The Case For Regulating Private Credit Funds

Simrat Singh | Finserv@vinodkothari.com

Private credit is, in essence, shadow banking without corresponding discipline. Market reports indicate that Private Credit in India (and globally) is beginning to show signs of stress. Several global private credit fund managers have reportedly frozen withdrawals amid rising investor withdrawals. Given that private credit by its very nature is supposed to be illiquid, even a modest redemption pressure may hamper the ability of the fund manager to honor the withdrawals. Although this type of liquidity risk is limited in Indian private credit funds since they are usually close-ended category II funds in which investors are mandated to stay invested throughout the tenure of the fund. However, other risks such a opacity still loom. An equally important issue is the regulatory asymmetry, with private credit funds being regulated far less stringently than banks, NBFCs and other comparable lending institutions. Private credit funds take money from investors and lend to businesses; so do banks and NBFCs. Both carry systemic risks and can trigger panic on failure. Yet, only one is properly regulated. 

In our earlier write-up on private credit funds we tried to list down the differences between regulated entities and these funds, a distinction which highlights the scarcity of controls and oversight in a lending fund that is expected in a lending vehicle. Notable examples include no uniform credit appraisal, no standardised reporting of performance of borrowers, no CRAR-like minimum capital requirement, no interest rate risk model etc. One may argue that the very absence of these requirements is what makes private credit funds tailor their deals according to the needs of the investee company; payment-in-kind, income-aligned repayment schedules are some of the examples. However, the absence of discipline also introduces opacity and potential systemic risks. Regulators globally have flagged these lending vehicles due to their opacity and market-wide risk (eg. RBI pointed out the systemic risk of private credit in its June 2024 Financial Stability Report). However, no action/mitigation measure has been taken as of now. In our view, atleast provisioning and NPA reporting-like safeguards should be there in such vehicles.

Note that these funds are not completely unregulated, SEBI AIF Regulations contain some safeguards such as concentration cap, valuation norms, no leverage at fund level etc. but these are generic safeguards and are not made keeping in mind the risks involved in a lending-based fund vehicle. 

The case for regulatory intervention, therefore, is not about imposing bank-like rigidity, but about ensuring appropriate discipline for bank-like activities. Whether such oversight should fall within the domain of the RBI, given its expertise in regulating lending institutions, remains an open question. The more immediate concern is that these entities continue to operate outside a robust prudential framework. Importantly, the relatively small share of private credit funds in overall corporate lending (currently less than 2%) should not serve as a justification for regulatory inaction. Risks do not become relevant only at scale; by the time they do, the cost of inaction is often far greater. It is therefore for regulators to move beyond a form-based approach and adopt a substance-based framework for such lending vehicles.