The Coming of Age of Private Credit in India Valuation

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The Coming of the Age of Private Credit in India

Kroll, hosted the second edition of its private credit conference in association with the IVCA. The event was divided into two panels.  The first panel was on the coming of age of private credit in India moderated by Rishi Aswani, Managing Director, Alternative Asset Advisory at Kroll. The second panel was moderated by Pratik Sengupta from Kroll and covered views on the emergence of private credit as an asset class from allocators of the Gulf Cooperation Council (GCC).

Opening Remarks (Rishi Aswani)

The event built on the prior editions of how private credit in India is one of the fastest-growing asset classes and why this is flexible solution capital that bank lenders cannot meet in short order. Bank lending growth has been retrenched over since the global financial crisis, equally so in India for a variety of reasons not limited to the recent NBFC crisis. Meanwhile, the need for capital is strong as ever, and there is still unmet demand by borrowers in the mid-market. On the macro story, if India is to reach the target of a $5 trillion economy, there will need to be liquidity and credit in the market. Given the current situation with bank lenders and the absence of a corporate bond market, private credit is expected to time the market favorably, much like it did in the United States and Europe after the financial crisis. Opportunistic private credit investors will find that their funds are still primarily being used to solve a particular problem other than growth. And so there is a long road ahead in terms of opportunities for this asset class.

Panel (Kapil Singhal, Managing Partner Credit True North; Dev Santani, Managing Director Brookfield Special Investments; and Eshwar Karra, the CEO of Kotak Special Situations Fund).

How We Got Where We Are

Private credit in India originated from being carried out in regulated vehicles, such as NBFCs, and borrowing traits from the banking sector in a structured, regulated and rated manner. It was also managed as a flow vs. a structured product, in the sense that there was a herd mentality towards lending towards borrowers that had certain names. There was also an alignment issue, incentivizing private credit managers by year-end bonuses and deal-making and not by asset management. The capital markets rewarded NBFCs with multiples of price to book valuations, and there was a lot of pressure to be on the treadmill and lend money out. In 2018, the tide ran out along with the NBFC crisis.  NBFCs and debt mutual funds left vacant today a lending space at 14% to 18% yield, where performing credit now sits in.

One of the biggest learnings is that one cannot increase their return and justify sub-optimal credit. A great amount of emphasis is laid on a smell test, which essentially means promoter quality. Funds have learned to walk away from a transaction no matter how attractive the returns appear because they may never see it materialize at the end of the day if it doesn’t pass muster. Asset management was highlighted as the critical make-or-break factor for private credit investments, even more than getting the underwriting thesis right.

Other risks that will not be underwritten would be businesses and sectors where are not ESG compliant, such as traditional energy sources that create pollution, etc. ESG is an important aspect of the lending process. One is making sure an investor is not doing something that is ESG negative. In terms of measurement of positive ESG, there are separate funds only making ESG impact investments.

The State of Private Credit in India Today

The credit space in India today is very polarized, with banks preferring to lend to A-rated companies, thereby resulting in slow credit growth. The mid-market has a large need for capital and is largely ignored by banks. Post refinancing situations and settlements for time-sensitive situations is where we see most private credit deployed; however, growth capital will be a big driver for private credit in the next few years. Private credit for growth will need to be priced accordingly, i.e., it will need to have a mix of base protection in terms of capital principle and coupon, but it also requires upside in terms of equity.

India has a certain risk premium as it is a developing country with its own currency, political system and credit rating agencies. Solving for a U.S. dollar hurdle is a challenge. Either the dollar hurdles have to come down globally for India, or debt in India has to operate truly as an asset class delivering debt-like returns in performing credit. Carries are also significantly higher for credit funds in India and will come down over time to global levels. Indeed, as the market matures, the hurdles should link to rupee rates rather than dollar hurdles. Some LPs already agree to this, and it will happen more and more.

Another unique challenge for foreign investors when they are underwriting transactions in India is that the cost of the hedging on the U.S. dollar is very high. Private equity sponsors have the ability to hold out if India hits a bad forex cycle and not sell the business till a spike passes. With credit, unfortunately, one has very limited control on the timing of your exit.

We’re even seeing private equity fund managers roll out private credit platforms for India at this time. Funds are assessing their own internal competencies and philosophies to evaluate if diversifying into a private credit business makes sense as they choose good business and promoters to back.  The trend goes the other way, too; there are credit strategy firms expanding into equity, too.

Asset Management in Private Credit

In terms of the realities of managing private credit investments in India, ultimately, returns boil down to exits, and this will be based on relationships as well as contractual obligations as well as how you manage the asset. All three parts need to be executed as an internally consistent whole: underwriting, asset management and exit.

What is key when things go wrong for private credit managers is to cut their losses and move on. That is on the asset management side. Debt is not a relationship product, and the most important element is building the risk management philosophy. Performing credit in India has typically seen two kinds of trades. One is on the operating company side that is cash flow driven, and the second is the holding company side that is basically event-driven and equity-event driven. Earlier, people thought that one is taking a debt risk simply because the instrument was debt. The instrument of investment does not determine the nature of the risk.

Unfortunately, borrowers in India tend to take covenants lightly because they are used to dealing with banks and NBFCs who never open their agreement after it is signed. Putting discipline early on is very, very important in most transactions. The second learning is even if you get the partner right, and structures are equity linked, the promoter will always try and renegotiate at the end. Investors do not want to get into a tussle for a few extra percent. They ultimately need to show an exit.

Some very positive developments in terms of pre-packs are emerging though. It is an excellent solution for funds to strike good deals and in terms of value creation for lenders because they will be able to reserve value before it goes into the entire IBC process. Pre-packs coupled with the recent national Bad Bank should present opportunities and a speedy resolution process.

One of the realities of the situation in lending is that the more you make as a private credit investor, the less the borrower retains. There tends to be a cap. Unlike in a private equity setup, both the investor and company can grow together. This makes private credit transformation capital for a finite period of time. The long-term providers of capital are either debt or pure private equity or public markets. This is somewhere in the middle, to solve a problem. That said the discipline has come around, and investors can negotiate risk-adjusted returns for a deal. A few deals, which have the potential of being multi-baggers, i.e., with uncapped returns, can get a manager back to fund-level returns.

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