Chasing Growth Debt in India

Credit- iStock | Creator: Sheriar_Irani

Growth debt is an attractive minimally dilutive debt instrument for financing growth companies. These companies have established product market fit and generating stable recurring cash flow. They are entering into an unrelated industry venture, risky turnaround, or gushing to scale up their operations, which requires financing but traditional debt is hard to access, while founders and investors cut back on their stake dilution. Every so often growth debt is sweetened with warrants ensuing lenders get onboard with the company’s growth vision. When NBFCs would lend at 12–13% with collateral, growth debt lenders charge 16–17% at not so stringent terms — subordinate debt, less collateral, with or without modest warrant coverage and convertible clause etc.

The credit market has been on a structural uptrend for more than two decades in India. Growth companies in India have regularly sought growth debt financing from lenders including marquee names such as KKR India. Dalmia Cement, Coffee Day Enterprise, GMR, CG Power, Bharti Infratel, Amtek, and Magma Fincorp to name a few have resorted to growth debt at some point in time.

There have been both hits and misses historically in lending to such growth companies. A high-yield debt portfolio of risky bets has not always paid off well in the Indian scenario. In around 2015, betting on India’s growth KKR India Financial Services (KIFS), the wholesale lending arm of private equity giant KKR was on a book building spree. In 2018, it experienced NPA as high as 50% on a book size of around $800M. It takes great prudence to manage a portfolio with such a risk-return profile.

Growth debt essentially serves two end uses- financing risky ventures and providing runway liquidity to companies till market conditions improve. Growth debt borrowers trade off higher rates of interest for accessible terms and convenience of finance. Convenience often comes in handy with growth debt financing. Private Equity capital and traditional debt can be painstaking as it takes a long time and bulky documentation to get sanctioned and close the deal. Moreover, there is a considerable legal and investment banker’s fee incurred in the process irrespective of whether the deal goes through or not.

Another aspect is the company’s preference for averting steep equity dilution which however is the usual outside means for financing of risky ventures and turnarounds. In undesirable times, when a company is getting a lower-than-desired valuation, the company might prefer to raise by way of debt over equity.

For companies, growth debt doesn’t give the lender the board seats, unlike equity financing. This is great for companies who do not wish to compromise on the company’s control. Companies can top up growth debt with warrants to make it lucrative for lenders as it allows them to enjoy the upside as well. Warrant issuance is covered more in detail later in the post. Lenders can add a convertible clause making debt convertible to equity to cover a credit event.

Debt enhances the return profile but is also accompanied by volatile earnings and agency costs. Moreover, companies with longer working capital should use debt to finance the working capital and shouldn’t be equity financed.

Empirical studies have shown that the optimal addition of debt can enhance the value of a company by 10–17% of the addition to debt. A company that switched from an all-equity capital structure to one that included $10 million of debt would, therefore, see its value rise by $1 million to $1.7 million.

Growth debt can be used to add to the cash buffer for the foreseeable cash burn, extending the cash runway to the next milestone. Therefore, ambitious companies in expansion mode should consider raising debt when they can —having both, considerable creditworthiness and favourable market conditions coinciding because, in times when either condition is not met, it is difficult and costlier to raise. Such cushioning should be done only when the company has a clearly outlined plan and the fund can be sourced at reasonable terms and rates of interest. In uncertain times, companies should carefully evaluate trade off between asset quality and growth. Growth debt taken for rainy days might turn dangerous as well.

Growth debt and venture debt look alike but are quite different in terms of underwriting thesis and risk profile. What private equity is to venture capital, growth debt is to venture debt. Venture capital and venture debt are more suitable for the companies in early-growth stage whereas private equity and growth debt suit mature companies. Venture debt is often indented to enhance the outcomes of the venture capital already invested into the company. Growth debt is normally available to both- VC-backed and standalone growth companies for risky expansions and turnarounds.

Growth debt is financed at less strengthened terms than that of bank debt. Debt financing has certain attributes — the company’s unit economics make sense or at least there is a viable business sense i.e. considerable and predictable cashflows and the company has accumulated sizable positive networth and fixed assets which is good for collateral and has a foreseeable low risk of insolvency. Bank debt is usually the cheapest form of capital. But when some of the aforementioned attributes are dubious such as low collateral or unstable cashflow etc. then companies resort to growth debt lenders.

However, you get to see companies financed by both banks/NBFCs and growth debt lenders. Companies going through a hard phase and overburdened with debt often seek risk capital for turnaround either in the form of equity or growth debt. In such a situation, bank debt is often inaccessible and equity comes costly, there, growth capital comes to the rescue and often comes along with warrants and is sometimes issued as convertible debt. In 2011, Avantha Group raised ₹1000 crores of growth debt with a convertible clause for its power venture- CG Group. But when coal block allocations were cancelled, the debt became unserviceable and got converted to equity worth less than 1/10th of the loan amount.

Like venture debt, growth debt can be an excellent add-on to venture capital, complementing recent venture capital funding round. By this stage, the lender gets to know the company and its prospects considerably well and has updated corporate information. Lenders can underwrite basis terms of deals in the recent rounds of funding and credibility of the investors.

Venture debt usually comes after the first round of venture capital financing of the early or growth stage companies and it often comes along with 2–10% in warrants which allows them to also participate in the upside of the company and the incentives align such that the lenders root for company’s growth and not just their survival until the debt is repaid.

If the same firm or its sister company has previously participated in any of the previous rounds of equity financing, the lender feels compelled to onboard with the promoters with a long-term view. Whereas, founders and existing investors can avoid further dilution as funding requirements for subsequent milestones are achieved by growth debt.

Borrowers should discreetly make use of warrants as a bargaining chip to lax covenants of the debt. Incorporation of a modest 2–10% warrants to the debt would make the deal look appealing to the lender as they can also enjoy the upside, ensuing lenders' corporation in hard times.

If the company lacks hard assets and doesn’t have holding group comfort or any sufficient financial guarantee, then the lender should seek warrants. Warrant can be issued in two ways, either entitle the lender to exercise a certain number of shares on or before the expiry date at a pre-determined price, or set a fixed percentage of the fully diluted ordinary share capital to be represented by shares on the exercise. The latter entitlement arrangement on a fully diluted basis will protect the lender (investor) from any dilution made between the issuance and exercise dates.

If the interest rate on debt is on the lower side, then no. of warrants can be kept on the higher side in order to balance the risk-return profile. If the warrants get exercised, it typically translates only to 1–2% dilution of the company. This is significantly lower than what it would have been if the company was fully ventured capital funded.

Example: A lender provides a company venture capital funding of Rs 10 crores with 10% warrant coverage. The company issues a warrant to the lender for Rs 1 crore worth of company shares with an expiry of three years, with a strike price valued at the current company’s equity value of Rs 500 crores. In two years, the company’s valuation zooms by 50% to Rs 750 crores and the lender decides to exercise the warrant to buy the company’s shares, now worth Rs 1.5 crores, thereby enjoying a fair upside from the deal.

The lender must look for anti-dilution protections of the warrant issuing company. If the company has already taken on venture capital, there are good chances that the investor has the benefit of anti-dilution protection that provides downside protection which may apply to on exercise of the warrant as well.

Debt is cheaper but it has certain hidden costs to it. One of the hidden prices often reins in the form of decreased flexibility. The growth company plans to take on risky ventures but the introduction of debt itself reduces the risk appetite of the company. Therefore, a sensible debt policy must be arrived at to have payoffs of debt capital more than that of equity.

The borrower needs to ensure that it is able to comply with all the debt covenants at all times, particularly in adverse times wherein the company sees a plunge in revenue, shrinking operating margins, dry equity funding, debt refinancing risk etc. which in extreme cases might invoke a credit event or make debt unserviceable. Growth debt is usually subordinated debt thus in event of restructuring or liquidation, it gets paid only after the senior debt is paid off.

Empirically, any overuse of debt lowers the payoffs for the investors and its lender. Therefore, CFOs must be clear on the real financing requirements and special characteristics in terms of currency, maturity, etc. and outlay a pragmatic debt policy. Most mistakes are made in buoyant times when the projections look just too good. In order to seize the opportunity, companies get tempted to take on too much debt which gets painful or even fatal in correcting times.

High inflation periods are often volatile and the interest expense amplifies the bottom line, thereby EPS, and by extension, the share price. Investors do care about volatility in share price. Whereas, lenders worry about the repayment risk in case inflation hits the company adversely.

Inflation allows borrowers to pay lenders back with money worth less than when it was originally borrowed, which benefits borrowers. Further, a higher risk-free interest rate in the economy also results in a higher warrant price and a similar positive correlation also follows with higher implied volatility.

Both the borrower and the lender should keep a close look at certain ratios particularly — liquid assets to short-term debt and interest paid as a per cent of EBIT. The former ratio keeps a check on any heightened default risk while the latter checks on the volatility of earnings. Inflation will reduce the former ratio and adversely increase the latter thereby heightening the risk of credit event.

India is a large size credit market with a competitive landscape. When the market leader, HDFC, the largest lending house in India, has been clocking 20 per cent growth for more than 20 years speaks of India’s market size and the latent room for growth. The size of the total lending market in India has grown to Rs 174 lakh crores as of March 2022. The economy expanding into unchartered business activities, and risky turnarounds are part of India’s growth story. This is financed by ‘risk capital’ — either in the form of equity or debt. But not everyone has risk capital. Most importantly, managing a high-yielding portfolio of risky assets is not everyone’s cup of tea. It requires great expertise to manage such skewed risk-return assets.

Traditional banks in India are generally averse to risky financing especially after having gone through a dramatic rough phase of high NPAs in the last decade, and rightfully so as they, on the other hand, have been entrusted with more Rs 140 lakh crores of depositors' money which they deem very-secure. Moreover, many Indian banks, especially the PSBs are not well capitalized, thereby lacking sufficient ‘risk capital.’ However, India has several NBFCs and AIFs which have expertise in this domain. They are often backed by private equity capital, large corporate houses and also gets funded by QIPs, even bank debt (usually lent to the holding company instead of a particular operation), and readily caters to companies seeking growth debt.

The size of the lender has great relevance in India. The ROA (return on assets) starts to fade for large lender groups after reaching a typical book size of Rs 20k- 50k crores. They are therefore compelled to resort to risker products or innovative lending channels. But lenders with weak or without parentage aren’t able to take on much leverage, thus, such companies in order to achieve a high ROA resort to high-yield products such as unsecured microfinance loans, construction loans, etc and growth debt is one of them.

High yields add to the portfolio risk. India has witnessed periods of reckless book building spree such as PNB Housing in around 2013, NBFCs in the period before the IL&FS debacle in 2019. Poor loan book has its ugly results setting in with a lag of a few years. Whereas, a strong book ensues growth over a long-term horizon, such as seen with Kotak Mahindra Bank. The availability of risk capital is sensitive to market sentiments. Post IL&FS and DHFL debacle in 2019–20, Covid times 2020–21, the risk capital disappeared for a good duration as both lenders and investors grappled with fear and uncertainty showed high reluctance to extent risk capital.

Note- views on any entity mentioned above are my personal views and may not be factual.

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Shubham Saxena

Products@Bank. Ex-corporate banker. Products ⇌ Equity ⇌ Debt. An investor in creators’ economy. Insights on corporate finance, venture capital and payments.