Nike co-founder Phil Knight’s memoir Shoe Dog recounts a turning point in the footwear giant’s initial years, when banks refused to extend credit and the business ground to a standstill. Finally it was a line of credit from Japanese trading company Nissho Iwai that resurrected the company named after the Greek goddess of victory. Such success stories powered by private credit are legion globally.
Private credit is non-bank lending in high-yielding and illiquid debt-like instruments to mid-market companies that are underserved by traditional sources of capital. It is one of the fastest growing segments within the alternative investment landscape with assets under management worth $1.6 trillion, or 14 per cent of global alternative investments. In India, private credit comprises $15 billion in AUM, or 11 per cent of total assets under alternative investment funds (AIF).
There are several reasons why many borrowers prefer private credit over traditional bank credit. According to an EY report prepared in 2023 for the American Investment Council, nearly 70 per cent of private credit providers surveyed in the US in 2021 reported that their borrowers were “too small for bank syndication”. Other factors included certainty and speed (91 per cent), higher leverage than banks will support (82 per cent), more flexible covenants (77 per cent), and stable relationship with a lender until loan maturity (65 per cent). The Indian experience is no different.
Total credit deployed in the Indian economy, as of April 2024, was about $3 trillion, with bank credit accounting for 58 per cent and the rest coming from sources such as non-banking financial companies (NBFC), higher rated corporate bonds, external commercial borrowings (ECB) and private credit. As credit demand surges with growth in the economy, banks will incrementally lose market share amid stringent macro-prudential regulations and their inability to accommodate varying and, at times, riskier non-traditional needs of borrowers such as debt financing with inadequate equity capital, lower credit ratings, revenue-based financing without adequate physical collateral or flexible repayment structures. Banks and NBFC will increasingly focus on retail lending and working capital solutions, leaving more room for private credit.
Demand growth
Private credit witnessed a compounded annual growth rate (CAGR) of 29 per cent over the past five years, vis-a-vis the 10 per cent overall credit growth. This is in line with the basic law of economics that demand will create its own supply. In FY 2015-16 the Reserve Bank of India introduced the asset quality review (AQR) programme, followed by prompt corrective action, leading to the consolidation of 27 public sector banks into 12 units and a write-off of $175 billion in bad loans. As banks moved away from funding private corporates, private credit stepped in to cater to both stressed borrowers and investors chasing high yields. This also suggests that policymakers prefer to insulate taxpayers from the credit risk that accompanies a growing economy.
However, regulators do remain vigilant to the risks induced by private credit. If private credit refinances the debt of large borrowers that struggle to access bank credit, it would lower the average quality of investments. Moreover, easily available, even if expensive, debt may have economic ramifications, given the temptation for the borrower to remain under-capitalised in the short to medium term, on the back of private credit, in order to raise equity at higher valuations later on.
With economic activity increasingly concentrated in the hands of a small number of private credit managers, regulators are on the watch against blind spots masking risk bubbles.
However, the RBI’s financial stability report in Juneshows that AIFs are not a significant part of the financial system network in terms of inter-sectoral exposure. A May 2023 Federal Reserve note, too, stated that “the financial stability vulnerabilities posed by private credit funds appear limited. Most private credit funds use little leverage and have low redemption risks, making it unlikely that these funds would amplify market stress through asset sales.”
Guardrails
Factors favouring the deployment of private credit include the enactment of the Insolvency and Bankruptcy Code, the creation of the National Company Law Tribunal and the National Asset Reconstruction Company Limited, a favourable tax environment for investors, AIF regulations from the Securities and Exchange Board of India, and facilitation of foreign investors through the Gujarat International Finance Tec-City in Ahmedabad. But there is equal need for guardrails against the build-up of excesses both for borrowers and investors.
Global evidence suggests private credit seeks deep pools of patient long-term capital from insurance companies and pension funds, while promising higher yields. However, regulators in India have already capped exposure to alternatives, thereby limiting potential losses to small investors.
The RBI, too, has periodically introduced regulations to prevent systemic risks. For instance, in 2023 it prohibited a regulated entity from investing in any AIF scheme with direct or indirect downstream investments in a debtor company of the RE. It is a healthy sign when a rapidly growing yet small asset class such as private credit is scrutinised by regulators for risk build-up.
(The writers are co-founders of Mavenark, a Mumbai-based investment banking and asset management services firm)