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Credit Funds: The New Frontier

March, 2018

CFO Insights on Financial Services

Maneesh Dangi, Co-Chief Investment Officer, Aditya Birla Sun Life AMC Ltd. writes about the advantages of investing in credit funds.

Capital is the lifeblood of all businesses, and the importance of its efficient allocation can’t be overstated. The whole financial ecosystem exists for just this purpose.  To an outsider, capital seeks the highest returns, and must be allocated to businesses which make the maximum amount of money. However, capital is not just the preserve of the saver who wants to choose the best among thousands vying for his attention. Capital is also extremely Darwinian in nature, and functions as society’s tool for progress. Therefore, agents of capital allocation are at the forefront of all new beginnings.

Because the task of capital allocation is inherently fraught with missteps, society has evolved to give dedicated mandates to various players, public vs private markets, equity vs debt, alternatives, mezzanine structures. Banks have been the earliest arbiters of capital worthiness, and they stay so with them being the only source for a large part of the economy due to their size, strength, and distribution reach. NBFCs have taken the reach to unbanked and the under-served. Credit funds have come into their own over last few years, filling gaps in the existing milieu with its own advantages.

When savers invest in bank’s Fixed Deposit or Savings Deposit, they don’t get specific asset exposure. Banks pool capital and hence, apply a very non-differentiated approach to its deployment. However, credit funds allow each investor to take on risks which they specifically want, and hence the capital pooled by credit funds share a common goal.

Also, credit funds disclose what they hold on a monthly basis. If a retail investor with a cursory knowledge of finance wants to assess the riskiness of credit funds, it’s just a matter of having a look at the credit ratings of all the exposures. Valuation agencies publish NAV on daily basis which further simplifies that task. As investors in credit funds, investors are the proprietors of capital.

If we take a growing credit fund, we are looking at what is arguably the most resilient avatar of a lending balance sheet – zero leverage, un-fixed cost of capita, minimal fixed costs with continuous capital infusion, all while providing the most efficient risk adjusted returns. Investor gets simple pass through of returns, adjusted for small management fees. Because credit funds focus on larger entities (top 1000 corporate), bigger deals (50 crs+), costs pertaining to distribution are obviated. Credit funds seem much cleaner vehicles devoid of opacity and inefficiencies.

The whole raison d'etre of credit funds is to allow customizability as per investor preferences. Different types of risk, mid vs large corporate, cyclical vs defensive industries, retail vs corporate, high risk vs low risk, short tenure vs long tenure, all can be effectively dealt within a fund structure. Even if the investor wants to invest in NPAs, they find a suitable platform in distressed funds. Bitcoins, well you can have them too. All this flexibility and customizability - just to meet investor expectations. Also, diverse risk appetites of investors ensures that there are a plenty of unique fund mandates.  The mere existence of such funds can bring down cost of capital for corresponding sectors. For instance, if investors are seeking infrastructure risk (through such designed funds), then naturally, cost of capital for infrastructure will go down. It’s important to stress that dedicated capital for such sectors is a matter of choice, and at the sole behest of investors. Unlike for instance, likes of development institutions or other specialized financing vehicles, where capital is blocked into certain financing needs even when returns are far from optimal. When investor interest wanes in sector due to lack of opportunity, just one fund’s growth gets stagnated, and it’s not a death knell for the institution.

Finally, there are certain opportunities which might be out of the reach of the banking system. This could be due to regulatory compulsions, or pricing expectation. For instance, few sectors like real estate, capital markets and corporate situations like acquisitions and promoter take-outs are not done by banking sector because the regulator deems them too risky. Investors, on the other hand, can take that view as far as they are well informed. Similarly, few large conglomerates and corporates are so finely priced, that even banks internal return on equity expectations are not met. Credit funds have to play role in variety of situations, from very risky, to event based, to super safe.

However, it would be a folly to assume that credit funds can replace banks. Different parts of capital markets serve different functions, with credit funds being best at large borrower underwriting at the most efficient price.  Banks and NBFCs have the wherewithal (both infrastructure and human capital) to reach every nook and cranny of India. A large part of the country is still unbanked, so many people still are unserved, and many businesses still starved of capital. Banks are best placed to solve the problem with their distributional advantages. Credit funds can focus on their key strength of pricing risk correctly with speed and efficiency. Society needs a well performing financial architecture, and all of us need to come together to give them the very best.

In fact, the regulator (Reserve Bank of India) also concurs with us on this one. Last year, they came with a circular nudging banks to reduce their single borrower limits, reduce the concentration risks and eventually, form a more stable banking ecosystem. Funds structure is lower risk for economy because of lack of any explicit returns promise, and presumption of well-informed investor, who knows what she is getting into.

We are well on our way to have an ever more vibrant financial sector, which can efficiently meet needs of various entities. Banks, NBFCs and Credit funds performing the roles we just discussed, distressed funds providing much needed succour to needy firms, venture debt to fledgling start-ups. Technological advances in payments etc. will make money move faster, and break down the monopolies predicated on inertia. Hopefully with GST, the days of underwriting manually are numbered and with Aadhar, individual identity will never be suspect. Insolvency and Bankruptcy code will rejuvenate the most moribund corner of financial services - the distressed firms, and will possibly stand for second chance in life. Future developments in credit information utilities, in legal precedents for credit resolution and actual result themselves will all shape behaviour of borrowers for times to come, and exciting times are in store for us.

However, at this crucial juncture, it’s important to highlight that credit funds have been hobbled by seeming lack of regulatory support in crucial areas like information asymmetry and enforcement. Funds should have unfettered access to SMA data from banks, and should be able to see CIBIL scores of borrowers. Unlike banks, which are owned by shareholders and just have to meet promises to their depositors, funds have a fiduciary duty to protect their investors. Hence, a fair ask would be for funds to be on the same pedestal as banks and be able to fulfil their duties.

Rest assured that the size of opportunity to bring in market efficiency to credit markets is phenomenal, and it is already playing out.  Over the last two years, RBI data shows that gross bank credit deployed by SCBs in the non-financial sector (the ‘real’ economy) has shrunk by 4%. Yet, Indian corporate bond issuances are showing robust growth y-o-y. We see a paradigm shift in how Indian corporates are raising fresh debt - share of non-bank sources in fresh debt has increased from a minuscule 10% in 2006 to 55% in 2017. Both corporates and investors are clearly seeing the benefits of participating in the bond market. The top 100 Indian corporates have come a long way over the last 2 decades from raising debt through private sources and banks, to accessing domestic and foreign bond markets. This trend is only set to intensify as companies seek to diversify their source of funding and debt investors become more comfortable with them. At this rate, credit funds in India would trace the growth path of US debt markets (where the corporate debt market is 5 times that of outstanding loans to the non-financial sector).

Growth of credit as an asset class is almost a given. The question is whether we will be able to live the promise. Our investments in technology, people and processes will have to keep pace with changing times. A plethora of changes in the business and competitive environment will disrupt our way of things. But we have faith that our unflinching commitment to people, to hard work, to not taking any short cuts, to treat fiduciary responsibility as utmost duty, to respect risk and on-board it judiciously, and to building relationships will hold us in good stead. 

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