#4th IFIS – Performing Credit – A New Alternative Asset Class?

The third session of the conference was an enlightening dialogue on what Performing Credit entails, its viability as an investment opportunity, and its growth prospects in India.

The discussion kicked off by defining what Performing Credit is and where it comes from. Anything which falls beyond the purview of mutual funds or typical lenders (like banks) falls under Performing Credit as long as it is performing.

The credit system needs some norms and regulations which leads to inefficiencies in the market. When small depositors hold money in banks, it closes some of the risky investing opportunities for banks, which leads to structural inefficiencies. Banks and NBFCs are mostly comfortable in cash credit and fixed income credit. Hence, those credits which cannot be catered to by formal credit institutions are left for players in the Performing Credit sector

Even excellent companies which have good debt-EBITDA ratios may also have some credit needs which may not fit into the typical banking template. These needs are then provided for by Performing Credit.

Performing credit may start from an interest cost of 7% and may go up to more than 20% interest cost.  A credit might not be a bank-able credit right now but it may become bank-able a year later. Hence, the Performance Credit sector sees several institutions graduate to borrowing from typical lenders.

For example, one of the panelists gave an example of a big logistic company transporting cargo in trucks over long distances. It requires large working capital since there is a lag of approximately 120 days (about 4 months) and the bank can finance that. But if it goes over that, banks refuse to cater to that need. During Covid, the cycle completion times inflated to about 150 to 180 days. So, at this point, a performing credit or private credit firm comes into the picture. There are also differences in yield between conventional forms of credit and performing credit. For a bank to be financing these receivables, they would charge an interest cost of 10-11%. However, since the private credit firm will be bearing a higher risk, they will require 13.5-14% return.

Two types of risk are involved in this sector: credit risk and capital scarcity risk.

There are ways of checking the viability of an investment. One way of approaching an investment as a performing credit firm is by looking at the firm’s credit rating. Additionally, we also look at the business, its promoter, its suppliers, its purchase, where does it bank with, its ROC, any case pending against it, and other details.

In the last 15 years, foreign firms have been the most active in this space. Some of them are Deutsche Bank, Standard Chartered Bank, Credit Suisse, Barclays, and Nomura. Some Canadian institutional investors have been active as well.

If investors believe that they will  get assured returns in this sector, they might be in for surprises. There are always possibilities of incurring losses. They might tend to compare this line of credit with venture debt. However, in a study which analyzed a combined portfolio of venture debt of 100-120 companies, it was found that less than 3% were EBITDA positive. When the same study was done on Performing Credit (on firms having credit rating of BBB and above), it was found that only about 3.5% of companies were EBITDA negative. So, in terms of risk, venture debt and Performing Credit are not in the same basket. One analogy might be to consider Performing Credit to be like mid or small caps while Venture Debt is more akin to micro-caps.

As of now, there are very few funds in the Performing Credit domain. But the number is growing very fast. There is tremendous appetite for credit in many sectors of the economy, and there is no reason why the Performing Credit sector should not see impressive growth in the years to come.