What is Performing Credit?

Performing credit, also known as high yield performing credit, is a subset of private capital. The strategy typically entails lending to the middle market companies that comprise of the SMEs (small and medium enterprises). Some uses of the loans by the borrowing companies include funding a specific transaction, meeting urgent working capital needs, and initiating a restructuring. Performing credit funds have enjoyed strong support from retail investors, high-net worth individuals, and family offices because of their attractive risk-adjusted returns.

Why Should Investors Consider Performing Credit?

The growth in performing credit space is a testament to the viability of the asset class and merits the consideration and inclusion of performing credit funds in client portfolios. The word ‘private’ usually scares away the risk averse investors who are happy with the safety they get with their traditional allocations. The performing credit strategy provides a good option to these investors to explore the world of private capital while still being able to feel secure about their investment. 

The strategy is quite simple to understand and does not require the investors to be experts to take a chance at it. The loans are lent to stable, mature, and profitable companies that are not able to raise the required capital from their typical lenders due to reasons such as regulatory constraints. The fund managers who have developed the expertise and network in sourcing good deals and discovering strong companies are set to benefit from the lucrative returns provided by this space. Where a loan by traditional lenders come with an interest rate of 9-11%, a loan by a performing credit fund enjoys interest rates as high as 16-18%. The primary reason behind this huge gap between the cost of these loans is the nature of the need of the borrower and the lender’s ability to meet that demand. Often, these deals are structured as bespoke investment solutions with low liquidity, resulting in higher yields. An example of a type of a transaction that usually passes the pipeline of performing credit funds is a domestic M&A deal. Post-covid era has seen a significant growth in such deals, which involve a company buying shares of another company with the purpose of acquiring it. In India, banks cannot lend for acquisition of shares as per regulatory guidelines. This demand is thus fulfilled by performing credit funds that can capitalize on the inability of the borrowers to raise capital through alternative sources. 

Another important tailwind for the asset class is its ability to provide diversification benefits to a portfolio. The loans provided under this strategy are usually a replacement for equity capital, i.e., companies typically resort to this source of capital when the only other alternative is raising equity capital. A typical middle market company in India has a cost of equity of 25-30%. Access to credit at 16% is thus a huge saving for them and helps retain ownership of the company. At the same time, since these are performing companies with stable operations and financials, the investors can be complacent that their capital will be returned. This contrasts with distressed situations where the underlying companies are struggling and require rigorous equity valuation and due diligence by the fund managers. This characteristic of performing credit helps the asset class provide true diversification benefits from equity and serve its role of a secured investment in a portfolio. In conclusion, performing credit is uniquely beneficial to all the parties involved; the lender can earn high yields on a safe investment, the borrower can enjoy a cheaper source of capital than issuing equity shares, and the investor can diversify his/her portfolio using a credit strategy with better returns than traditional bond funds. 

How do Fund Managers Ensure Safety of Capital?

The main goal of fund managers of a performing credit fund is capital preservation, justifying the role fixed income investments are expected to play. The loans are secured by hard assets, such as land, plant, machinery, and receivables. These assets have a value of their own, independent from the value of the company. This provides added security against unpredictable events. Seasoned players in the market have also been able to incorporate past learnings and implement more stringent terms in the loan documents, including covenants and bankruptcy remote structures. Initially, performing credit funds had smaller ticket sizes and thus formed a small part of the overall capital structure. In the case of default, this worked against them as they did not have authoritative roles in the liquidation process of the company. Treating this as a learning exercise, fund managers now include bankruptcy remote structures in the loan terms. These structures essentially isolate certain parts of the collateral package from the rest of the company. The funds have the first right on the value of these assets and these cannot be used to settle any other obligation of the company post default. Inter-creditor agreements have also become common. These legal agreements lay out roles, rights, and responsibilities of the lenders when things go wrong. As a result, the lender community has contributed towards making the space more institutionalized, reducing the fears of foul play by the parties involved in such transactions.

What are the Risks of Performing Credit?

Illiquid nature of these loans and the absence of an active market for them presents a challenge for investors who may be faced by circumstances requiring them to get their money out. As such, these investment products are better suited for investors who are willing to have longer investment horizons. Another risk comes in the form of the credit rating of the borrowing companies. Since these companies are not highly rated (AAA or AA) and can be located in non-urban areas, there are concerns on governance and trustworthiness. Additionally, these investments require specialized field due-diligence, technology, and expertise. These risks can be largely managed by investing with successful and reputable fund managers who have shown a good track record across market cycles. 

What Does the Future Hold for the Performing Credit Space?

There has been an outsized growth in the performing credit space with both the demand and supply of such loans rising at an unprecedented rate. According to Preqin, private credit assets under management in India reached approximately $10 billion in 2023, a substantial number for the asset class. This growth is indicative of the rising demand for alternative financing solutions in India as banks and other traditional lenders continue to face regulatory constraints.

Experts believe that the sector is expected to grow at a compounded annual growth rate (CAGR) of 15-20% over the next five years, driven by continued economic expansion in India and increasing demand for alternative financing solutions. Innovations in financial products and lending practices, coupled with increased participation from international investors, will further bolster this growth.

Performing Credit Alternative Investment Funds

Performing Credit AIFs (Alternative Investment Funds) are a category of investment funds that focus on investing in "performing credit" assets. These are debt securities or credit instruments where the borrower is meeting all the repayment obligations, meaning there are no defaults or delays in interest or principal payments.

Performing credit investments are typically considered less risky compared to distressed or non-performing credit investments. 

Key Features of Performing Credit AIFs:

• Investment Focus: Performing Credit AIFs invest in debt securities issued by companies, such as bonds, loans, debentures, or other credit instruments, where the credit quality is relatively stable, and the issuers are making regular payments.
• Yield Generation: The primary objective of these funds is to generate stable and predictable returns by investing in high-quality credit instruments that offer regular interest payments.
• Risk Profile: Compared to distressed debt funds or other high-risk alternative investment strategies, Performing Credit AIFs have a lower risk profile because they avoid investments where there is a high likelihood of default.
• Types of Instruments: The funds may invest in a range of credit instruments, including: Investment-grade bonds, High-yield bonds, Loans to mid-market companies, Structured credit products like Collateralized Loan Obligations (CLOs)
• Target Investors: These funds are usually targeted at high-net-worth individuals (HNIs), institutional investors, and other sophisticated investors looking for exposure to the credit market with a relatively lower risk profile.

What are the Available Options for Investing in Performing Credit?

There is a plethora of options of performing credit funds in India for investors to choose from. Some examples include:

• Neo Income Plus Fund
• Vivriti Diversified Bond Fund – Series II
• Edelweiss Alternatives Performing Credit Fund
• Piramal Alternatives Performing Credit Fund
• Avendus Structured Credit Fund