Alternative investment funds turn key source of private funds

In the aftermath of the IL&FS fiasco, regulatory measures tightened, significantly limiting the ability of debt mutual funds to provide substantial credit yields. Seeking safer options, these funds started gravitating towards quality and liquid names, consequently reducing net yields. Not surprisingly, this prompted investors to explore alternative products in search of more attractive returns. The mutual fund industry, once a significant player in credit schemes, witnessed a drastic 68 per cent decline in assets under management (AUM) in credit schemes by March 2022 compared to its peak in August 2018.

If this wasn’t challenging enough, another blow struck in 2023 with the abrupt removal of the indexation benefit on debt mutual funds. This move further diminished the superior post-tax yield that debt mutual funds once offered. In response to these shifts, savvy investors are strategically redirecting their capital towards structured debt products offered by a diverse array of alternative investment funds (AIFs). This trend, initially the domain of High Net Worth Individuals (HNIs), has expanded to capture the attention of insurance companies, corporate treasuries, and family offices.

Projections hint at an impressive growth trajectory for AIF AUM, set to surge at an 11.5 per cent CAGR over the next five years, reaching a substantial $23 trillion from the current $13 trillion. This surge signifies the escalating dominance of private equity and private debt as the fastest-growing asset classes, positioning AIFs as the vanguard of this financial transformation.

Meanwhile, traditional lenders, specifically banks, grapple with a dual challenge. Firstly, their reluctance to extend credit to lower-rated companies and secondly, the tightening embrace of regulatory constraints. In an effort to reduce Non-Performing Assets (NPA), banks have shifted their focus to safer, higher-rated products. This shift is evident in the changing composition of banks’ assets under management (AUM), with reduced lending to industries and an increase in personal loans. The resulting void for lower-rated companies seeking loans is further exacerbated by Non-Banking Financial Companies (NBFCs) shifting their focus away, creating a discernible gap in the market.

This market gap has become the fertile ground where performing credit AIFs gracefully step in. Offering interest rates ranging from 12% to 18%, and in some cases even reaching 20% to 24% for riskier credits, AIFs have seamlessly positioned themselves as the preferred choice for businesses seeking funds outside traditional banking channels.

The remarkable ascent of AIFs, however, doesn’t necessarily foretell doom for traditional lenders. As the Indian economy charts an upward trajectory, the demand for capital is poised to soar. A noteworthy impact of AIFs is seen in the unorganised private lending sector, once dominated by ultra-HNIs and corporate promoters. AIFs, through improved structuring, diversification, and legal avenues, have attracted private lenders to invest in them, marking a transformative shift in the sector.

Amid economic uncertainty, non-traditional sources of financing, like private credit, have found their moment to shine. This vacuum has given AIFs a robust start, and although the attraction towards credit AIFs may seem sudden, it is, in fact, an outcome of a genuine market need in India. As this nascent asset class continues to evolve in India, it’s essential to recognise that AIFs are not enjoying a free run but are a response to the changing dynamics of the financial landscape.

As investment choices evolve, risks are inherent in the AIF landscape, including potential mis-selling and over-concentration in specific sectors. Investors should be prepared for longer lock-in periods. In navigating these challenges, a comprehensive evaluation of the “Three P’s” – people, process, and portfolio – becomes imperative before committing capital to credit AIFs.

AIF is an evolving asset class at a very nascent stage in India, unlike developed global financial markets where similar products have been in existence for decades. In the analogy of financial evolution, AIFs are not merely players but architects, reshaping the financial landscape of India.

(The writer is CIO and founder, Valtrust)