June 2022 APAC Private Credit Newsletter

Most investors see APAC as a growth region, driven by its emerging markets. India is expected to be one of the fastest growing economies in the emerging markets re-affirming its position as the second largest emerging economy after China. The IMF forecasts India’s GDP growth to be around twice that of China in next two years. As of 2020, India was the sixth largest economy in terms of GDP ($2.7tn) and poised to overtake UK to become the world's fifth-largest economy (it was tenth when Prime Minister Narendra Modi was installed in 2014).

Is it really different this time?

Long-term emerging markets investors will know that, with India, optimism on progress and secular growth potential often gives way to evidence of inefficiency, cronyism, corruption and segmented or captured markets. Furthermore, the recent path of growth been far from smooth, and India has had its fair share of bad news over the last few years.

Its population was hit hard by the pandemic, especially in 2021, with a high death toll and the largest wave of internal migration since 1947. More recently, an extreme heatwave has swept through northern India and the country has suffered food and fuel price shocks from the Russia-Ukraine war. Both have created a strain on resources and exacerbated social inequalities.

The new structural pillars underpinning India’s new growth phase

But as recent articles in The Economist highlighted, India is emerging from the pandemic underpinned by some visible new structural pillars. These provide support for a more robust growth thesis than previous eras.

The most important is the emergence of a single national market via a modern financial system which is superseding the informal cash-based network. The development of this market has been underpinned by the development of physical and digital infrastructure. Highways, airports, mobile-phone base stations and warehouses have all rapidly increased in number or been aggressively improved since 2014.

Tax evasion, fraud and captive markets have all been pushed back by the creation of the "India stack" - a unitary digital infrastructure which combines biometric ID for all Indians (Aadhaar), a national payments system (UPI) and a nationwide push to make sure everyone has a bank account, facilitating direct digital welfare which boosts poorer Indians' ability to spend via job support and other benefits sent straight to bank accounts.

Start-ups benefit from the national stack. India has long been a leader in technology services and outsourcing and five million people already work in the industry. The result is a rapidly deepening venture capital market which can finance start-ups through their life-cycle.

The stack is also bringing scale to the broader corporate landscape. The 2017 introduction of a national goods-and-services tax (GST) has also made tax evasion increasingly hard for small, localised firms who incorporated this practice into their business models. The Modi government is taking a more strategic approach to industrial development to benefit from MNCs diversifying from China. "Production-linked incentives” (PLIs) pay out as firms’ revenues expand in such fields as solar panels, batteries, and pharmaceuticals.

However, India is still very much a country of small businesses. The country's giant conglomerates (Adani, Reliance, Tata) are reinvesting strongly in India, but their profits still account for a very small percentage of GDP. As the McKinsey Global Institute (MGI) report, large firms’ revenue contribution to GDP in 2018 was 48%. India’s potential is to achieve 70% by 2030, in line with outperformer economies. To achieve potential, MGI say, “India needs to triple its number of large firms, with more than 1,000 midsize and 10,000 small companies scaling up.”

LP considerations for investing in India

The foundations are being laid for India to become a friendlier place for creditors. However, the market is still in transition and LPs need to consider the following factors and incorporate them not only into their asset allocation decision but also into their GP selection criteria.

Promoter credibility: Incoming investors must implement stringent control and monitoring measures around deals, as risks associated with complex corporate holding structures, corporate governance issues and cash leakages continue to plague the India mid-market segment. As in other markets, promoter background checks are essential to mitigate any business and reputational risk during investment horizon.

Enforceability: Time to enforce contracts/securities and legal costs are still relatively inefficient compared to other markets. While this is reflected in the risk premium, private credit deals in India should be based on strong cash flow visibility and credit conviction. Also, recent regulatory measures (viz. ease of acquiring bad loans by credit funds and setting up an investment vehicle) coupled with willingness among traditional lenders to quickly resolve their debt, and a developing secondary market, has led to a reduction in the gap with more developed markets.

Delay in bankruptcy process: The motive of the IBC was to bring about a time-based debt resolution. However, the absence of substantial judicial infrastructure and the past backlog of cases has led to a significant delay in the resolution of debt through IBC process. Almost 75% of the ongoing bankruptcy case are delayed. The IBC is currently at a nascent stage (five years old) and the Indian government has made numerous amendments since introducing the code to help streamline the timelines and facilitate faster resolution aiding both creditor recovery and commercial returns for investors.

Secondary market: Even though the public bond market in India continues to remain comparatively illiquid compared to developed economies (with most of the financial institutions holding the debt until maturity), the private credit market has been witnessing a realignment of capital on the back of multiple secondary sale transactions and new capital inflow done bilaterally with creditor/promoters.

ZEROBRIDGE PARTNERS

Zerobridge Partners Asset Management Limited is focused on giving institutional & high net worth investors globally access to APAC alternative credit opportunities. The strategy seeks to take advantage of the less developed banking and capital markets in the APAC region and capitalize on our strong proprietary deal flow.

Zerobridge Partners Advisory Limited is a debt advisory firm focusing on raising new capital, creditor negotiations and debt restructuring for companies in Asia-Pacific. We come with deep investment banking experience and a strong track record across multiple credit cycles in Asia.

Growth Forecasts : APAC (real GDP growth in %)

Source : World Economic Outlook Database, International Monetary Fund, April 2022

Along with rapid growth, India may overtake China as the world's most populous country even before the UN projection of 2027. While the “BRICS” era has left us somewhat sceptical that demographics are the be all and end all of national economic destiny, the implications for how the “Asian Century” evolves are compelling:

Source: Our World in Data

Scale needs capital: The opportunity for private credit investment

Strong GDP growth, demographics, structural growth pillars, a strong start-up culture and the potential for SMEs to scale up should make India an exciting venue for a range of investors.

Easier access to capital is required to capture this potential. MGI estimate the total capital requirement for India to reach its potential by 2030 at about US$2.4 trillion. SMEs need access to more than US$800 billion which – if cross-referenced against the Bank for International Settlements’ estimates – means India accounts for around 20% of the total regional funding gap. This should be fertile ground for lenders providing growth and restructuring capital.

This funding gap was exacerbated by the failures of Non-Banking Financial Companies (NBFCs). These shadow banks were established post-GFC to cater to riskier companies which required a customisable and flexible funding structure. Driven by banks’ risk aversion, the need for quicker decision-making processes and demonetisation in 2016, NBFCs quickly became a significant part of the financial system. In 2018, more than 50% of credit in real estate sector was provided by NBFCs and 12-14% of banks’ direct lending was to NBFCs.

Unfortunately, asset-liability mismatch is an inherent business risk for the NBFCs, as most borrow short term funds from capital markets and lend long term. This became glaringly evident in 2018 when one of the largest NBFCs, Infrastructure Leasing & Finance Services (IL&FS), defaulted on its obligations due to rising non-performing assets (NPAs), creating contagion across the financial system due to several banks’ and mutual funds’ high exposure.

Institutional private credit investing is well-placed to fill the gap left by NBFCs and there are deal opportunities across the yield spectrum, including:

a. Growth Capital for performing credit with expected IRR in the range of 10-14%;

b. Special Situations lending to support the existing promoter in turnaround of business currently in stress, arising from the corporate debt books of the financial institutions in India. Deals might range from a one-time settlement (OTS) to acquisition funding to providing exit to a private equity investor to bridge financing. IRRs are expected to be in the range of 15-20%;

c. Distressed opportunities to buy existing assets along with a strategic investor at a deep discount. Deals vary from taking an equity risk to funding the creditworthy strategic investor.

What’s different this time: Insolvency & Bankruptcy Code (IBC) and tax reforms

IBC:

The introduction of the Insolvency & Bankruptcy Code (IBC) in 2016, which is probably the most important structural change for the new Indian corporate landscape. Bigger firms are growing due to economies of scale and can take advantage of the IBC to consolidate as underperforming companies exit markets. Private Credit investors are no longer bamboozled by multiple agencies and laws dealing with the debt, defaults, and insolvency which led to delays, complexities, and higher costs in the process of Insolvency resolution.

Tax Reforms:

In 2012, the Indian government introduced a law that retrospectively levied capital gains tax on companies and investors on the sale of their investments. The said law stoked high profile legal challenges and soured the investment climate in India.

In 2021, the government scrapped this law and set clear guidelines of taxing transaction (ie. capital gains) henceforth only from a future perspective. The amendment is expected to resolve at least 17 disputes of tax payments amounting to US$6.7 bn.

The move is widely seen as boosting investor confidence and is expected to help attract foreign investments in India.

Objective of the IBC

Shift the existing regime from ‘Debtor in possession’ to ‘Creditor in control’
Time bound resolution and efficient solution for value maximization for all stakeholders (financial & operational creditors)
To differentiate between fraud and business failure cases and give both an opportunity to revive

Salient features of the IBC

Both financial & operations creditors and debtors can take the company to insolvency
Minimum default threshold of INR 1 crore (USD 135k) required for resolution under IBC
Resolution process to be completed within 180 days or max 270; failing which company goes into liquidation
Moratorium on all debt repayment until completion of insolvency process (i.e., max 270 days)
Resolution professional (RP) under the supervision of committee of creditors (CoC) runs the company on an ongoing basis
Current promoters, management and board of directors are suspended by NCLT
Resolution plan (RP), submitted by interested bidders, is voted on by the CoC is binding on all the parties involved
Clean balance sheet; legally possible to write off past liabilities including debt, contingent liabilities, tax liabilities. Indemnity to investor from any past fraud or illegal activities in the company

Examples

* : Deal Date, Coupon and Yield varies for different Investment Tranches.

Sources: Deal 1 – Corporate press release; Deals 2&4 – EY Report (Evolution of Private Credit in India); Deal 3 - Reorg

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June 2022

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