Private credit is the buzzword on deal street. The global private credit market is estimated to be US$ 1.5 trillion and likely to reach US$ 2.7 trillion by 2027. While most of this is centred around the United States and Europe, private credit is rapidly becoming an alternate pool of debt capital in India. Some reports estimate that private credit investors had almost US$ 15 billion of assets under management in India as of December 2022 and over US$ 4 billion was deployed in the first half of 2023 alone.
In the aftermath of the crisis in the non-banking financial sector, many non-banking financial companies have focussed their attention to the retail sector and are re-balancing their wholesale debt exposures. Indian banks, who have recovered some of their non-performing loans thanks to the Insolvency and Bankruptcy Code, 2016 (“IBC”), have pulled back from riskier corporate loans. As a result, there is an increase in demand for new avenues of debt capital. The IBC has brought about a robust insolvency regime and in the last seven years, more than 800 resolution plans have been approved and creditors have realised over Rs. 3.16 trillion. Several promoters have lost control over their companies and creditors have truly been in the driving seat for the first time in India. Not surprisingly, debt alternative investment funds have mushroomed in India over the past few years, and global and Asia Pacific credit funds have also steadily increased their allocation to India.
Private credit, as a substitute for traditional forms of financing, is gathering tremendous momentum across all types of borrowers and transcending different sectors. Flexibility in structuring the deal and minimal end-use of proceeds, coupled with the speed of execution and certainty of funding are some of the reasons why Indian borrowers have been lured to borrow from private credit investors.
While the future of private credit looks resilient, to ensure that it remains buoyant for a long time period, private credit investors must thoroughly evaluate risks and rewards before deploying their capital. In addition to commercial factors such as diversifying their portfolio and assessing and monitoring the borrower’s creditworthiness and cashflows, investors need to concentrate on legal and regulatory risks and address any concerns with the help of able professional advisors. Some issues that private credit investors would be prudent to consider are given below.
Understanding the regulatory landscape: India is a regulated economy and private credit investors must thoroughly review the regulatory regime that would apply to their investment and their borrower. Most private credit investments have taken place in India through either alternative investment funds (“AIFs”) or foreign portfolio investors (“FPIs”), both of which are regulated by the Securities and Exchange Board of India (“SEBI”). For example, category II AIFs may need to have more than 50% of their investments in the form of unlisted instruments, which currently do not benefit from the provisions of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (“SARFAESI Act”) that allows for speedier enforcement of certain type of assets. Further, any foreign debt investments into India are also governed by regulations and circulars issued by the Reserve Bank of India (“RBI”). For instance, FPIs are not allowed to invest in unlisted non-convertible debentures if the end use is to purchase land. Also, Rupee denominated debentures issued by Indian companies which are guaranteed by persons outside India must have a minimum average maturity of three years. Additionally, sector specific laws and regulators could be involved depending on the business of the borrower. Illustratively, if the borrower is an insurance company, there are compliances for creation of pledges on shares of an insurance company. An extensive understanding of the regulatory landscape will enable investors to better structure a deal at the outset rather than spending several months cooking an inedible recipe.
Diligence and risk mitigation: Conducting a robust legal due diligence on a borrower is virtually non-negotiable for any private credit investment. The primary objective would be to determine (a) the ability of the borrower and other obligors to transact, (b) consents required from existing lenders, shareholders, contracting parties or governmental entities for any part of the transaction, (c) actual and contingent liabilities, (d) onerous legal or regulatory proceedings, and (e) title in relation to secured assets. Investors may address potential concerns either through redesigning certain components of the deal, or through conditions precedent, conditions subsequent or suitable covenants to safeguard their interests.
Assessment and perfection of security: Where private credit is being provided on a secured basis, it is imperative for the investors to evaluate and assess the quality of the security as well as any impediments to its title and enforcement. If the security is illiquid or will not fetch sufficient value in an insolvency/liquidation, then such risk needs to be appropriately factored. If a security provider is legally or contractually restricted from creating security but still does so, the enforcement may become arduous or face the risk of being set aside in insolvency of the security provider. Further, if the security is not appropriately perfected or registered, where so required, the same may not withstand an insolvency or liquidation. Therefore, it is crucial that all necessary steps to determine the value and quality of the security and for creation and perfection of security are undertaken in a timebound fashion to mitigate enforcement risks.
Robust documentation: A comprehensive set of legally binding and enforceable documentation is a sin qua non for any lending deal, and private credit is no exception. Indian courts have generally upheld the commercial bargain that is struck between the lender and borrower and seldom re-negotiate commercial contracts. Therefore, it is imperative that the documentation clearly sets out the terms on which the debt is being offered. While covenant-lite packages may be offered in certain situations, investors must carefully negotiate the covenant package. Cure periods, materiality thresholds and carve-outs for certain covenants may be agreed, but ought to be scrutinized and stress-tested to prevent unforeseen consequences or situations that defeat the very purpose of requiring the clause. For example, the IBC provides for a time-period of 14 days for admission of insolvency applications. Once the insolvency application is admitted, there is a moratorium on enforcement of security. However, if the document provides a longer cure period before the creditor can declare an event of default, then the creditor may not be able to enforce security once the insolvency process has already commenced. Further, a strong set of information covenants in relation to a borrower’s financials and business affairs would also enable the investors to monitor their portfolio and action steps to mitigate potential risks before they become irreversible.
Evaluating enforcement strategies: This is one of the most important aspects when structuring a deal. An investor needs to understand what steps it can take if trouble starts brewing. Typical steps would be initiating civil proceedings for recovery of debt, enforcing security and filing of insolvency proceedings. Sometimes, commencing insolvency proceedings may not be the best alternative, especially in situations the asset is liquid and security enforcement process is quick, or the value of the security is insufficient to repay its debt. The benefit of insolvency proceedings is that they whitewash any liabilities preceding the commencement of insolvency resolution process. However, the downside could be that the process may take longer than expected due to frivolous litigation or may not receive enough bidders depending on the type of business or assets. Also, where the debt is in the form of an unlisted debenture, then the beneficial security enforcement process under the SARFAESI Act is not available. Where the security is on immoveable property, the SARFASI Act process may be quicker than a traditional mortgage enforcement suit and therefore, it may be preferable from a creditor perspective for the debenture to be listed. However, if the security is in the form a pledge on securities, the remedies under the SARFAESI Act are not available and listing of the debenture is not necessary. These aspects should be debated before finalising the transaction structure.
An enormous opportunity belies private credit funds in the Indian sub-continent. Deliberating the above matters at the outset will go long a way in identifying and alleviating any risks, safeguarding their returns, and ensuring that private credit remains a sustainable form of debt for a long time.
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