Emerging market private debt in Asia-Pacific offers high returns, but relationships and structuring are crucial if investors are to avoid singed fingers.
With private debt being a relatively new asset class in the region, investors are not necessarily seeking emerging or developed market exposure. Richard Johnston, head of Asia at advisory firm Albourne Partners, says: “Most Asia-Pacific private credit strategies do not differentiate between developed and emerging markets, and most investors are looking for regional exposure. GPs may well focus on certain strategies or groups of markets, but there is rarely a developed/emerging market divide.”
“To be successful in the long run, you need flexibility into what opportunities you allocate your capital to”
Tor Investment Management
Private credit makes up only 25 percent of the lending market in Asia-Pacific, compared with 50 percent in Europe and 75 percent in the US. Johnston estimates there is $50 billion of private debt capital at work in the region, with China, Australia, India and Indonesia being the most active markets. He also estimates that funds currently in the market are looking to raise $21 billion of capital between them.
Alastair Gourlay, a banking and finance partner in law firm Baker McKenzie’s Sydney office, says: “While private credit investment in the region has grown significantly, the private credit market in each economy varies at different stages of development due to local regulations. This presents investors and borrowers with a unique set of opportunities and challenges that vary from market to market.”
Gradations of predictability
The region’s developed markets – Hong Kong, New Zealand, Australia, Singapore, South Korea and Japan – are “creditor-friendly and have predictable US- or UK-based legal frameworks”, says Patrik Edsparr, chief investment officer and co-founder of Tor Investment Management, an alternative credit manager. In contrast, the developing markets – China, India, Indonesia, Malaysia, the Philippines, Thailand and Vietnam – “have varied and less predictable legal frameworks”.
Some managers also differentiate between emerging and frontier markets and might include Vietnam in the frontier category, alongside countries such as Cambodia, depending on their assessment of the inherent risks.
A notable factor in investor considerations is that developed markets are a relatively small part of the overall private credit pie in the region. Despite the size of its economy, Japan offers relatively few opportunities due to the activity of its banks and ultra-low rates. Australia, however, offers far greater opportunities as its banks pull back from anything other than ‘plain vanilla’ lending. Data is hard to come by in the region, but managers say the most active markets for private lending are China, Australia, India and Indonesia.
The relatively nascent market means there are few single-country funds available and the emerging markets where they are available are China and India, the largest emerging market economies in the region. There are strategies targeting Chinese real estate lending, while India specialist Edelweiss has launched India-only private credit funds. Edsparr says: “We do hear of some interest for single emerging Asia country funds. However, our investors share our view that to be successful in the long run, you need flexibility into what opportunities you allocate your capital to, and these shifts happen much more swiftly than any normal allocation cycle would allow for. We believe that the diversification we can build into our funds across countries and, more importantly, across underlying risk factors, is one of the main selling points to LPs seeking alpha in this region.”
Keeping it in the family
There are fewer financial sponsor deals in the region
A key difference between Asia and other credit markets is the lack of financial sponsors; instead, borrowers tend to be families with a network of companies. Chris Mikosh, portfolio manager and co-founder at Tor Investment Management, says: “Private equity is fairly active but many Asian founders prefer creative debt solutions to selling down stakes to private equity, with an associated loss of control.”
This lack of financial sponsors means networks and relationships are more important for generating business and that lending involves collateral and personal guarantees. The lack of a lender-friendly enforcement regime in emerging markets puts extra emphasis on structuring.
China favours home market
A growing number of domestic Chinese private debt managers, often linked to larger investment management groups, are pursuing domestic strategies for domestic investors. In contrast, most investors in pan-Asia-Pacific vehicles are North American pensions, with some allocations from Asian sovereign wealth funds and insurance companies.
Most private lending in emerging markets is direct lending to companies for acquisitions, capital expenditure or working capital. There are a growing number of distressed or special situations strategies, often targeting India. The latter have attracted a lot of interest from global debt fund managers since the country introduced insolvency legislation in 2016. Real estate lending is important in many markets – it is the mainstay of private credit in China – and may include mezzanine deals.
“Transactions need to be highly structured in order to avoid jurisdiction risk,” says Johnston. “There are several countries where a lender would want to avoid the local courts. For example, lending to an Indonesian family business might involve collateral in Singapore.”
Edsparr adds: “Our emphasis across more difficult jurisdictions is structure and our ability to find mitigating solutions in order to avoid enforcement in a local court. Many of those techniques and solutions are similar, even when the underlying jurisdiction varies.”
The returns for taking these risks are attractive.
Mikosh says 12-20 percent can be achieved across developing markets for direct lending to healthy borrowers, depending on the reason and timeline for the financing, the capital structure ranking, the nature of the company or sponsor, the collateral pool, cashflows, jurisdiction and tenor. “We generally see higher returns for emerging Asia of about 300-500 basis points over developed Asia-Pacific,” he says.
Emerging market private debt in Asia offers opportunities for GPs and LPs due to the strong demand for credit from mid-market companies. These companies are finding it increasingly tough to borrow from their domestic banks, while global banks are tending to pull back from the region. At the same time, the number of Asia private credit managers is small compared with other regions, and global credit GPs are themselves in the early stages of their business in Asia-Pacific.
Albourne’s Johnston says: “Many of the global GPs operating here are still on their first or second Asia-Pacific fund and private debt is a much smaller part of the overall market.”
The other key attraction of Asia is its potential for growth. The International Monetary Fund predicts that GDP in the region’s markets, excluding China, will grow by 7.1 percent annually from 2021 to 2025. These markets are also less leveraged overall than their developed counterparts.
A report published in April by Allianz Global Investors concluded: “Investors can earn attractive yields, while simultaneously benefitting from protections such as relatively low corporate leverage rates, strong covenants and board seats, and personal loan guarantees from company owners. These unique characteristics serve to manage volatility, and potentially enhance long-term risk-adjusted returns.”