Beyond banks: Alternative financing in India

The few GPs in India with funds specializing in distressed assets have long enjoyed the benefits of a market rich in opportunity but sparse in competition. In the wake of a slowdown in economic growth - the country's GDP is expected expand 5.5% in 2012, down from 7% and 10% in the two previous years - they see the investment scope widening.

Yet at the same time, the competitive landscape is changing. Traditional private equity players are encroaching on the specialists' territory by differentiating their product range in the direction of special situations.

This isn't necessarily a distress play. There is strong demand for capital among India's entrepreneurs, many of whom don't have access to conventional bank financing, but is isn't matched by a willingness to give up equity. In need of alternative means of deploying capital and building relationships in the small- and medium-sized enterprise (SME) sector, private equity players are taking structured debt mainstream.

The distress and special situations incumbents aren't surprised by the transition. "India is a specifically compelling region for alternative finance because there are better bankruptcy laws than people recognize, there is a strong lending history in India with good documentation, a good enforcement history, and the absolute benchmark rates are pretty interesting." says Rob Petty, co-founder and managing partner of Clearwater Capital Partners.

"These are the components that have encouraged other players to look more intensely at alternative finance than previously, and for Clearwater to redouble our efforts in this space." The GP has been operating in India for the last six years and has eight investment professionals in the country.

Diversified strategies

Another factor that has precipitated the move toward alternative finance is the perception that Indian private equity has not performed well. The country's capital overhang is well-documented: India has seen just $12.8 billion in exits since 2009, having seen fundraising surpass $24 billion between 2006 and 2008. Some investments, made at the peak of the market, are underwater; others remain in the queue for an IPO exit, waiting - so far in vain - for liquidity.

"Most investors haven't seen liquidity from GPs in India," says Edwin Wong, managing partner and chief investment officer at SSG Capital Partners in Hong Kong. "So, we are seeing more GPs and more managers coming out and starting to look at raising different kinds of credit funds or more mezzanine funds."

The transition is facilitated by the fact that such funds fill a gap in India's capital structure - the country needs long-term capital to support growth, but lacks deep and liquid capital markets.

When KKR established a presence in India three years ago, its goal was to develop a multi-asset class alternatives business in the country, comprising both private equity and private credit. "The idea was to be a holistic solutions provider to local businesses and promoters, leveraging on our deep local relationships and understanding of businesses, and investing up and down the capital structure as a long-term capital provider," says B. V. Krishnan, a director at KKR India.

"We have found this to be a very relevant approach to the market, which is dominated by promoter-led businesses. These stakeholders need growth capital, and have historically depended on banks or the equity market given the lack of deep debt capital markets."

Slowing economic growth and tighter credit conditions have exacerbated these needs. SMEs have found it harder to access bank credit in the past year, with bank lending to the sector down 2% year-on-year in 2012, according to Nomura Equity Research. Banking sector loan growth across the board is at a 14-year low, increasing just 14% in the current fiscal year, well short of the peak of 31.7% in 2004-2005. As a result, GPs must be more creative in generating support for portfolio companies.

For Clearwater's Petty this spells opportunity. "The domestic market is far less interested in SME lending right now. Banks have non-performing loan issues and they just aren't as available as when the economy and their balance sheets were more robust." he says. "There really is a scarcity of lender capital for the fastest growing and most dynamic of component of the Indian economy at the moment, the middle market."

The growth in opportunities for alternative funding has benefited one part of the financial services sector in particular: non-banking financial companies (NBFCs).

Excluded from retail banking and the foreign exchange, NBFCs are not subject to the same restrictions as conventional lenders, which means they have the capacity to work with businesses that might be a considered risky. These institutions have also become a target for private equity: either as high-growth portfolio companies or as a PE vehicle in themselves, offering the capacity to provide structured debt and mezzanine financing. 

Since Indian banking sector reforms were introduced in 1997, NBFCs have evolved considerably in terms of operations, variety of products and instruments and technological sophistication. They currently represent 11% of India's $1.06 trillion loan market, with total assets valued at $125.6 billion in 2010. This is double where they were in 2006 and around 20 times where they were in 1998. This trend runs counter to the decline in banking sector loan growth seen over a similar period. It suggests that NBFCs are increasingly seen as an alternative to banks.

Distress funds have led the way with NBFCs, both using them for capital and, in some cases, setting up their own. "India has tight restrictions on what you can and cannot lend to," says Wong of SSG. "I think having a NBFC is going to be very useful when you looking at structuring around these situations."

Similarly, as traditional private equity firms move into alternative finance, they see the value in setting up their own NBFCs. Not only do these institutions allow PE firms to issue local currency debt, but they also represent a useful device if high valuations are proving an obstacle to a pure equity deal. The investor could offer a two-year debt package with a 5-6% coupon via the NBFC, using the target company's assets as collateral. Certain deals might also include an equity kicker, which would allow the PE firm to take an ownership stake after a certain period of time.

KKR's NBFC, KKR India Financial Services, is the primary vehicle through which the PE firm executes its credit strategy in India. Since early 2011, the NBFC has lent more than $1 billion to Indian companies.

"In a growing economy like India, certain businesses can benefit substantially from long-term debt capital. Additionally, the deeper such capital pools are, the better it is as it can help promoters and businesses achieve their growth objectives," says Krishnan

KKR is not alone in this approach. In 2009, Goldman Sachs and Everstone Capital Partners teamed up to create Indostar Capital Finance, while Apollo Global Management and with ICICI Venture offer structured debt financing through their own NBFC.

However, regulation remains an obstacle, limiting the practice to bigger GPs. "It is not easy," says Akil Hirani, managing partner of law firm Majmuder & Partners in Mumbai. "If you need to set up an NBFC in India, there is a $50million capitalization over a two year period, and for some people that is a high hurdle."

The trend is by no means universal and some GPs are yet to recognize any need for a move toward alternative finance. For example, Munish Dayal a partner with Baring Private Equity Partners India, while recognizing the qualities of the NBFC model, has yet to urge his firm to take the plunge. "Is it imperative for doing business in India? I don't believe so," he says. "Will it get the kind of returns one is looking for by deploying PE capital? I think will be tough."

However SSG's Wong still sees this trend continuing, with India having already proven itself to be an attractive destination for GPs looking for exposure to alternative financing in a relatively underpenetrated market. "The deal flow is very real and there is genuine demand for capital," he says.

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• Topics
• South Asia
• Investments
• Credit/Special Situations
• Financials
• India
• Financial Services
• KKR
• ICICI Venture Funds Management Company
• Clearwater Capital Partners
• Distress