchase of their own shares. As a result, lenders are unable to secure their exposure against assets of the target in a leveraged buyout, which is why most such transactions are backed by shares and sponsor-level guarantees. Banks are unable to lend in such instances, which is one of the reasons why private credit has emerged as the go-to capital for acquisition financing.

 

Founders looking to increase their equity positions or provide an exit to private equity investors have also looked to private credit as a solution. In several such structures, returns are pegged to the growth in equity value and include both a fixed income and “equity upside” internal rate of return-linked component. The other key “pull factor” is that private credit can be flexible. Several deals involve back-ended capitalised interest structures or a combination of cash coupon and redemption premium. This has proved to be a particularly useful solution for borrowers looking to manage cash flow mismatches in business cycles.

 

Flexibility in structuring returns has prompted technology platforms, startup founders and mid-sized companies to turn to private credit as a source of growth capital. In many cases, investors have been able to offer a hybrid (debt and equity) financing solution involving a combination of non-convertible debentures, convertible instruments or warrants. A key advantage is that it allows founders to limit equity dilution and reduce the cost of borrowing. Restrictions under foreign exchange regulations that limit the ability of offshore investors to invest in optionally convertible instruments have meant that a large part of the capital to midsize borrowers looking for growth capital has come from domestic funds.

 

Private credit has also become a useful source of funds to meet pre-initial public offering, or bridge financing, requirements where returns could partially be linked to the post-listing price. Private credit fund mandates cover the full spectrum, from performing credit to special situations, and cut across sectors with direct lending to real estate, renewable energy, and manufacturing likely to get the most deal flow.

 

Given most onshore funds are structured as AIFs and not subject to stringent lending norms, there has been some concern expressed by the central bank about “knock-on” systemic risks of such investments to regulated entities. The Reserve Bank of India (in December 2023) had issued a set of rules aimed at regulating bank and non-banking financial companies’ exposure to AIFs linked to ever-greening of loans (indirectly via investments in AIFs). As the private credit ecosystem grows, there is likely to be more regulation and scrutiny of investment structures.

 

Most private credit deals tend to be highly structured and negotiated, as a result of which, the secondary market is fairly limited. Greater regulation and transparency will not only deepen the secondary market but also ensure continued growth of private credit.

 

The writer is partner (head-fintech), Shardul Amarchand Mangaldas & Co