India’s rapidly expanding economy, coupled with a decline in credit availability from banks and non-banking financial companies (NBFCs), has created a void in the traditional financial system. In this scenario, private credit has not just emerged but surged as a compelling alternative source of financing, particularly for small and medium businesses. It could play a pivotal role in helping realise India’s aspirations and present a significant opportunity for investors.
A $50 billion opportunity
While private credit is a relatively new concept in India, its emergence and success in the US are well documented. Following the 2008 global financial crisis, tightening regulations on traditional banks created a financing gap for mid-sized companies – the engine of economic growth. This vacuum gave rise to the private credit industry in the US. As of 2023, private credit is a $1.6 trillion behemoth in the US, accounting for about 6 per cent of its GDP. In the Indian context, before 2018, traditional lenders like banks and NBFCs had been grappling with high levels of non-performing assets and low capitalisation. Coupled with a more risk-averse approach after the 2018 IL&FS crisis, it has led to a decline in commercial credit growth. As private credit players stepped in to fill this void, the segment has grown rapidly, and could be as big as $10 billion in 2024, representing only 0.3 per cent of India’s GDP. With India on track to become a $5 trillion economy, even at a conservative projection of 1 per cent of GDP would translate to a $50 billion private credit market over the next 3-4 years, suggesting a significant headroom for growth.
Myriad use private credit holds for SMEs
Given the state of bank lending in an economy of India’s size, private credit can be a critical conduit for flexible capital, providing tailor-made financing solutions for several situations and use cases. It can fund activities like acquisition financing, share buybacks, and others that are restricted/heavily regulated for traditional banks. Unlike banks and NBFCs that require assets as collateral, private credit lenders can offer revenue-based financing and other flexible features like delayed amortisation and bullet repayments. This is mainly useful for growth-stage startups, enabling them to raise patient capital through private credit without equity dilution. Further, mid-cap companies struggling with credit lines with banks and unable to access bond markets due to low credit ratings can access capital via private credit.
Unique opportunity for investors
Unlike equity investments, which may experience volatile returns, private credit offers a more predictable cash flow, making it ideal for investors seeking stable returns through regular interest payments. Private credit investments often carry an illiquidity premium, compensating investors for the limited liquidity of asset classes. This illiquidity premium enhances the risk-reward profile of private credit compared to other fixed-income investments. Private credit also offers investors access to niche opportunities that may not be readily available through traditional channels such as investments in specific industries, regions, or themes with potentially superior returns.
The maturity curve in India
As a fledgling asset class with tremendous potential, all stakeholders must temper optimism with prudence rooted in lessons from past mistakes. Moreover, as the private credit market matures, so will its participants. Funds and fund managers will be able to develop sophisticated underwriting and risk management practices. Investors, presented with more data and experience, will better understand the risks and rewards of this asset class and make informed decisions. Also, regulators, learning from the market’s evolution, will be able to introduce more nuanced regulations that strike a balance between fostering innovation and ensuring adequate investor protection, creating a level playing field with other financial institutions.
Criticisms and risks
The growth of private credit in India is not without its critics. Some argue that the lack of transparency and standardised regulations could lead to risky lending practices like leverage-on-leverage and evergreening loans. Another red flag is interconnected transactions across funds, investors, and borrowers, which can lead to systemic shocks, particularly if banks are involved. Others point to the potential for mis-selling, given the complexity of the instrument. These concerns are not unfounded, and it is important to acknowledge and address them as part of a balanced discussion on the topic. On their part, regulators have been responsive and have issued guidelines that address some of these challenges. For instance, the Reserve Bank of India (RBI) has barred banks, NBFCs, and other regulated entities from investing in Alternative Investment Funds (AIFs) in which they have direct or indirect downstream investment.
Having said that, the emergence of private credit in India is a natural progression of a dynamic and evolving financial system. It presents a significant opportunity for investors seeking higher returns and businesses seeking alternative funding sources. Challenges exist, undoubtedly, but with the right approach from all stakeholders, private credit has the potential to become a significant driver of growth in the Indian economy.