The murky uses of India’s private credit funds

By Andy Mukherjee

There are plenty of high-performing private investment vehicles in India, but it’s the few that are being set up for dubious purposes that may bring harsher regulatory scrutiny to the country’s most rapidly expanding asset class.

So far, the most egregious use of these so-called alternative investment funds has been by nonbank finance companies, several of whom have employed these bespoke structures for pure regulatory arbitrage.

When it looked like their big-ticket borrowers, especially real-estate projects, were going to default, some financiers took recourse to new funds tailormade for them by Wall Street firms. Investors who pooled money were issued senior securities, earning them interest. The finance company also contributed, but in a smaller junior tranche that ranks lower down in the repayment pecking order and is the first to absorb any losses.

The private funds then lent money to the same stressed borrowers who, in turn, repaid their original loans and avoided bankruptcy proceedings. Finance companies were happy, too, since any mark-to-market losses on the securities they now held would be far lower than the provisioning burden they would have had to bear in case of soured credit.

This is how at least some shadow lenders in India have “evergreened” their loan books to avoid being on the radar of the Reserve Bank of India, their regulator. But the Securities and Exchange Board of India, the stock-market watchdog, has cottoned on to the sleight of hand. According to a Reuters report in October, the SEBI has detected at least a dozen cases involving $1.8 billion to $2.4 billion where alternative investment funds have been misused to sidestep other financial regulators including the RBI.

The amounts involved may be small, but the problem with such shady practices is that they invariably lead to stiff regulation. And that could slow down the blistering growth of alternative funds, a broad category that includes venture capital, private equity, real estate funds, and private credit. A prominent Mumbai-based PE investor pointed out to me that it’s mostly the Wall Street firms that sponsored the cute structures. The same marquee buyout specialists will be the first to complain when, as a direct consequence, regulation in India takes a sterner turn. The lawyers who advised on these deals would wash their hands off.

Currently, it’s international investors who dominate the alternative-asset landscape in the world’s most-loved emerging market. But a rising number of affluent Indians are also looking at them for returns superior to what they can get from public equity, debt and residential real estate. For a growing class of high-net-worth individuals, the minimum ticket size — 10 million rupees ($120,000) — is not a showstopper.

However, the game will not stop with the rich. Domestic institutions’ participation will increase, too, once insurance and pension firms are given more leeway to invest in alternative assets. Since that will indirectly bring the regular Indian saver to the rich person’s playground, it’s one big reason why the SEBI can’t afford to ignore the dodgy structures. A global PE sponsor buying a riskier portion of a fund would be par for the course, but a local nonbank finance company that’s not the sponsor providing a loan-loss cushion to make its balance sheet look good? Or a big international retailer using a fund to get around New Delhi’s foreign direct investment limits? The regulators are losing their patience.

The zeitgeist is in SEBI’s favor. The US Securities and Exchange Commission, under Chair Gary Gensler, came out with rules in August to tighten its grip on hedge funds and private equity. Their industry associations have sued the SEC, alleging that the agency has gone too far and that the new rules “would fundamentally change the way private funds are regulated in America.”

Which is perhaps why the SEBI wants to act early. The alternative-asset industry in India has venture capital and hedge funds as its two bookends. The main body, however, consists of private equity and private credit. Whereas just a decade ago these two asset classes were a $200 million sideshow, now they command $83 billion, or more than four-fifths of the $100 billion committed by investors to private funds.

If this past growth is any guide, it won’t take too long for the firepower to grow to a point where the industry can flex its lobbying muscles — both in New Delhi and Washington — to thwart any attempt to rein it in. Even now, it isn’t exactly easy for SEBI. A tussle between the regulator and the fund lobby has been playing out for more than a year, the Economic Times reported in July.

The stakes are increasing on both sides. Alternative funds will continue to be the fastest-growing segment of India’s investment landscape, CRISIL, an affiliate of S&P Global Inc., noted in a report last year. That growth has been made possible by light-touch regulation: As conduits of foreign capital into the country, the industry has enjoyed a lot of latitude. But now that the local saver is getting entangled, expect an end to private funds’ freewheeling ways. Global PE firms’ questionable deals have made that outcome inevitable.