Huatai International: The growing Asian appetite for private credit

Private credit looks set to become an ever-more important feature of Asian capital markets over the next decade as banks retreat from corporate lending, say Huatai International’s Ryan Chung and Isaac Wong.

This article is sponsored by Huatai International

What opportunities are there in Asian private credit at the moment?

Ryan Chung

Ryan Chung: Asia is a very attractive and growing region for private credit. The region accounts for roughly 40 percent of global GDP and is expected to grow to 50 percent by 2030. At the same time, Asia-Pacific receives less than 10 percent of global allocations to private credit markets, which highlights the tremendous under-allocation.

Asian economies have a large composition of SMEs. Asian SMEs represent 96 percent of all business enterprises in the region (by count) but face an estimated financing gap of around $5.2 trillion every year. In Asia, private credit’s opportunity to expand into the dislocation vacated by local banks is evident in various markets in the region.

With Asian banks retreating and de-risking within a higher interest rate environment, Asian SMEs are expected to continue to be underserved by traditional banks for the next several years. Corporates need more flexibility and tailored financing solutions from private credit to retain more cash for debt servicing and for growth investments to stay competitive. Private credit continues to be an attractive asset class in Asia over the medium to long term, taking advantage of the region’s growth starting from a low base.

Isaac Wong

Isaac Wong: We believe that over the next five to 10 years, private credit will become a permanent feature of the Asian capital markets – for investors and for borrowers/sponsors. While the amount being allocated to private credit will not necessarily overtake public debt or equities, the potential for growth is definitely there.

What role can Asian private credit play as part of a well-diversified portfolio?

IW: Private credit tends to be specific to domestic economies, so the exposures that LPs can get in Asia are not necessarily the exposures they get in the US or Europe – both in terms of sectors and in terms of com panies. For example, Asia is the manufacturing hub of the world. The companies here produce products and services for global consumption. This is something often overlooked by investors that are located outside of the region, for which private credit principally provides exposure to property or companies focused on domestic regional services.

RC: While a lot of Asian credit is based around performing loans, there is ample opportunity for LPs to capture opportunistic credit as well. This allows those investing into Asian private credit to benefit from a high degree of capital protection whilst enjoying capital appreciation as the investee companies grow in equity value. The opportunities we see vary significantly between countries in Asia, and they are very fluid. For example, an industry that works in Greater China or Singapore today might not work in South Korea. Different industries in different countries find themselves in very different stages of development.

How are LPs managing the risks and challenges that are embedded in Asian private credit?

Isaac Wong: As with any other asset class, investors need to maintain underwriting discipline. We must make sure that we have sufficient in-depth working knowledge of the countries and sectors in which we are investing.

There is also definitely a trade off in liquidity, but that is also the benefit of the asset class as well. Private credit is not meant to be liquid. This lack of liquidity means that LPs are not forced to make redemption decisions because of short-term market conditions. The key is to make sure that the investment can endure across economic and credit cycles providing a consistency in performance. When viewed through this lens, the liquidity risks of being in private credit are actually mitigated by the very nature of the asset class.

European and US investors still dominate Asian private credit markets. Are local LPs showing more interest in the asset class?

IW: Yes, there is a deepening appreciation across the region of the non-correlated and less volatile returns that private credit provides vis-à-vis the public markets.
Private equity and publicly listed assets have seen over-valuations recently, with current mark-to-market valuations lying well below the entry valuations that these acquisitions were made at or where they were two to three years ago. This makes it very difficult to generate exits and could make LPs more cautious from allocating more to these strategies. Therefore, private credit is increasingly playing a more prominent role in many portfolios as a result.

RC: Another reason that LPs like this asset class is that it provides a very broad range of investment instruments within the entire capital spectrum to maximise return with capital preservation, from pure direct lending all the way through to hybrid debt and quasi-equity. At the same time, private credit is typically secured against assets of economic value for downside protection.

IW: Interest in private credit is often driven by the liability needs of the LPs. The whole of Asia – and no country is really immune – is going through significant demographic change. Populations are ageing, and a growing number of people are hitting retirement age. Retirees are looking less for capital growth and more for steady income that is hedged against inflation. A lot of LPs are looking at private credit as a suitable investment asset class for matching the long-term liabilities that they have to their members/beneficiaries.

Has covid-19 had much of an impact on investor sentiment towards Asian private credit?

IW: We don’t think covid-19 has had a direct impact on the interest in Asian private credit. In fact, private credit has been able to shine in the unfortunate period that the world has just gone through.

Rising interest rates have meant that public fixed income is not actually as safe, stable or resilient as the private credit market. Private credit has proven its worth. It is therefore no wonder that LPs have been increasing reallocating their portfolios into this alternative asset class and we expect this to continue.

Why do so many Asian LPs still invest in the US or European private credit markets, rather than closer to home, and is this changing?

IW: This is really a function of the fact that the US and European markets are much deeper and more developed than those in Asia. Many Asian LPs have therefore found it much easier to allocate capital overseas historically.

What we’ve seen recently, though, is that some of these Asian LPs are now allocating more to the region as their home economies continue to demonstrate sustained growth. At the same time, there are also LPs that have been in the US or European credit markets for some time now, have enjoyed good performance there and feel that now is an opportune time to invest in Asian private credit.

RC: It also goes back to prevailing macro conditions. Economic growth in the US is slowing, Europe is going through a lot of geopolitical issues, and that forces investors to look into Asia for its growth and where they see attractive risk-return opportunities. The region offers to investors countries with different risk profiles, from fully developed to emerging and frontier economies.

How should GPs avoid pitfalls or mitigate risks in Asian private credit?

RC: There are investment opportunities in every phase of the economic and business cycles for each country and industry. GPs are responsible for identifying, mitigating and taking educated risks with a consistent and disciplined approach, and of course, one should be ready to walk away if the risk is too binary for failure, or risk-adjusted return is not suitable.

“The opportunities we see vary significantly between countries in Asia”

Ryan Chung

GPs should exhaust all means to protect principal via effective tailored structuring, strong collateral and on-the-ground knowledge, including tools that are commonly adopted by growth equity. Many private credit houses have underperformed recently as they conveniently relied on corporate guarantees buying into the doctrine of “too big to fail”, taking on light covenants and adhering to weak recourse structures with over-valued collateral. Heavy reliance on liquidity events from capital markets or refinancing as the primary source of repayment are common pitfalls as well.

To what extent have current macroeconomic conditions fed into the development of the asset class?

IW: In APAC, although inflation is definitely elevated, it’s not quite as high as in the US or Europe (yet). Therefore, Asian central banks have not had to raise interest rates as rapidly as their counterparts in the US or Europe. We’ve seen this across the region. Even in Australia, which has seen quite a bit of inflation, rates are not rising to the same extent. So the macroeconomic conditions remain relatively stable.

This has allowed companies to readjust for increased costs over a longer period of time, which has fed into their performance and resulted in them being a bit more resilient against the prevailing macroeconomic headwinds. Current conditions, therefore, are supporting the asset class, simply because firms have had more lead time to readjust their business strategy to cope with higher cost structures. This has helped keep default rates down across the region.

Furthermore, because of the floating rate nature of a lot of private credit investment strategies, LPs generally don’t need to worry about interest rate hedging overlays. The asset class is naturally hedged against interest rate increases, which is very important in the macroeconomic environment in which we now find ourselves.

RC: Rising interest rates are also deterring investors from allocating to traditional fixed income products, such as public bonds, due to the capital losses sustained within these types of investments. So LPs are moving their money into private credit instead, as it offers more stable returns.

Are you confident that interest in this asset class will continue?

RC: We are confident. Right now the Asian private credit market has an AUM of around $1.4 trillion. We’d expect this number to grow to over $2.3 trillion in the next four to five years. So this trend will definitely continue – perhaps not at quite the same CAGR as we’ve seen to this point, but definitely the growth will be there.

IW: The other thing we should mention is ESG. LPs that invest in private credit want to be good corporate citizens and make sure that GPs have the right ESG framework in place. It’s harder to directly implement ESG within private credit than it is within private equity, because it’s harder to direct the investee company’s board, but GPs will exert pressure via other means to ensure ESG outcomes. Private credit as an asset class is making its own contribution to the global ESG agenda.

Ryan Chung is head of principal investment at Huatai International and Isaac Wong is executive director of principal investment