1 May 2017
India’s mid-market turns to development and growth finance
Indian mid-market companies are growing fast to meet burgeoning demand for goods and services.
Kanchan Jain is head of India credit at BPEA Credit, part of the Baring Private Equity Asia group, having joined towards the end of 2016 after six years focused on Indian mid-market corporates at Religare Group.
She explains why India is attracting considerable interest from debt fund managers as mid-market companies seek flexible capital to take them to the next stage of development.
Why are many fund managers turning their attention to India?
India is a high-growth economy, with GDP of around 7 percent, and it is also an extremely diverse economy. Within India, there are two different worlds. One is represented by the 20-30 percent of the population with very basic standards of living and a lack of social fabric. The other is a burgeoning middle class of 150-200 million people benefitting from massive technological advances and the opening up of the economy, and that middle class is only going to grow over time.
There is huge demand for goods and services from this population, which has the same number of consumers as the largest four or five European economies put together. Agriculture was historically a large driver of the economy, but today it represents under 20 percent and is growing at around 2-4 percent per year. By contrast the overall economy is growing at 7 percent because you have very entrepreneurial and advanced sectors growing at close to 10 -15 percent, and these have become the new drivers of the economy.
Why is there perceived to be a new opportunity for lending in the country?
India has been a huge beneficiary of globalisation, which led to an inflow of liquidity and an opening up of the technology and media sectors. There are now a number of high quality businesses that started as small and family-run businesses, but today after being around for 15-20 years, are significant mid-market businesses. In that time they have come to generate say $100-200 million in revenue at compound annual growth rates (CAGR) of around 15 percent and with increasingly dominant market positions.
These businesses need capital to keep growing. Importantly for credit managers, they have track records that allow for proper analysis, and often a strong borrowing and repayment history. So credit providers today have a much deeper opportunity set of potential borrowers, and much more information available on the borrowers going back 10-15 years. Before, these kind of opportunities did not exist but now there are some very interesting ones. It’s these kinds of companies we are looking to invest in.
And why are these companies prepared to consider debt finance?
There are plenty of large corporates which are able to obtain traditional financing, especially for big infrastructure projects, while the SMEs get assistance from priority sector lending targets imposed on banks by the government. The mid-market, however, tends to get crowded out. There are a lot of companies that need flexible capital for three or four years to take them to the next level of operations. They find debt capital attractive in that it is non-dilutive and it gives them additional capital for expansion and acquisitions. These companies are more creditworthy borrowers than SMEs given their large balance sheets and multiple sources of collateral, yet are faster growing and frequently better leveraged than the large corporates. For us, it’s a great opportunity to provide needed capital while protecting the downside.
What are the keys to investing successfully?
We are big proponents of proprietary sourcing, and have a dedicated origination team that is constantly talking to companies. We try to understand their businesses and what keeps the promoters up at night. Outside of the obvious centres like Mumbai and Delhi, there are seven or eight important economic centres in India such as Chennai and Pune. We cover them all. There are some very interesting mid-market companies, and we find that by maintaining a constant dialogue, even if you can’t help them today, there is a good chance you’re the first person they call when they do need a financing solution in the future.
How much experience do Indian borrowers have with accessing private credit from groups like yourselves?
The private credit market in India is still evolving, so there is still something of an educational process with Indian sponsors. We welcome new credit players because the larger the market becomes, the more actively the potential borrowers will seek our capital. There can be some hesitation from borrowers about the cost of finance from fund managers, particularly as we have to generate a certain level of returns for our investors. But in return for that slightly higher interest rate they get more flexibility and someone who can customise the funding to their business needs, which is something the banks cannot offer with their strict lending guidelines.
Alternatively they could seek a short-term bridge with a view to a refinancing, but in doing so you might be putting a stable business into a high-risk zone if you’re unable to refinance. By contrast, with us the financing is locked in for four or five years and this largely eliminates the refinancing risk.
And you’re confident that you’re backing solid companies?
We are not seeking to lend to unprofitable businesses or start-ups. Our target borrowers are established, mid-market corporates with long track records. Indian companies are globally competitive today, not just because of low labour costs, but because they have bigger and more highly skilled workforces that bring in research, design and other innovation-enabling capabilities. That has added to their competitive advantage. There are 900 multinational companies with 1,000+ R&D centres across the country in the automotive sector alone. Pharmaceuticals, biotech and chemicals are other sectors where the competitive advantage has been cemented and has actually improved as firms have moved up the value chain.
No longer are these companies just low-cost producers, they are good stable companies that can really capitalise on the opportunity and understand the value proposition. At the same time, they are aware of the private debt wave and the fact that private debt funds are filling the gap left behind by traditional bank lending.
Of course we also need to conduct our due diligence on each borrower, and we always insist on multiple sources of collateral to secure our investments. The point is that today there are a huge number of Indian corporates which pass our strict credit analysis, and would be very attractive to credit managers around the world given their scale and growth profile.
Do you find yourself competing with private equity funds?
Private equity has been around in India for over two decades, so the dynamic between private equity funds and private credit funds is not new. Today we see the private credit space as offering the promoters a flexible and non-dilutive alternative to minority growth equity capital. There is also a role for private equity in India, although as a firm we believe the Indian private equity opportunity is most attractive at the larger end of the market, be it control buyouts or corporate partnerships.
For a promoter that wants to remain in charge while he grows his business, the promise that we can provide finance without diluting equity is very attractive. The benefit for us is that we can strongly protect our downside, which is something the growth equity investors cannot easily do, even if they say that they can. If you look back at the growth equity deals in India over the past 10 or so years you’ll find that, in many cases, promoters have done far better out of those deals than the private equity firms. Private credit managers use collateral and contractual repayments to reset that imbalance and guarantee their exit.
What is a typical situation for you when it comes to new deals?
We look for a strong track record, both in terms of execution of the strategy and also financing. We like established companies with professional management. Typically, we’ll provide last mile or expansion finance, maybe for acquisitions or refinancing and with a cash yield element. The market is evolving but is not as segmented as it is in the US or even Europe. It’s segmented between the mid-market and large corporate deals, and also between performing and non-performing companies.
What’s the return target for a strategy such as this?
Our target return is between 18-20 percent in local currency terms, and we are pleased that we have been able to achieve this to date through disciplined deployment and careful borrower selection. We invest in largely secured debt with amortising loans and quarterly or semi-annual coupons to reduce the repayment risk and smooth out currency fluctuations for international investors. We’ve found that the returns to our investors work out better with a combination of periodic income distribution, recycling and amortisation of capital than if it were just one lump sum redemption. In fact if you convert our historic returns to euros or pounds they’re actually much better than in local currency terms.
Is this market affected much by the global political shocks we have been seeing?
A lot of the key sectors in India are relatively insulated from wider political shocks as they have grown on the back of the domestic market. Private debt also benefits from being of a ‘buy and hold’ nature. The volatility of Asian markets can mean investors occasionally crystallising large losses but this is not so much the case in the private debt market.