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Sun, 4 Jun 2023 | Live Mint
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Why alternative investment funds are betting on performing credit

Credit risk is no longer a popular term among mutual fund (MF) investors after the Franklin Templeton crisis that shook the MF industry in March 2020. From managing ₹61,837 crore of assets under management (AUM) before FT crisis, the credit risk MFs now manage ₹24,687 crore of AUM, which translates into a decline of about 60%.

On the other hand, banks and non-bank financial companies (NBFCs) are constrained in terms of the type of credit exposure they can take, due to regulations stipulated by the Reserve Bank of India.

This has given an opportunity to alternative investment funds (AIFs) to steadily increase their activity in the private credit space. In 2022, the deal value for AIFs in the private credit space stood at $2.3 billion (₹18,926 crores). According to industry experts, performing credit space is where a sizeable amount of new AIF flows is getting deployed.

Consultancy firm EY in a report in November 2021, said the opportunities in the performing credit market were expected to range between $39 billion and $89 billion over the next five years.

PERFORMING CREDIT

Performing credit refers to lending to companies that are running their business on an ongoing basis, have a long track record and are profitable at Ebitda-level (earnings before interest, taxes, depreciation and amortization). These funds don’t invest in entities where the businesses are no longer viable or are in distress.

Aakash Desai, Chief Investment Officer & Head - Private Credit at 360 ONE Asset (formerly IIFL Asset Management), puts it, “For us having a really strong and verifiable track record is important, governance of the promoters is important, fairly stable financials are important, payment track record is important. If you look at all of these aspects, you will typically get solvent-growing profitable businesses, which are by themselves fairly stable, but have a requirement that is fairly unique and can’t be met by conventional lenders. That is how we would define performing credit," Desai says.

WHAT CAN INVESTORS EXPECT

AIFs are meant for ultra-high net worth and high net worth investors who have adequate surplus to park for a longer tenure. AIFs are close-ended and in performing credit space, the tenure of funds can range between 3-5 years. AIFs require a minimum investment of ₹ 1 crore.

Depending upon the strategy followed by the fund, investors can expect returns of anywhere between 10-14% on a pre-tax, post fees and expense basis. These funds can offer higher yields than regular debt investment products but also come with higher risks.

Like with any credit risk strategy, there can be default risks. The security taken by the AIF, whether through hard collateral, promoter’s personal guarantee, etc. can help with recovery, but still, credit risks cannot be wished away.

Performing credit AIFs are set up as category II AIFs, which have been accorded a pass-through status. That means capital gains from these AIFs are taxed in the hands of the investors, in the same manner as if these investments were held directly by the investors. Performing credit AIFs typically make quarterly payouts to investors, which are essentially coupons received by investee companies.

These AIFs have a hurdle rate of 10-13%, depending on the asset manager and underlying exposures. The hurdle rate is the minimum return fund required to deliver before the asset manager can charge a performance fee.