KKR: Asia is not all about distress

Distressed and special situations have been the focus of Asia-Pacific private debt markets, but Brian Dillard of KKR highlights an opportunity to back a wider universe of companies.

This article is sponsored by KKR

How has Asia-Pacific evolved so far as a region for private debt?

We have observed that the majority of capital raised over the past 10 years for Asia private credit has focused on distressed credit and special situations, with a high-teens to 20 percent returns target. In contrast, private debt capital focused on performing credit and lending to healthy, growing businesses has remained nascent, especially relative to the size of the overall market opportunity.

Brian Dillard

In a global context, debt capital markets in Asia are underdeveloped relative to the US and Europe, and we believe that many companies are unable to get the kind of debt capital that they need. Further, unlike the US and Europe, Asian banks dominate the market, providing approximately 80 percent of all credit extended in Asia-Pacific. Companies that do not have access to efficient credit from banks often seek equity solutions, which can be more expensive and dilutive. We spend our time focusing on these gaps in the market where the local banks do not participate.

Over the past 18 months, KKR has deployed more than $1 billion in performing private credit investments across Asia-Pacific. Relative to Asian distressed credit, we see a much larger opportunity set where traditional lenders struggle to fill a capital gap for strong borrowers and where we believe we can find better risk-adjusted returns. Distressed credit opportunities may be compelling at a given moment in time, but we view performing private credit as a more robust strategy across the business cycle in these countries.

Is a more opportunistic or focused approach appropriate across the private credit spectrum in Asia-Pacific?

We believe an opportunistic investment approach is more appropriate than a siloed strategy like you see in the US or Europe, where strategies are often focused on only direct lending, mezzanine, capital solutions or structured credit. Our approach allows us to find the strongest risk-reward opportunity across the widest opportunity set. We view this as core to the strategy and provides the flexibility to select what we view as the right structure for a deal rather than forcing opportunities into a narrow investment mandate.

We see a wide variety of performing private credit opportunities across the region; for example, lending through unitranche structures to sponsor-backed companies in Australia, subordinated collateralised structures for South-East Asian corporates and asset-based finance opportunities in the more developed regions. We are focused on relative value across Asia-Pacific, and our strategy is to be responsive when we see attractive opportunities.

What have been some of the main impacts of covid-19 on Asia-Pacific?

We see three main impacts of covid-19 on the market, all of which we expect to be ultimately positive for the opportunity set.

First, we have seen international firms start to leave Asia as part of a capital outflow from the Asian credit market. Our observation is that, for many firms, Asia tends to be one of the last places they focus on during the good times and one of the first areas where we see a pull-back when the global market dislocates.

Second, banks in Asia, which are the source of the vast majority of credit extended in the region, have started to raise the bar for new financings as well as focus more on their home markets and core businesses. It has also become much more difficult for a company to get credit for a cross-border transaction outside its own market.

Third, we have seen opportunities where valuation gaps between buyers and sellers have made it difficult or more expensive for companies to raise equity. We think private credit capital can help bridge this gap as a more attractive financing solution.

To what extent do SMEs in Asia-Pacific recognise and accept the private debt option?

Our experience has been that both medium-sized and large businesses quickly understand the benefits of private credit. We had one situation in Singapore where an SME came to us and some of our competitors, initially looking for an equity investment, and, after doing the diligence, we offered a bespoke credit solution. You can imagine their response when we presented their business plan overlaid onto a credit structure versus the more dilutive equity proposal that they were receiving from other managers. It was an efficient financing for the company and an attractive, downside-protected credit asset for us.

“We believe an opportunistic investment approach is more appropriate than a siloed strategy”

Looking across Asia, we have observed that SMEs represent approximately 60 percent of employment and 40 percent of GDP but only receive 20 percent of bank lending. What makes us so excited about the opportunity is the demand we see from companies like these that otherwise would have to choose between inefficient bank financing or more dilutive equity capital.

How do Australia and New Zealand fit into the strategy?

We have seen many of the same themes in Australia and New Zealand that we see across Asia. The market is dominated by a small number of banks, which we believe are fairly rigid in terms of how they structure and price deals. The profitability of these banks is largely driven by their mortgage books and not from financing SMEs or sponsors to make investments or acquire other businesses.

We believe there continues to be a very interesting opportunity to provide financing to other private equity sponsors when they acquire assets in Australia. The market is a bit larger than many other markets in Asia, and we see a greater proportion of control buyout activity in Australia. In many ways, the market for sponsor-backed financing is more similar to the US and Europe, including creditor protections that are more aligned with the US or UK than many other emerging markets within Asia.

We have been active in the unitranche financing market within Australia, focusing on top-tier sponsors, market-leading businesses and larger transaction sizes. Last year, we completed a A$1 billion unitranche for a large public-to-private deal, which at the time was the largest unitranche financing ever done in the Australian market.

If you could press fast-forward, what will prospects be like in the region in a few years?

We expect continued growth, which we believe will surpass growth of the broader capital markets as private credit takes a greater share. We have talked a lot about companies seeking out more bespoke credit solutions. We are deeply committed to the region as a firm and have further expanded and invested in our platform to meet this growing demand.

The other important theme we see across Asia-Pacific is driven by what is happening in the private equity market. Capital formation for Asia-dedicated private equity funds has been extremely strong over the past several years and current Asia-focused undeployed capital is almost $400 billion, which is more than double what it was three years ago. The market now has a handful of large $5 billion-$15 billion funds that are looking to invest.

We believe this will lead to two things. The first is larger transactions, and the second is a greater share of traditional leveraged buyouts. Both of these factors are positive for the development of the private credit market as private equity sponsors look for financing partners.

Today, we think the Asian market looks a lot like Europe did 10 years ago. There is currently roughly $4 of private equity capital for every $1 of private debt capital in Europe. In Asia, it is roughly $24 to $1, which we see translating into a large runway for growth.

We have built large third-party sponsor finance businesses in the US and Europe and are using a similar playbook to think about the sponsor opportunity in Asia.

How do you assess relative value as a firm that operates across the world?

This is a topic that gets a lot of attention. Some investors perceive Asia-Pacific as an over-banked market where credit capital is readily available and the price of it is very cheap. That may be true for national champion businesses or large state-owned enterprises supported by their local banking systems, but we see large capital gaps across the market where companies cannot access the right form of credit.

Ultimately, one of the biggest drivers of relative value is the amount of capital chasing investments versus the size of the opportunity set. Our experience in Asia-Pacific is that we have often been the only counterparty pitching a credit solution or have been part of a very small group of potential debt providers looking at a deal. This is a very different situation compared to the US or Europe today.

Returns are important, but core to our philosophy is the risk side of the risk-return equation. Our observation of the syndicated markets in the US and Europe is that documentation has become much more borrower-friendly and fundamental creditor protections are being eroded as firms compete to deploy capital. We have not seen this dynamic in Asia; our deals typically have covenants, rational EBITDA definitions and structures that are intended to protect our downside if the investment does not go as planned.

At the end of the day, downside protection is a core tenet of our approach, and we are comfortable walking away from transactions where we do not believe we have appropriate protections regardless of the return potential.

What are the main opportunities and challenges in the region today?

The biggest opportunity for the Asian credit business is the broader economic growth within Asia and the demand for capital which accompanies that growth. Asia represents more than 60 percent of global GDP growth but less than 7 percent of private credit capital.

Many leading Asian companies do not have the funding options that their European or US competitors would have. We think this is a big opportunity and, with limited participants able to provide bespoke private credit solutions, we are finding what we believe are exceptional risk-adjusted return opportunities, often with companies that we have known locally for a long time.

The key challenge in Asia is the lack of a single market culture, legal system and language. The same investment team looking at a deal in Malaysia probably will not have the right relationships and skills to look at an investment in Indonesia even though these two companies might be headquartered less than 100 kilometres apart. This challenge is a double-edged sword. On the one hand, it makes it difficult to develop a scaled platform across markets that has the requisite depth to be successful; on the other hand, it creates a natural barrier to entry. We believe a localised approach is key to successfully operating in Asia, and our credit strategy is deeply integrated with KKR’s established country teams across the region.

Brian Dillard is a managing director and head of Asia credit at KKR