KKR’s Dillard: Why Asian alternative lending benefits from turbulent times

Bank retrenchment and capital outflows have created opportunity for firms with a commitment to the region, maintains Brian Dillard of KKR.

This article is sponsored by KKR

What have been the impacts of covid-19 on the Asia-Pacific region, including the supply of capital?

Brian Dillard

The way I look at covid-19 and the impact on private debt in Asia-Pacific is really in three ways. First, immediately after the US and European markets started selling off, we began seeing big capital outflows from the credit markets and from all capital markets in Asia. It was interesting because the impact of covid-19 was being felt in mid to late January in Asia, but the markets were basically unchanged and immune to it until the US and Europe started their sell offs in late March.

Asia tends to be the last place that people go when times are good and the first place they leave when people pull back. We have seen that outflow abate, but we have not really seen a huge inflow or a rush back.

Covid-19 tended to make firms focus more on their core markets. We have seen firms downsize and close their Asia credit operations, so from our perspective, being local, being long term and being committed to the region – we have been here for 16 years – is an interesting dynamic compared to those who have a “fly-in-and-fly-out” approach.

The second impact is around the banking system. Banks account for 80 cents of every dollar of credit capital in Asia. Most banks are pretty clear in their view of what constitutes acceptable risk and they really do not have a lot of flexibility to lend in situations outside that scope.

We saw bank credit committees become more conservative in the aftermath of covid-19 and much more focused on their home markets. You saw the Australian banks become more focused on their domestic market and less focused on Southeast Asia where they had previously started becoming more active. Thus, you have seen a retrenchment of the banking system both in terms of scope of credit and geographic focus.

Most of the time, alternative capital is for companies who cannot get what they need through the banking system. An alternative for many companies is to go out and raise equity capital.

Finally, during covid-19, equity capital became more expensive in some sectors and geographies, which has made a credit solution much more relevant. In many cases, it is a less expensive form of capital than private equity, so we have seen credit-oriented solutions become popular.

The overall Asia credit story is a story of supply and demand, and covid-19 really just accentuated this imbalance. For firms like KKR, who are committed to the region, we see big opportunity.

What kind of resources do you need to have an effective operation?

It is easy to forget, sitting in New York or London, that mobility in Asia is still very much curtailed in this current environment. If you want to leave Hong Kong and come back, you may have a 21-day quarantine on the way back in, so covid-19 has made it much more difficult to be a “fly-in-and-fly-out” investor.

We look at our own platform and think KKR’s presence in Asia is an enormous advantage. We have more than 130 investment professionals across eight offices and six focused jurisdictions in Asia-Pacific and have built investment teams that are local. The whole idea behind our investment model is taking the best pieces of our global credit business and bringing them into local markets where we are seen as a local player rather than as a transient player. The executives that lead each of these focused geographies are people who have spent their entire careers making alternative equity and credit investments with a huge focus on driving proprietary origination.

We have invested significantly in building what we call local ecosystems of relationships with key stakeholders including companies, governments, entrepreneurs and families and business groups that put us in the midst of meaningful dealflow – both debt and equity. This ecosystem also provides us with unique resources that we can use to do due diligence, source new investments and manage those investments. We have a team of eight credit specialists in Asia who are embedded with each of our country teams and are responsible for sourcing, executing and monitoring the credit investments in each of those regions. Importantly, these specialists are deeply integrated with what is happening at a local level.

Ultimately, to be effective in Asia you need local talent, local expertise and local relationships, and we have that by virtue of what we have built in Asia over the last 16 years. In normal times, that is already a huge competitive advantage but even more so post-covid-19.

What are investors telling you about the significance of Asia-Pacific within their portfolios – in relation to things such as diversification, relative value, correlation, etc?

Asia credit provides diversification through different underlying macro drivers than those in the US or European markets. However, I think the distinguishing characteristic, and what really drives the exceptional risk-return in Asia, is the structural barriers to entry associated with local economies, languages and business practices. Asia is a less competitive market, and we are often the only counterparty that is pitching a credit solution or are part of a very small number of debt providers looking at a deal. If you look at what goes on in the US and Europe right now, you have got a tremendously competitive space for deploying capital and not a lot of differentiation among lenders in the small to medium-sized market. That is a very different dynamic from what we see in Asia.

On a relative value basis we do see premiums to the US or Europe of, on the tight end, maybe 50 to 100 basis points in a market like Australia for a sponsor-led financing. For some of the other opportunities that are a bit more bespoke and further down the capital structure in more developing parts of Asia, we may be 500 basis points wider of the equivalent deal in the US or Europe.

We certainly see a return premium, but we are keenly focused on risk-adjusted returns and think very carefully about the structure. My observation is that documentation in the US and Europe has become much more borrower-friendly, and some fundamental credit protections are being eroded as firms compete to deploy capital. We do not see that dynamic in Asia where all our deals have covenants, EBITDA definitions that make sense and structures that protect our downside if the investment does not go according to plan.

It is not just whether we are getting paid a premium; it is also the controls we are getting as part of that premium and what the balance of risk and return looks like. Over the last 12 months we have seen a general uptick in interest in the Asia credit story. Part of this is investors looking beyond the US and European markets for better risk-adjusted return.

What impact do you see from the volatility in China’s property sector?

We have no exposure to China property within our private credit portfolio, so the impact on our existing portfolio will be minimal. What is interesting is when you contrast what is happening right now with what happened during covid-19 when you had a general capital outflow.

If you look at what is happening with Asia high yield, the most impacted have been the single B-rated China developers. If you look at double B-rated China developers, they have actually been relatively unscathed, and if you look at sectors outside of China property development, then generally you have not seen very large price movements.

Part of this is just investors rotating into higher quality – out of China property developers and into Indonesian or Indian corporates – to stay invested but shift their mix. Therefore, we are not seeing the wholesale outflow dynamic from a year and a half ago. That has made it hard to find many really interesting trading opportunities unless you are willing to take a view on lower quality Chinese property developers.

One interesting theme is that generally the Asia high yield market has a shorter maturity profile than the high yield markets in the US or Europe, and a significant amount of companies have maturities that are coming up within the next 12 months. A sustained dislocation in the high yield market could generate more private credit opportunities, helping companies address near-term maturities.

I think this is probably a healthy thing for the market overall. These are offshore structures with the assets all onshore, but creditor protections in China tend to favour onshore structures, and it has not felt like this dynamic has been priced accurately for a long time.

Longer term, it could be a positive for the market to price more on fundamentals and on the structural realities of those credits rather than on the expectation that that there is some sort of additional credit support that comes from outside of the structure. That is one thing we are watching very closely.

We are not spending any time at all on Evergrande. We think it is a very difficult situation to figure out with just the sheer quantum of liabilities onshore including customers, suppliers, local financial institutions, wealth management products and trust companies that have invested in the company. We are cautious on how offshore bondholders will be treated given all that is happening onshore in front of us.

Ultimately we are more focused on the private credit opportunities that may exist where we can structure deals based on the collateral and secure a better risk-adjusted return than on buying into the high yield bonds.

Brian Dillard is managing director and head of Asia Credit at alternative assets firm KKR