This article is sponsored by Abax Global Capital
Well-publicised defaults by real estate developers, unexpected power shortages and sudden regulatory changes might unnerve investors, but China’s growth story remains as strong as ever. This year its GDP is set to grow by more than $1 trillion, larger than many developed economies. China has a host of mid-market companies starved for growth capital, creating compelling opportunities for private lenders.
Michael Wang is managing partner and president of Abax Global Capital, a Hong Kong-based private credit investment manager focusing on China and Southeast Asia. He talks about the depth of the opportunity in China and how to exploit it.
What is the opportunity in China private debt over the next 10 years? How significant is it, compared with other Asian geographies?
In a global environment where interest rates and bond yields remain near all-time lows and asset prices are at close to record highs, you want to be where the growth is. Asia is the prime engine of global growth and China is half of Asia’s growth. I think China, already the second largest economy in the world, still has room to grow at about 5-6 percent annually for the next few years, and that is starting from a gigantic base. China has managed the covid-19 pandemic admirably to-date, and we are confident it will continue to drive global economic growth as the world starts to re-open.
China continues to urbanise, and I believe there’s still a long way to go in the third, fourth-tier cities. The middle class is growing, and consumption is shifting toward new things, whether that is travel, electronic gadgets, EV cars or private education.
There’s a vast universe of middle-market companies in China. They need non-dilutive capital to fund their continued growth, either organic or via acquisitions, but are severely underserved by commercial banks, which prefer to lend to state-owned enterprises. And they aren’t yet big enough to access the syndicated loan or public high-yield market. Private debt helps fill this funding gap for middle-market businesses – a gap that’s become even more pronounced in the wake of covid-19.
Based on our experience in the past two decades, China has contributed the largest share of quality deals in Asian private credit markets, reflecting its size, strong growth, multitude of growing middle-market companies and readiness for global and domestic IPOs. While recent regulatory reforms have injected an element of uncertainty into a handful of sectors, overall we see increasing interest in China private credit from global investors who are aware of the attractive risk adjusted returns.
Structured private credit is a defensive way to participate in China’s growth, with high yields, downside protection and potential equity upside. Competition is limited compared to the developed, even crowded, private credit markets in North America and Europe. When excluding lenders focused on real estate or distressed assets, the number of private credit lenders with a primary focus on China is limited to a handful of players.
How does the current upheaval in China, for example the regulatory crackdown and Evergrande debt crisis, affect private debt investments?
China has structural problems just like the US and other developed economies. But China still has upside growth potential to help it ride out its troubles.
Since Abax began in 2007, China has gone through a number of cycles and upheavals, with the fallout from the global financial crisis, Xi Jinping’s ongoing anti-corruption drive, the crackdown on shadow banking, and the ongoing geopolitical tensions. But when we look at China’s competitive advantages, we still see great opportunity given its 1.4 billion consumers, increasingly developed infrastructure and manufacturing prowess. The Chinese government has demonstrated its superb ability to mobilise vast resources to manage a crisis like covid-19. Still, investors must sometimes navigate regulatory ambiguities as we’ve recently seen in the education, real estate and fintech sectors. We believe such uncertainty offers an even stronger rationale for private credit, which is more defensive in nature.
Unlike many of our peers, we’ve always shied away from lending to China’s real estate sector, primarily due to its usual high leverage and unfavourable risk/reward. Our focus has been lending to mature and fast-growing corporate borrowers in an array of industries and, through lending, obtaining inexpensive or even free equity options to participate in the upside. With the fallout of Evergrande and other developers, we expect private credit managers in this region will move away from real estate lending and focus more on corporate lending going forward. We have strong conviction in businesses that disproportionately benefit from China’s continuing economic expansion including the consumer, healthcare, renewable energy and water treatment sectors, as well as certain pockets in education.
How does a China-focused debt manager think about ESG and does the approach differ from developed markets?
We primarily invest in China and Southeast Asia, where ESG standards lag those in the US and Europe. Abax is a signatory to the UN’s Principles of Responsible Investing, so we build ESG principles into our investment decision-making processes.
Previously, staying abreast of investors’ ESG concerns involved not doing the wrong thing, like investing in ‘taboo’ sectors. Now we focus on actively doing the right thing. We look to allocate capital where it is most needed, which is not difficult because SMEs, which generate more than two-thirds of incremental GDP and employment, are so starved for growth capital.
It is also about lending to the right sectors, providing not only an economic benefit, but a positive societal impact. For example, China is embracing a carbon neutral future, so investments in anything from solar energy, storage technology and charging infrastructure can help reach that goal.
What skills do GPs need to successfully operate in private debt in China?
First, you need to be local to succeed in China and that means more than just opening an office in Hong Kong.
It is critical to have strong local roots in the Mainland with the required language, network and understanding of cultural nuances to navigate the quirks of China’s business world. Access to attractive investment opportunities in China and emerging Asia is highly relationship driven. You need to know how to build a trust-based relationship with a company’s owners and executives. We’ve also learned there is no substitute for experience investing and managing across different market cycles.
It is also imperative to have an experienced team who intimately understand the local legal systems to be able to properly structure deals and navigate complex distressed situations should they arise.