Monthly markets podcast India September 2021

Narayan Shroff (NS): Hello and welcome everyone to our monthly podcast for Barclays Private Clients India. I am Narayan Shroff, part of the India Investments team and I will be your host for this podcast.

In the next few minutes I will share with you our broad economic and market outlook and our investment strategy, followed by a short interview with our guest Kapil Singhal, one of the top names in Indian private credit market and the Managing Partner, Private Credit at True North. Kapil will share with us his perspective on the opportunities in the Indian private credit markets from the current vantage point.

India’s economic recovery seems to be on track despite rising COVID-19 infection levels in the country. With the economic impact of second wave relatively muted in the country and despite the overall threat to the global growth of the Delta variant and Chinese crackdowns, increasing rate and the levels of vaccinations seems to be supporting India’s economic revival.

Around 35% of the Indian population are likely to be fully vaccinated by the end of October. Furthermore, rising vaccine supplies is expected to cover 52% of the population by the end of the year. We upgraded our India GDP growth projection for the financial year 2022 by 1% to 10.2%.

With commodity prices cooling of late and the relatively stable Indian currency, concerns over imported inflations are abating. Additionally, any input price pressures from imported inflation may not result in higher output or retail prices as demand and pricing power in the economy still remains weak.

Much of the inflation risk seems to be already priced in. With supply constraints likely to ease in the coming months, inflation may undershoot forecasts in the near term. Of course, any supply shocks resulting from a potential spike in COVID-19 cases or a significant pickup in demand putting pressures on the output prices and retail inflation, are the key risks.

RBI is expected to continue to maintain its accommodative monetary policy until it has more clarity on sustainable growth prospects. Given the Central Bank’s recent policy statements, policymakers may be looking at inoculation rates, the global growth outlook and the signs of growth in credit and investments. RBI’s stance to build up foreign currency reserves also seems to support keeping Indian rates low relative to other emerging markets.

The earliest we think the RBI might start hiking the reverse repo rate is by December 2021 although repo rate hikes do not appear likely until early next fiscal year. Only two repo rate hikes appears to us to be on the cards at most in 2022, that is if the rate of inflation slows down by then.

Also, RBI seems unlikely to aggressively remove liquidity from the system. They may prefer to let liquidity naturally reduce as the demand for currency and credit increases.

On the fiscal side, the government’s capacity to spend remains healthy as the tax revenues perk up and plans for more privatisations and asset monetisation are executed. Any correction in crude oil prices and relatively stable rupee may also abate any pressure to reduce oil taxes.

Beyond a point, a period of broader, better-quality growth depends on the private sector participating more. With several reforms already announced by the government to boost private investment and the economy opening up, stronger consumer and business sentiment, higher capital expenditure and thereby higher employment and disposable income in the country seems more likely.

Following a stronger performance period and higher valuations in Indian equity across the broader market, the scope for significant upside has faded. Much of the expected earnings revival in stocks due to pent up demand has already likely been priced in.

The benchmark blue chip equity indices may deliver returns more in line with the realised corporate earnings growth trajectory, and given the limited room available for margin expansion, this may depend more on the sales growth.

Rotations across sectors, themes and market capitalisation are adding to volatility. As such, bottom up stock selection, active management and appropriate portfolio diversification look key to maximising returns. Any market correction is likely to be short and shallow and to mitigate the potential volatility, staggering allocations and buying on dips might help.

We have more conviction in quality companies across market caps and themes. Mid and small cap stocks appear favourably priced with opportunities to build on longer term positions in any corrections.

Unlisted securities continue to be in demand, especially in the late stage venture capital, private equity and the pre listing markets.

We continue to recommend keeping core fixed income portfolios invested in high grade corporate bonds of up to five year maturities ideally through a mix of rolldown strategies and actively managed portfolios in this segment.

Allocating to mid yield, high yield and structured credit at this stage of the broader economic recovery appeals. In public debt, we target sectors likely to profit from government policies and domestic economic revival. This includes infrastructure and residential real estate backed debt and select NBFCs that focus on housing finance and on smaller enterprises.

With the latest set of RBI restrictions on banks and nonbanking financial companies and enhanced guidelines on credit mutual funds, more opportunities are available for private debt managers in the midmarket performing credits. With the risk appetite in this segment still muted and traditional participants abstaining, this credit market offers opportunities to build portfolios with an attractive risk premium.

Prudent selection, diversification and monitoring is key when investing in private credit.

To discuss more on the Indian private credit market, we have our guest Kapil Singhal with us. Kapil has over 25 years of experience in the Indian credit market and has invested more than $3 billion of capital across many investing cycles. He currently leads the private credit strategies as Managing Partner at True North. He has previously worked for global names like KKR, Goldman Sachs and Deutsche Bank. Today he leans on his experience of all these years and speaks to us on his views on the evolving private credit landscape in India.

Hi Kapil, thanks for joining us today.

Kapil, India has seen credit pressures since 2018 with the IL&FS default, NBFC-led credit stress in 2019, and then the pandemic led crisis since early last year. Do you see an inflexion point in the private credit markets, and why?

Kapil Singha (KS): Thank you, Narayan. And thank you Barclays for giving this opportunity to speak today.

To answer your question, Narayan, India is a very nascent market for private credit. It has a very high potential for growth in the Indian wholesale lending market of almost $800 billion dominated by banks. Globally, the world has already shifted as you would know, Narayan, from lending by banks to alternative asset providers. The same transition is happening in India now. That is the key.

Timing wise also it seems perfect. Just like equities, high yield credit also goes through greed and fear cycles. Currently, it is emerging from the worst of the fear cycles. Both investors and lenders are fearful today.

Unfortunately, most investors start investing in high yield credit when fears settle down. As most lenders start competing, collateral, coverage, underwriting standards start getting diluted to justify the yields, and then they burn their hands. One just has to keep a discipline through the cycles. That is the key.

And also remember that private equity has taken 20 plus years to mature and come through lows and highs to settle and the same is happening with private credit now.

The inflexion point is already evident from the recent fundraising activity in both performing and special sit space in Indian private credit with close to $5 billion of dedicated capital that the local managers have raised in the recent past.

A similar number additionally have been deployed mainly in distress and special sit space by offshore funds which are a part of larger Asia or global pools of capital. While these numbers are small globally, Narayan, but this means that virtually we would be doubling the private credit market every year. As a result we could have a fourth of the $800 billion wholesale lending space, which is currently dominated by banks, to be catered by alternatives in the next few years. It’s a lot.

All in all, Narayan, it could not be a better time and now is the clear inflexion point. I hope that answers the question.

NS: Yeah, thanks, Kapil. Have regulatory changes helped this market?

KS: Narayan, private credit has been around for 10 years in India and it’s clearly at an inflexion point with a series of events unfolding post IL&FS leading to long term structural changes. Let's talk a few specifics here.

First of all, private credit should be a flexible capital and should always have been done in more flexible legal entities like alternative investment fund vehicles, that is the AIFs. However, the growth of the Indian private credit has happened in the non-bank finance companies, as you would know, in the NBFC format and then in the mutual fund format.

NBFCs are regulated, levered and rated vehicles. They offered great pricing with leverage thrown in, but had fixed lending structures and no ability to handle delays, default and restructuring, all of which are requirements of a flexible capital provider. NBFC managers were constantly thinking how my lenders will view this default, how would this impact provisioning, how will this impact rating, rather than taking the right decisions for the best recovery of the underlying asset. So one delayed the action, kicked the can down by refinancing, gave new money after bad money and a total recipe for disaster.

On the other hand, there was mispricing in the mutual fund category as investors' return expectations were low in the debt category and the mutual funds were chasing volumes to drive fees. On top of that, these deals were done in the open ended mutual funds where there was a total asset liability mismatch. One publicised bad news in the newspapers and the result was that there was almost a run on a particular scheme. This also resulted in uneven payoffs to the mutual fund investors.

Furthermore, almost all financial incentives of money managers hitherto were skewed towards annual dealmaking with less focus on exit based incentives. Remember, incentives drive behaviour.

Look at what has happened now. Mutual funds have permanently withdrawn. The regulator appears not too excited by this category. Even the boards of the mutual funds have taken a conscious call to reduce or avoid this category given the recent events unfolding of a large mutual fund, including the capital market regulator imposing personal liabilities on a few fund managers.

On the NBFC front non-corporate wholesale NBFCs do not get decent leverage, which was the fundamental basis of their business model. And secondly, the stock market does not value wholesale NBFCs. So now almost all NBFCs have shifted their business models to retail lending.

Fund structures solve the ability to deal with this riskier asset class with: Number 1, no provisioning, leverage or rating issues; Number 2, adequate alignment of managers' compensation and carry; Number three, skin in the game. There’s always a GP contribution in the team in a fund format.

In terms of regulatory changes of signalling from these relevant regulators that has also ensured that NBFCs and mutual funds stick to their core business - high grade wholesale and more retail. For example, loan against shares, minimum cover requirements has gone from 2x to 4x for mutual funds.

If you look at fund regulations they have constantly improved with more responsibility and onus on fund managers, clear guidance on ICs of funds, more flexibility to insurance companies in India to invest in funds. So, yeah, a lot has happened.

The Indian bankruptcy law has been the most significant change directionally for credit in India. A lot has been said and debated but it is a clear and huge step forward. In addition, prepack guidelines recently released for small and middle market companies remove all the bankruptcy process’s obstacles and yet provide the regulatory aircover to lenders to incentivise to resolve issues.

So, Narayan, in a nutshell lots of regulatory changes and a very, very clear path forward for private credit in India.

NS: Yeah, thanks, Kapil. Also, are there uniqueness about Indian credit markets compared to other global markets?

KS: So I would say, Narayan, that overall Indian markets are unique in many ways.

For starters, high yield trading is non existent in India and most people have to hold their assets to maturity. Illiquids in India are truly illiquids.

Secondly, operating companies and holding company distinction as stark as you’d find in India does not exist anywhere else in the world. Leveraged buyouts, which are pretty common offshore, including free cash movement between various legal entities, are not easy to execute in India. Governance, understanding owners is vital.

Till the bankruptcy law, the capital structure priority was not even properly set. Simply speaking, one cannot be a desktop investor or a suitcase banker in the Indian credit market, so an on-ground presence of a local, well-experienced team is the key.

NS: Indeed. Kapil, which segment in the credit space do you see are best positioned from a risk/reward perspective and why?

KS: So, personally I believe that the midmarket companies, the performing credit category that yields from 14% to 17% INR is the best positioned today. This is primarily, as the biggest competition was from mutual funds and NBFCs, and that has gone out of the market. Even the private credit books of some of the aggressive private sector banks have receded.

If you look at the distress and special sit space that has already been around and they have done well, but the competition in this asset class has heated up now and there is pricing pressure that’s building up.

So overall, my vote goes for performing credit 14% to 17% category.

NS: Yeah, and which sectors and themes do you see are better positioned in the private performing credit space? And which are the ones you would avoid?

KS: So, Narayan, ideally performing credit space should be sector agnostic. Now that’s my opinion. However, on holding company deals, we would be focusing on typical private equity sectors of consumer, healthcare, finance and technology.

We would be less picky on private credit with respect to sectors on cashflow deals, whether opco or holdco. However, given the focus on governance and avoiding sectors with a lot of government interface, we would avoid sectors like coal power, mining, gems and jewellery and construction.

Thematically, we believe that performing credit is transition capital and should stay on borrowers’ book for a very short period. However, the borrowers should eventually return to more permanent forms of capital, even the low cost banking debt or more flexible equity, whether private or public.

So in that context, if you look at acquisition financing, tenor elongation of maturing debt, consolidation of promoter stakes, consolidation of smaller companies by larger companies have been the traditional performing credit themes and that works for us.

Overall, Narayan, the key message is to focus on exit strategy, avoid companies with fraud and governance issues. Sectors we’ve not been that picky other than the holding company trades.

NS: Yeah, thanks. And with the interest rate rising at some point next year, how do you see private performing credit markets reacting to that?

KS: So, Narayan, this is my belief that there is a limited translation of the rates market into the private credit market. I would hazard roughly 50% translation of equivalent changes in the base rate on the rate side to the private credit space. An increasing interest rate environment would only help the private credit market as we will get better pricing and the economic environment will be overall better.

If you ask me, the more extensive parameter to watch out for is the current market participants' continued discipline around pricing, structure and choice of companies, which currently I’m thrilled and, you know, if it continues to stay like that, it will just improve the overall credibility and image of private credit in India.

NS: Kapil, in India, which activity do you ascribe the highest weight in managing private credit portfolios? Is it sourcing and selection, risk or asset monitoring and management or is it exiting the positions? And why?

KS: So all three are actually, Narayan. However, the biggest reason for losses in India in private credit have been lending money to companies and owners with governance issues. So that is the single biggest issue that we need to watch out for.

Staying focused, grounded and with the basic understanding that the things will go wrong in a couple of deals no matter what, as this is a higher risk asset class, is another crucial aspect. This will allow you to take action on time.

Exit is vital, but that is the result of choosing a well governed company and managing the position well through the life of the deal. Of course, one should get paid for doing a mezz or an equity part of the capital structure or a non-bank end use or taking an event call or a risk to exit, but nothing can price in a fraud or a governance risk. That’s just not a risk that we want to take.

NS: Absolutely. Makes sense, Kapil. But how do you incorporate credit default or delays in your portfolio return estimations?

KS: So, Narayan, we will bake in about 100 to 150 basis points IRR loss in a conservative case in our return estimates. That’s our basic philosophy. We hope to do better than that, but we are mindful of the previous track record of the industry, the current state of the legal system and governance framework. If you tell me that nobody’s going to make any mistakes, I don’t believe it. In fact, we don’t believe anybody who says that a credit portfolio will not incur any loss due to delay or default.

The silver lining is that the recovery rates in India have dramatically improved post bankruptcy process, which has been put in place with near 50% recovery from the earlier 15% to 20%. So all in all we are in a very, very conducive environment for private credit in India. It is headed in the right direction. That will be my kind of closing comments on this.

NS: Thank you again, Kapil, for joining us today.

KS: Thank you, Narayan, and thank you Barclays for having me on this podcast. Really appreciate it.

NS: With this we come to an end of our podcast. Thank you for listening to us. Stay safe and healthy and happy investing.