Why Hybrid strategies across Cat 2 AIFs and private credit are gaining traction?

The private credit ecosystem in India has matured rapidly, with a sharp rise in Category 2 AIF commitments (from Rs 12,000 crore in FY15 to over Rs 10 lakh crore in FY25) and new fund launches, outpacing any other asset class. Private credit now accounts for 17 per cent of India’s total alternates AUM, owing to the significant traction from HNIs, family offices, and institutions, up from just 5 per cent in 2018.

Traditional lenders still originate roughly half of India’s outstanding credit, but interestingly, the private credit AUM has grown 3x vis-a-vis the banks’ equivalent. Bank and NBFC loans to the industry saw a sharp decline in FY19 (following the ILFS crisis) and have plateaued ever since, shifting their focus to the retail side. Private credit funds have tapped into this opportunity to fill the credit void of mid-market companies through bespoke, flexible solutions. That being said, a local presence with a thorough understanding of the Indian market dynamics as well as the legal and regulatory landscape is critical for success in this space.

At the heart of this shift is structured capital, a hybrid blend of traditional debt and PE, that offers flexibility, scalability, and alignment with today’s borrowers' and investors' demand. This shift is being powered by the strong fundamentals of India Inc. and the macro tailwinds confluencing the credit landscape. The government’s focus on manufacturing through PLIs (India’s manufacturing PMI of 58.4 in June 2025), infrastructure push, and digitalisation (as can be seen in the surge in UPI transactions) is creating investment opportunities across sectors. Robust demand levels, capacity utilisation back to pre-COVID highs, healthy corporate balance sheets with gross D/E ratios at 15-year lows, have set the stage for capex, M&A, refinancing, promoter buyouts, etc. They directly support capacity creation, formalisation, and employment generation – core pillars of India’s pathway to a $5 trillion economy. Promoter-led firms are increasingly choosing private credit over PE due to its non-dilutive and relatively low-cost nature.

On the policy front as well, the framework has evolved meaningfully. IBC norms post-2016 have enabled greater enforceable rights, as can be evidenced by the ratio of resolution to liquidation, which has improved from 0.20 in FY18 to 1.89 in Q4FY25. Recovery rates have surged ~50 per cent from FY21 to FY24, as reflected in falling GNPAs in SCBs (NPA ratio fell from a 10-year high of 11.180 per cent in 2018 to 2.75 per cent in March 2024). SEBI’s pro-investor-friendly frameworks on the AIF side (including the recent consultation paper on co-investment through CIVs) are poised to encourage greater participation since they open doors to attractive private deal flow to HNIs and family offices. Overall, private credit is a powerful portfolio diversifier - low correlation with broader markets, steady income, high yields, and risk-adjusted returns (2-3 per cent alpha over traditional fixed income products), tax parity with debt MFs, and capital protection.

But we must be cognisant of the fact that if capital pours in faster than quality deal flow expands, competition could compress yields and dilute covenant strength - echoing the ‘late-cycle’ dynamics that plagued U.S. direct lending pre-2022. LPs are also becoming increasingly aware of the fact that, unlike the developed markets like the US and Europe, where a large chunk of the deals could be structured covenant-lite, in India, the deals are structured with water-tight covenants, escrowed cash flows, hard asset collateral, etc.

For now, the demand for private credit from mid-market enterprises still exceeds the available supply. Until that balance shifts, disciplined managers with on-ground sourcing, sectoral expertise, and rigorous structuring will retain pricing power and continue to deliver superior risk-adjusted returns in a market where traditional credit avenues are constrained.

Disclaimer: The opinions expressed above are of the author and may not reflect the views of DSIJ