Private Credit – An important addition in HNI investment portfolios
InCred Wealth July 24, 2023
Emergence of Private Credit
Private credit is fast emerging as a critical element in the debt portfolio for high-networth individuals. If we purely consider the credit investing options in India, the options can broadly be divided into:
a) Open ended products: Such as Sovereign bonds, Band FDs, Corporate NCDs/MLDs, Corp Bonds, Credit Risk Funds
b) Close ended products: Debt AIFs
The biggest difference between these two options (Figure 1) is the availability of liquidity on-demand (or in a short span of time) to the investors.
Traditionally, Indian investors had all their credit investing options in the open-ended format with a large portion of Indian savings being invested in bank FDs and / or in Corporate NCDs. These options on an average provided returns to the tune of c. 7% per annum.
Only in the last 8-10 years, Indian investors started getting access to innovative products in credit investing. These products were structured as close-ended credit focussed Alternate Investment Funds (AIFs) which could offer up to 13-20% returns per annum.
These Credit or Debt AIFs provided the potential of a big alpha in terms of higher yield to the investors while locking in investors’ capital for a defined period of time.
Not that from a yield perspective but also from a structure perspective Credit AIFs are innovative vehicles which allow investors access to an investing strategy which combines the best of private equity styled returns with debt like protection (Figure 2).
High potential but under-penetrated in India
It is interesting to observe the supply side of credit in India; with c. 75% of credit in the country being provided by either banks or NBFCs (Figure 3), in the wake of successive economic disruptions like demonetisation, GST, IL&FS led liquidity crisis and COVID; the banks and NBFCs in India are steadily pulling back from the market leaving a big supply gap in the credit markets.
This together with improving framework of contract enforcement and debt recovery is resulting in a big investment opportunity which investors can benefit from on a scalable and a sustainable basis
Another reason why credit markets in India are providing interesting dynamics is because at c. 55% of total GDP, India has amongst the lowest private debt to GDP ratio in large economies’ cohort (Figure 4).
Within the overall landscape, we believe that there is a big white space that has opened for investors to take advantage of within the credit rating zone of A- till B. This segment of credit markets was earlier catered to by small private banks, mutual funds, NBFCs and foreign investors. Due to the recent market disruption this entire market segment has become the exclusive playground for foreign investors and Indian investors participating via Alternative Investment Funds (AIFs). With yields between 13-18% (Gross IRR) to the investors, this has become an attractive market segment.
Traditionally, Indian investors had all their credit investing options in the open-ended format. Large portion of Indian savings were invested in bank FDs and / or in Corp NCDs. These options provide returns to the tune of c. 7% per annum.
Types of Private Credit Funds:
Private Credit as an investment class has various sub-strategies to invest into. These sub-strategies can be classified basis the life cycle of a typical company.
1. Early Stage / Start-ups : Funds operating in venture debt cater to companies at this stage of their life. The usage of money is to provide non-dilutive capital to fund cash losses. In this stage as the risk of failure is high; funds typically take equity upsides (in form of warrants) alongside fixed coupons. Investor should expect total IRRs in the range of 22%+ (gross at portfolio level) in these strategies. This IRR will be split 12-14% (fixed) plus balance in form of warrants upside.
Typical duration of funds in venture debt space is 7+ years with warrants upside realized in the back end of the fund life. These funds also generate regular income for the investor and distribute quarterly / semi-annual income to its investors.
These funds deploy capital quickly and lock in capital for longer period of time (due to longer tenor of the fund)
2. Emerging Corporates : Once a company achieves certain scale and is profitable; their risk profile reduces and simultaneously their expectation of cost of debt. These companies no longer are willing to give warrants/ equity upsides at the time of raising debt. Another important aspect is that their usage of debt no longer is to keep themselves afloat. Thei usage of debt is to finance their working capital or fixed asset creation. At this stage IRR that the fund makes is 17-18% (gross at portfolio level).
Typical duration of funds in this space is 4-5 years. These funds generate regular income for the investor and distribute income monthly to its investors.
These funds deploy capital quickly and lock in capital for longer period of time (due to medium term tenor of the fund)
3. Mid Corporates : Once a company achieves maturity and is profitable; it becomes a bankable corporate. As a result, their expectation of cost of debt is more bank rates. These companies no longer are willing to give warrants/ equity upsides at the time of raising debt. Another important aspect is that their usage of debt no longer is to keep themselves afloat. Thei usage of debt is to finance their working capital or fixed asset creation. Various credit funds provide debt to these companies only for a) usage which is non-bankable in nature or b) because these companies rating is still low. At this stage IRR that the fund makes ranges between 13-16% (gross at portfolio level). The IRR range is wide and is dependent on the situation for which money is lent for and the rating (or the lack of it) of the borrower.
Typical duration of funds in this space is 6+ years. These funds don’t generate regular income for the investors and distributions are irregular and event based.
These funds deploy capital over a long period of time (as the deployment is a function of finding such situations where corporate needs such money and heavy negotiations) and lock in capital for longer period of time (due to medium term tenor of the fund).
4. Special Situations/ Distress : Many credit funds also invest into companies who are going through financial troubles and need credit capital either a) for bank settlement, b) last mile capex or c) shoring up depleted working capital. These companies are facing financial troubles and, in most cases, have already defaulted to its existing banks.
Credit funds get involved in these special situation scenarios with a full understanding of the financial, legal and governance related issues in the companies. Hence the skill sets required are around all these three. At this stage IRR that the fund makes ranges between 18-22% (gross at portfolio level).
Typical duration of funds in this space is 8+ years. These funds don’t generate regular income for the investors and distributions are irregular and event based.
These funds deploy capital over a very long period of time (as the deployment is a function of finding such situations where corporate needs such money and heavy negotiations) and lock in capital for longer period of time (due to medium term tenor of the fund)
Past performance of private credit asset class
This asset class has been around for 8-10 years in India. CRISIL (which tracks the performance of this asset class) indicates that private credit AIFs across the market cycles in India have consistently beaten the open-ended fixed income products in India. This outperformance is the reason because of which total Category II AIFs (which includes private credit, Private Equity and Real Estate Funds) have grown to Rs 2.23lakh crores in a very short period of time. We believe that private credit in itself is totalling to Rs 30,000 crores and growing at 30%+ growth year on year.
What should investors keep in mind?
In last 5 years, Private credit has emerged as a sizable asset class for the investors. There are various sub-strategies and products which are available for investors to invest into within this asset class. We believe an investor need to keep following in mind before choosing the best product for themselves:
a. Margin of safety in this asset class is low : Because returns are capped in this class of investing. Hence choice of AIFs needs to be judged from the risk management and granularity (position sizing) of portfolio perspective. A fund which has best in class risk management policies and is focussed on position sizing should be first choice for the investors.
b. Hybrid funds are very common : In private credit it needs to be understood which fund is offering pure credit risk-return vs which fund is taking equity risks in garb of credit fund structure. A lot of products invest into debt securities where either a) returns are back ended or b) returns are dependent on happening of certain events (corporate or capital market). Such funds are effectively taking equity risks and should be evaluated accordingly.
c. Regular income distribution : Investors have a choice of funds which are providing returns on regular basis or on accrual basis. We believe that investors should choose funds which are distributing regular incomes to the investors.
d. Capital drawdowns : AIFs do not invest investors’ money in one-go. They scout for investment opportunities and once identified they call investments from their investors. Most of the time such capital calls from AIFs to its investors spread across few years. We believe interest rate cycle is peaking and hence funds which can lock in high returns for its investors immediately should be preferred over funds which take long period of time for capital calls.
View on Current Vintage : In our view, the current vintage is conducive for fixed income asset class. This is due to the run up in equity valuation over last 3-4 years, inflation and consequent interest rates globally. In these situations, fixed income is relatively more attractive as compared to equities. In these times, we suggest asset managers to take advantage of higher rates and lock in those rates for medium terms. With a view that in 3-4 years equity markets will become attractive again and this allocation towards debt can be rotated back into equity market then. The suggestion is to take exposure in medium term pure credit funds which can deploy capital quickly. The idea is to deploy quickly and take exposure in debt class for medium term. Hence ideal fund types will be Emerging Corporate Funds .