By Srinath Sridharan

In a surprising yet crucial move, the Reserve Bank of India (RBI) has slammed its regulated entities (REs) for resorting to the Alternative Investment Fund (AIF) route to cover up evergreening of loans. The sector now faces the challenge of upping its game in devising crafty strategies to mask or postpone the inevitable bad news. Ever-greening, a deceptive practice where financial institutions extend new credit to cloak issues with existing debts, has been squarely addressed by the central bank. It’s a crackdown on transactions that manoeuvre direct loan exposure from lenders to borrowers by camouflaging it through investments in units of AIFs—essentially, a covert play within the lender’s customer base.

The private credit sector in India has been witnessing strong growth, deploying over `30,000 crore in selected transactions during the initial half of 2023. Notably, the Non-Performing Assets (NPAs) of scheduled commercial banks are presently at historic lows, causing a slowdown in the distressed asset investment pipeline. Consequently, fund managers have been focusing in structured solutions tailored for special situations, including acquisition financing, bridge-to-IPO funding, and capex funding.

The past few months, non-banking financial companies (NBFCs) have been strategically redirecting their focus towards retail loans, with some concurrently engaged in the reconstruction of their wholesale loan portfolios. Simultaneously, a number of startups are opting to abstain from securing equity capital at discounted valuations. The domain of debt mutual funds has seen net outflows, a consequence of the removal of indexation benefits that once distinguished its tax treatment among fixed-income products. The current market conditions, marked by a constrained influx of fresh capital, are affording private credit funds a distinctive advantage in negotiating higher interest rates. Their position as a limited but sought-after source of capital for businesses enhances their bargaining power. Globally, private credit constitutes approximately 10-15% of assets under management in the broader domain of private capital, spanning private equity, venture capital, real estate, and other sectors. However, the landscape in the Indian debt market differs significantly, characterised by its limited depth, with a substantial portion of available funds directed towards government entities. This scenario underscores a notable imbalance in India’s banking sector.

Historically, Indian banks have heavily relied on extending credit primarily to large corporations and government entities. In contrast, more developed debt markets globally witness both corporations and governments turning to bond markets for their borrowing needs. This shift enables banks to reallocate their focus towards retail banking, mid-sized enterprises, and smaller businesses, thereby fostering diversification in their lending portfolio.

In India’s financial landscape, a metaphorical ‘AAA mindset’ prevails. Within this framework, mutual funds and non-bank lenders engage in intense competition to secure credit-worthy businesses with AAA and AA ratings. Conversely, entities rated A- and BBB are increasingly seeking recourse in the private credit sector. This trend stems from disparities within the credit market, where the mispricing of risks has resulted in notably sluggish lending growth for companies holding a credit rating of A and below.

Private credit funds play a pivotal role in supporting these businesses, often structuring transactions into tranches. For the riskiest credit, returns can reach as high as 24% to 28%. However, this potential reward is accompanied by a significant caveat—the heightened risk of default. Exiting such investments can be challenging due to the illiquid nature of these securities. Private credit funds predominantly draw in high net worth individuals (HNIs) and institutional investors with a high-risk tolerance. However, concerns arise about the contagion effect if one of these funds collapses. Private credit funds, especially promoted by PEs, could face conflicts of interest, especially in ensuring timely exits of portfolio companies. Notably, conflicts could arise if these private funds extend loans to companies where their promoter PEs have equity stakes, posing concerns.

However, in this rapidly expanding Indian private credit market, lack of transparency and illiquidity emerge as significant risks. Lenders frequently engage in these transactions to retain the debt until maturity, given that private debt loans typically lack the liquidity associated with broadly syndicated loans. If an AIF dealing in special situation funds without mandatory loss reserves faces write-offs, how soon would public markets be told? This becomes crucial if the credit quality of borrowers receiving these private loans begins to decline, posing potential systemic concerns.Private credit transactions allow investors only restricted insight into the underlying risks. In the Indian context, this opacity raises disconcerting questions for the RBI and Sebi. The measures taken toward preventing ever-greening appear prudent and expeditious due to the regulator’s access to granular data obtained from the lenders under its supervision.

The authority over credit rests with the RBI, and one hopes it doesn’t escalate into a turf battle. This situation may prompt Sebi to take decisive action around the regulatory standards of risk management, levels of disclosures and its frequencies, and accelerated improvement in governance norms of the AIF. But then, currently Sebi’s access to detailed data on AIFs is constrained, posing a limitation. Hopefully, its supervisory approach towards AIFs may entail a more rigorous regime, presumably with increased supervisory bandwidth. In financial regulation, the refrain “I did not know” holds little weight.

Private credit markets stand to benefit significantly from more granular disclosures, enhancing transparency and fostering a healthier credit ecosystem. Detailed disclosures can provide investors with a clearer understanding of the underlying risks associated with private credit transactions, ultimately facilitating better-informed investment decisions. Moreover, increased transparency is pivotal for improving credit access, as it instills confidence among market participants and attracts a broader range of investors. However, it is crucial for regulators to acknowledge the persistent challenge of evergreening and recognise that creative financial routes have long been employed to mask the true health of loans. Regulators must elevate their market intelligence and proactively seek out novel methods employed to conceal bad loans. By staying ahead of evolving market tactics, regulators can play a crucial role in maintaining the integrity of the financial system.

(The author is Corporate advisor and policy researcher)