As debt returns dwindle, Avendus Finance explains why private credit funds work

One area that has benefited to a large extent from the quest for more lucrative returns is the private credit space, including Alternative Investment Funds.

In an interview to ETMarkets.com, Nilesh Dhedhi, Head of Structured Credit, Avendus Finance, charts out how the NBFC crisis following the collapse of IL&Fs and then the onset of the COVID-19 pandemic drove the shift to private credit.

“…the debt returns came down significantly (~ 4-5%) the allocation which was in this debt side obviously started yielding much lower return in absolute terms. “

“That is where the private credit gained popularity which was operating in the 11%-18% IRR kind of a bucket with differentiated strategies, so people naturally gravitated towards the debt opportunity, which could give you a higher return to offset the very, very low return that people were getting otherwise, and a lot of NBFC is also started moving towards the fund structure.”

Edited excerpts:

Borrowing costs across the economy are set to go up. We have a large government borrowing program. We have the prospect of US rate hikes and we have high oil prices. What is the outlook for the private credit market?

The domestic factors, as well as, the company related factors come into play more than the global factors. Firstly, the companies which generally under the purview of private credit are not typically very large companies who have export driven businesses or have multiple businesses which are affected significantly by macroeconomic or a global event.

Secondly, and more importantly, the situation or the particular requirement we are catering to is not like a typical long term corporate lending by banks that is done for five – seven years.

So to that extent my personal view is because it is so specific to a situation or a company or a requirement at that point in time we haven’t seen the private credit at least for the underlying borrowers getting affected so much by the global parameters now because they are not dependent on the foreign capital. Most of them are not in export driven businesses that is affected. .

On the fund raising side, which is on the supply side of it – since the industry is growing and is at an early stage; a lot of these kinds of transactions were initially or earlier were being executed by the NBFCS.

Now it is moving towards the AIF private credit fund, kind of a structure. Most of the players have entered the platform only in the last one year. Most of the supplies are in the domestic market, which are your HNI family offices and maybe some of the corporate treasuries. Now that segment on the supply side is doing well, because till at least two months back everything was moving up. There was a lot of liquidity in the system.

I think that market has been growing steadily and that is why we see loads of fundraising in the market. Also since the debt returns came down significantly (~ 4-5%) the allocation which was in this debt side obviously started yielding much lower return in absolute terms.

We saw a natural shift to find new avenues where one could earn a higher interest rate, and that is where the private credit gained popularity which was operating in the 11%-18% IRR kind of a bucket with differentiated strategies, so people naturally gravitated towards the debt opportunity, which could give you a higher return to offset the very, very low return that people were getting otherwise, and a lot of NBFC is also started moving towards the fund structure.

Venture debt also attract a lot of capital as a new asset category and similarly now in private credit also people are looking at a new asset category.

So I would say these are the factors because of which you see the rise of private credit fund.

What could be the risk factors that are now associated with the AIF space?

So, I would still say that 80% of the players are still new or are doing their first fund raising rather than someone who has been doing it for a long period of time, so that way I would say the entire industry itself is a very new industry.

So to compare it with the situation three years back or four years back from IL&FS days, I think may not be correct because there weren’t many players. However, what necessitated this shift to an AIF private credit is definitely IL&FS and then obviously the pandemic.

The transactions from the NBFC balance sheets made one realize that the liquidity was becoming a challenge. Higher leverage is something which people were not that comfortable with. Credit rating agencies were probably downgrading some of them because of the asset quality issues and the pandemic related lockdowns, and all the mutual funds were affected after the IL&FS, DHFL kind of episodes.

They almost got out of the space where they were not lending to any of those structures – lending to NBFCs; banks kind of reduced their exposure. The wholesale lending as a whole; they also went into their shell a bit. So, there were a lot of supply side issues and then there were a lot of balance-sheet related things which would work out in a growth scenario.

Also, because RBI became a much more regulating entity, it has been the biggest driving force towards the shift to AIF, which was seen as a relatively more flexible structure compared to the NBFC loans.

It’s a private it’s a closed ended fund, right? It’s an unlisted entity. So you could provide a lot of flexibility which you otherwise can’t in a much regulated environment.

A lot of stuff which RBI allows or doesn’t allow to be done by banks and NBFC can be done by the fund. So I would say that was the second part of it that naturally the flexibility which this particular product requires from the clients perspective, what probably better given or suited in the AIF structure compared to the NBFC structure.

Taking forward the point about surplus liquidity, we can expect that in the next financial year that the RBI would gradually move away from a surplus liquidity regime and that could cause a rise in bond yields and returns to a certain extent. So do you see more of an interest from entities such as HNIs?

I would still say yes, because of 2-3 reasons. So one is that unlike your traditional data set or equity assets, if you look at any family or any HNI – let’s say if you’ve got Rs 100 then many of them would be mostly on the debt side of it, right? I mean, typically the debt allocation is let’s say Rs 60 and the equity allocation is Rs 40. Now, within that also, typically people have been gravitating a lot at a personal level towards the bank FD, G-sec bond tax free bond AAA, right. So, the safer assets till now have been taking almost, I would say 70 to 80% if not more of the debt allocation itself.

So what we call alternate and then mutual fund of course the credit funds, the ultra-short term fund, the bond funds, which give you 7%, 8% return.

Now anything outside of this category, from FDs to credit, mutual fund, bond mutual fund which is 4% to 8%, you will hardly see any investment avenues also or you will hardly see any demand also from the investor side of it.

So what we used to call alternate debt; alternate investments category and then on the equity side, people who are very comfortable with the listed equities. Within that obviously, let’s say Sensex will be 60% and then midcaps and other things. So that way, the allocation was very clear now as far as the wealth is concerned, the wealth of the HNI as a whole in India or in a particular segment is not going down because they would have invested in something or even if they have not invested in something which has grown, they have their own businesses.

People who on the corporate side have survived this pandemic are only growing and becoming bigger and obviously getting a higher valuation. Lots of companies are becoming unicorns, lots of companies are getting sold, a lot of promoters getting the liquidity.

I think that part is still intact, and it is increasing. However, the bigger thrust will come when the asset allocation changes.

I agree with you that going forward there may not be so much liquidity. So maybe earlier if you put Rs 100 it used to become Rs 120 within six months, become 130 within a year; those kind of returns may not be available but that 100 becoming 110, the allocation of the alternate products, which was earlier, let’s say less than 5%, even if it becomes 10%, then you’re opening up a huge amount of potential investment which could come in.

The Avendus credit fund two is estimated to provide a 16 to 18% return based on the lock in of course and the tenure. Are you on track to achieve that target and what are the growth prospects are for the next financial year?

So, this is our second fund; just to give a context, we did our first fund four years back that is almost exited as you would know, probably eight out of nine transactions exited.

We have written the capital back 120% and that fund at a gross portfolio basis has generated or around 18% kind of return. The second fund that we’re talking about is still in the fund raising phase. We have done two closes and we have reached 65%-70% of our target size. So we have done a couple of investments and this fund over a period of 1 to one and half year, we’ll do another 10 to 12 investments. At a portfolio level where we are targeting 16% to 18%.

Our sense is that we should be able to find another eight to 10 deals which will provide that return because we have done it for 10 deals in the first fund.