Finance in India has a new bogey called private credit

The Reserve Bank of India (RBI) recently harmonized its regulatory framework for project finance to create a level-playing field between both commercial banks and infrastructure-focused non-banking financial companies (NBFCs).

Private credit is another area crying out for such synchronization.

Private credit is advanced by funds pooled together from mostly institutional investors and actively managed by professional managers. These funds usually invest capital in startups and early-stage companies in the form of non-publicly traded debt, without going through the intermediation of banks or NBFCs.

Private credit thus becomes an alternative, non-conventional source of borrowed capital for many privately held companies. Another crucial difference with traditional loans, apart from their repayment structure and security creation, lies in private credit charging higher interest rates.

Private credit has been picking up in India, stepping into the breach after credit markets gummed up and lending activity froze following the 2018 collapse of IL&FS Ltd and other finance companies. A report by audit firm EY estimates that private credit totalled $7.8 billion (about ₹65,000 crore, 108 deals) during calendar 2023, compared with $5.3 billion (close to ₹43,500 crore, 77 deals) in 2022.

Two deals stood out: a 3-year, ₹1,723-crore refinancing deal for the Shapoorji Pallonji Group and a ₹711-crore refinancing loan for Vedanta Group. In fact, it is believed that a large chunk of the private credit in India during the past few years was earmarked for refinancing stressed real estate loans.

RBI was forced to step in last year when it became clear that a significant portion of private credit being lent by private equity funds was used for ‘evergreening’ existing loans, or providing a fresh loan to corporate borrowers on the verge of defaulting on an old loan. The central bank detected that banks and NBFCs were investing in these funds which were then routing money as private credit to companies which had already borrowed from the same banks or NBFCs; the inflows were then used for meeting older repayment obligations.

This worked as a win-win for both the borrower and lender. The borrower could avoid loans getting tagged as non-performing assets (NPAs) and being referred for bankruptcy proceedings. The lender, on the other hand, avoided having to recognize loan impairment, which would have entailed reduced income and higher provisioning, both affecting profitability.

The credit fund, in turn, earned interest income and was able to keep a lid on risks by offering subordinate paper (which carries lower repayment obligations) to investing banks and NBFCs. RBI forbade banks and NBFCs from investing in funds which were lending money to these stressed borrowers.

This sleight of hand apart, private credit comes beribboned with several potential vulnerabilities. The April 2024 edition of Global Financial Stability report from the International Monetary Fund has devoted an entire chapter to risks from private credit.

At a general level, private credit is remarkably opaque in its operations and remains lightly regulated when compared with banks or NBFCs that are subject to relatively stronger regulation and supervision. Even bond markets have some disclosure requirements that impose an element of restraint. In addition, private credit is like a bilateral over-the-counter deal between borrower and lender, with no standardized contracts or terms and conditions.

Given this level of opacity, any default by a private credit borrower has the risk of catching the financial sector unawares and acquiring the characteristics of a contagion, especially since institutional investors have extensive ties across the system. Indian private credit’s revealed propensity for refinancing stressed assets is another red flag, in which one risk event can potentially send the entire credit market into disarray.

Then there is the issue of uneven regulation leading to uneven competition. Lending by banks and NBFCs is circumscribed by their capital base; funds extending private credit have no such restrictions. In fact, unlike regulated entities, private credit providers do not have to make any minimum provisions while extending credit. Worse, given the veil of secrecy that shields these funds, there is no clarity when asset impairment gets recognized, or whether the fund has any provisioning standards or documented recovery processes.

Most private credit comes structured with lenient restructuring clauses. There is also the question of capability: despite past slippages, most banks and NBFCs have developed deep institutional capacity over the years for credit appraisal, pricing, structuring, monitoring and recovery. Private credit, being relatively new in India, has competence gaps and this has shown up on numerous occasions over the past few years.

Clearly, there is a need for regulatory intervention here. Nobody wants a repeat of the 2008 chaos.