Huatai: LPs wise up to Asia private credit

There are still deals to be done for private credit funds within the Asia-Pacific region, say Ryan Chung, head of structured finance and principal investment, and Isaac Wong, executive director of structured finance and principal investment, at Huatai International.

This article is sponsored by Huatai International

There are still deals to be done for private credit funds within the Asia-Pacific region, say Ryan Chung, head of structured finance and principal investment, and Isaac Wong, executive director of structured finance and principal investment, at Huatai International.

How are LPs currently approaching the private credit opportunities across Asia-Pacific?

Ryan Chung
Ryan Chung

Ryan Chung: Limited partners in this region are changing the way they allocate their resources with more capital flowing towards private credit as an asset class. Traditionally the split between private equity and private credit has been approximately two-thirds to private equity, but today that has switched around and LPs are pivoting to allocate additional capital into private credit.

There are many reasons for that: key drivers are the downside protections, resilience against market downturns and high certainty of returns to LPs.

In general, it is much harder for private equity funds to exit their investments under the prevailing market conditions, which are stale with a dreary outlook. Many private equity GPs in Asia are feeling the pressure more than their counterparts in Europe and North America as IPOs served as a major exit avenue, and that exit route has largely been shut this year. This has also rendered many private equity funds reliant on trade sales for exits and it is likely that one will be selling to professional investors that will not value assets the way public markets do. A lot of private equity firms are also exiting positions to other sponsors but query how long can the musical chairs last.

Meanwhile, private company valuations benchmark against public equities, so as equity market valuations continue to spiral down, combined with rising interest rates, we are seeing pressure on all asset valuations. It has been a good run of increasing valuation multiples over the past decade, but now we are going through a reset. On the credit side, a lot of LPs were also historically major investors in public fixed income products, with the public bond markets seen as safe and stable. But with recent defaults in the Asian bond markets, that premise has changed and LPs have turned to private credit markets.

Isaac Wong: On the fixed income side, actual performance in Asia has been quite underwhelming over the last two years, and it is a similar story for public equities. For allocators, the private credit space has thus far shown itself to be an attractive place to allocate capital, given the relative stability in performance ranging from high single digits to mid double digits for more direct lending strategies. The relative stability of those returns is working in favour of private debt.

How can managers mitigate risks and avoid potential pitfalls?

RC: To avoid pitfalls, you have to maintain discipline in your investment thesis. The underwriting of the underlying credit has to be thorough. Many private debt investors took more of a trading approach, relying on the creditworthiness of the equity sponsor rather than studying the fundamentals of the underlying credit and understanding the need to mitigate risks effectively through tailored structuring.

Many transactions done in recent years have been mispriced relative to the risk, and a lot of private credit investors have failed as they over-relied on the guarantees of the equity sponsor, accepted light covenants and weak recourse structures to pledged assets, and have then also looked to refinancing in public markets as a primary source of repayment. But you need to be fully aware of the underlying credit risks and aim to mitigate those so that you are taking educated risks. Taking directional risk for capital preservation and buying into the doctrine of “too big to fail” are common causes of failures seen in the private credit markets.

That understanding of risks is of paramount importance to then translate into the structuring of investments. This could range from taking a board seat of the company with a laundry list of reserve matters to incentivising the company to meet certain milestones.

Isaac Wong
Isaac Wong

IW: The key is really to maintain your fundamental analytical underwriting framework. There are always opportunities, especially in the current environment, because borrowers have all been negatively impacted by the lack of an ability to access new issuance in equity and public bond markets, and the bank loan market has been cautious about where and how they deploy their balance sheet. This has resulted in borrowers and sponsors being much more generous in the returns they are willing to offer private credit, which in turn can make it tempting for GPs to invest into situations they should probably pass on.

But, despite an increase in investment opportunities, we think it is very important to remain disciplined and stay consistent to our underwriting framework and assessment of the underlying credit and deal structure. Seek companies that are resilient and have the ability to weather economic storms.

Where do you currently see the biggest opportunities in private credit for GPs in the region?

RC: This is an interesting macroeconomic environment to be investing in. With the interest rate rising cycle we are going through, this acts like a tailwind for private credit as most of our ongoing investments adopt floating rate, which naturally increases our returns. Then there is a dislocation in the US currency against mostly all currencies within Asia-Pacific, this could generate higher returns if entering into local currency-denominated investments as these Asia-Pacific currencies recover over time. Of course, attention has to be given to corporate credit risks at the same time under this scenario.

The market is complex within Asia-Pacific because there are multiple jurisdictions with different dynamics in each country, with both the political and economic environments varying. As a result, different industries are going through different cycles, so one industry that’s well supported in one country may be impacted differently in another country. You really need to have good local knowledge as a GP to navigate and secure good investments.

IW: It is an interesting environment because it’s one we haven’t seen in the last 20 years, where interest rates have risen so rapidly – USD rates have risen 300bps in the space of six months, which has not occurred in the last 30 years. That is having a large impact, most immediately on corporate valuations, which have come down rapidly and may have further to go. Whereas the impact on corporate earnings is yet to fully flow through, the corporate earnings being reported today are based on a period before those interest rate increases started to hit, so we are in an interesting period where we are yet to see that impact on reported earnings. We’ve already started to see the impact in recent corporate reporting of inflationary cost pressures (which kick-started the rate rises), but this is likely to continue for a while yet until supply-chain issues ease.

We want to stay disciplined in our approach, still looking for companies and sectors where earnings are more resilient to an economic downturn. That leads us to key sectors that are similar to infrastructure or essential services, like healthcare, technology and logistics. There are also still opportunities in property. In addition, investors are starting to focus on covid recovery plays in areas like hospitality and transport. Overall though there is a flight to quality, and those are the key themes that will present good opportunities across the region. We see ourselves as a strategic partner to our investee companies rather than transaction-based investors, which would naturally cultivate a deal that works to achieve each party’s goals.

ESG is an over-arching theme, with LPs and GPs very focused on investing for a sustainable future. Opportunities to provide capex to fund the expansion or upgrade infrastructure of companies in technology or power are also good places to be going forward.

How do the challenges and opportunities vary from country to country in the region?

IW: There currently are many opportunities across Asia. In China, for example, bank financing and onshore liquidity has severely tightened through the first three quarters of this year, but there are good companies that are on a healthy expansion curve and require growth capital.

This is a common theme across geographies, so there are many opportunities for private debt to step in and fill the void. Performing credits are attractive right now because the risk-adjusted returns stack up for private credit, which has been driven by a reduction in the alternative sources of liquidity.

RC: Hong Kong has traditionally been a hub for raising private credit, particularly acquisition financings for PE sponsors and for corporates as well as real asset owners across the region. Then as we move into Southeast Asia and Australia, there we see reopening trades, with a lot of hospitality-related assets now performing very well because those countries have started to reopen and enjoy a strong rebound in demand.

IW: We see quite a lot of opportunity is Australia, which has always been well liked by investors across the board because of its legal system, transparency and openness. The opportunity set for new acquisitions was quite subdued in the first half of this year, but given the amount of Asia-Pacific private equity funding that has been raised, the next 12 months we are likely to see a lot of deployment. That provides the opportunity for private credit to meet the needs of sponsors and borrowers.

Across the region, dealflow has been slower in 2022 compared to previous years and there has generally been a widespread deterioration of corporate credits, so the challenge is to maintain discipline when assessing which companies will come through the other side as companies face different challenges going forward.

What are your predictions for the private credit asset class in Asia-Pacific going into the future?

RC: Corporates are getting more sophisticated and constantly seeking out alternative channels to raise growth capital without equity dilution that is typical with private equity funds. Private equity sponsors are adopting more complex capital structures including structured credit to enhance their return. And with Asian economies and markets still growing, ensuring robust demand for capital support, this all together ensures healthy demand for private credit going forward.

We expect international GPs will continue to raise capital successfully for its Asia private credit strategies, but smaller local GPs might struggle on fund raising. Despite the geographical conflicts, many GPs and LPs take a long-term view on the growth and potential of committing their resources to the Asia region. Nonetheless, private credit is still a small percentage of the lending market and a small proportion of total asset allocations by LPs in the region. We expect LPs to allocate more into this asset class, attracted by its characteristics and returns.

IW: We are very positive on the asset class in the future, and we think there is a lot of dry powder to be deployed so the outlook is healthy. As GPs we see private credit being well-positioned to continue to grow. A lot of GPs will be deploying next year because this year has been a bit slower, and it may take some time still for other sources of capital to re-open, which creates strong deployment opportunities for private credit across Asia-Pacific.