India: a tale of woe?

To try to predict where the Indian Rupee (INR) will be in one month’s time let alone six months is a mug’s game. Unless you are expressly paid to take a view on foreign exchange, best leave it well alone. At the time of writing,  former IMF Chief Economist and Chicago Business School professor Raghuram Rajan has just been appointed as The Reserve Bank of India (RBI) Governor. It is a pretty good bet that the FX markets will try to test his mettle at some point when they realize the lack of policy tools he has and the obstacles he faces but I do not think anyone in Asia or elsewhere could hope for a better person to head the RBI.

So let us accept that INR weakness is here for the foreseeable future. Also, we have to assume the necessary reforms required to tackle both the fiscal and current account deficits will be limited due to campaigning for the National Elections timed for May 2014. The worst case would be the announcement of further populist measures which increase the deficits with little real benefit for the voters or the economy.

What does this mean for private debt investors and India?

If you already have exposure to Indian rupee cashflows via debt strategies and you are unhedged then you will have already taken pain (to the tune of 19 percent depreciation since June 2013) and may have to face plenty more to come. Hedging costs via offshore non deliverable forwards (NDFs) or options have leapt. However if you are a private debt investor who is not expressly paid to take FX risks (see above) then I am not sure why you are not hedged.

I should highlight that domestic lending in India (in rupees) requires you to be either a bank with a domestic license to operate in India or to be a local non-bank finance company (NBFC) regulated by the RBI. A number of foreign private debt funds over the years – whether focused on mezzanine lending, special situations, real estate or infrastructure – have formed new wholly-owned NBFCs or purchased, at minimum, controlling stakes in existent ones.

But how successful have the fund owned NBFCs investments been to date? I would say the results have fared from ‘mixed’ to ‘poor’. A few early entrant private debt funds in the special situations space made good money (even very good money in a few cases) on private financing deals with stressed corporates as India moved to a better creditor rights regime in 2002 – 2003. Since then, most deals of that ilk have not worked out well, primarily I would argue due to unfeasible valuations resulting in unlikely equity upsides versus very low contractual cashflows in terms of coupon.

The same problem has been faced by mezzanine lenders in India – NBFCs do not have as strong creditor rights as the banks, in particular lacking the ability to enforce under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act (SARFAESI). So an NBFC without a sufficiently structured loan faces the danger of earning debt-like returns with equity-like risk. Many funds, to get investments done, have ended up with skewed risk / return profiles.

At the same time real estate private equity investments have been pretty much a disaster zone for many foreign investors. So there has been a more recent push to look at real estate debt investments via NBFCs. However, there’s been lots of talk, but little done so far.

As for infrastructure funds, for years people have anticipated the waves of infrastructure spending required to take India to developed country standards (or even middle-income country standards), yet the usual pitfalls of government and bureaucratic foot-dragging and red-tape have led to few real investment opportunities for foreign infrastructure debt providers.

So does all of this make me a perma-bear when it comes to private debt opportunities and India? Not at all. I think the current scenario means plenty of opportunities may arise for potentially lucrative Indian debt and quasi-debt investments.

There is a heavily overleveraged corporate sector in terms of domestic debt. In addition many Indian corporate groups are burdened with increasingly expensive foreign loans. The banks typically lend to corporates in large syndicates led by the public sector banks, so as borrower quality deteriorates, NPLs will jump across the board. The real estate sector is increasingly unable to access bank debt.  Finally you have a government that may be forced by the markets to open up infrastructure spending in a meaningful way to foreign investors.

So I see investment opportunities ranging from working with good companies and promoters to refinance their domestic debt on attractive special situations terms or via sensibly structured mezzanine lending, to picking select real estate developments and infrastructure projects to finance. There’s also the secondary market which can be used to target the foreign debts of stressed companies with significant overseas assets and / or providing new financing to such borrowers. Of course at that point if you are taking INR risk you will need to build in the cost of your FX hedging but there should be significantly more returns juice available to make the hedge feasible.

So book your tickets for Mumbai and New Delhi, time to go see what is out there.

P.S. Of course this all assumes that:  (a) the government does not do something monumentally stupid such as draconian capital controls which will cause panic and exacerbate the situation; and (b) that India does not face a genuine crisis point similar to that faced by much of Asia in 1997. I do not feel these scenarios are realistic but they need to be borne in mind nevertheless for your worst-worst case analysis.  ?