The resilience of private debt investments during the pandemic will encourage investors in Asia-Pacific to allocate more to the asset class. LPs and GPs based there agree that, for investors with a short history in private debt, stability during hard times has provided ‘proof of concept’, which ought to lead to further investment.
Furthermore, Asia-Pacific’s economies have proved more resilient to the effects of covid-19. This is encouraging some investors to look more closely at their home region, even though it does not offer the same breadth and depth of opportunity as North America or Europe.
“We did not expect a black swan event like covid,” says Dong Hun Jang, chief investment officer of Korean public pension fund Public Officials Benefits Association. “However, our private debt portfolio was resilient. Over the longer term, our private debt investment has generally exceeded expectations.”
Ryan Chung, head of Chinese investment bank Huatai International’s structured finance and principal investment team, says: “In 2020, private credit really did show how it can outperform. And the outperformance is not just on the return side. It’s actually on the risk side. If you are an LP with long-term money then it makes complete sense.” Chung’s team has made balance sheet investments in Asia-Pacific private debt, as well as on behalf of a range of investors.
The number of Asian investors targeting private debt has risen significantly over the past five to 10 years. However, it is still a fledgling asset class in terms of the investors, managers and strategies that focus on the region. Private Debt Investor data show global private debt fundraising fell sharply in 2020 as a consequence of global economic upheaval. This followed static figures for the previous five years, with the exception of a bumper 2017.
“Pension funds, both public and private, have been a major source of capital for private debt strategies,” says Edward Tong, head of private debt Asia at investment manager Partners Group. “A major source over the past 10 years has been the various sovereign funds, while in more recent years we have seen more activity from insurance companies looking for yield as rates have fallen.”
Chung adds: “In the near future, there will be a wave of LPs in China looking at alternative investments and, with the volatility in private equity exits, we expect and hope more will allocate to private credit.”
First to recover
Asia was the first region to be hit by the coronavirus and has been the first to recover, though the pace of the recovery has varied. China did not dip into recession and posted 2.3 percent GDP growth in 2020. This compares with predicted falls of 1.1 percent in Korea and 5.4 percent in Japan. Meanwhile, the US economy is estimated to have contracted by 3.6 percent and the EU’s by 7.8 percent.
The varying performance of global economies is naturally affecting where Asia GPs are seeking to invest. “Our focus is on North America and Europe,” says BK Cheon, chief investment officer at Korea’s DGB Life Insurance. “The US has shown good resilience to the pandemic, so we prefer North American private debt at the moment because of slightly higher returns and because the market is quite deep. Europe has further to go with covid and their debt market also is relatively smaller than the US, because the European market is dominated by the banks.”
Although China is the standout performer in terms of resilience to the economic effects of the pandemic, there is a general perception that Asia-Pacific nations have done better in containing the virus and its economic backlash. Neither Japan nor Korea have had severe government-imposed lockdowns, while Australia, New Zealand and Taiwan have had some success in fencing out the virus. Fatality rates overall have been lower than in Europe and the US.
“If you take a macro view, Asia has outperformed, particularly in the last 12 months,” says Tong. “Over the next 12-24 months I think the outlook is pretty positive from a recovery standpoint. There is a much quicker path back to normalcy on this side of the world than perhaps in other parts of the world.”
Bev Durston, founder of investment consultancy Edgehaven, adds: “Many of the sectoral themes – transportation, tourism and hospitality being worst affected – remain the same. However, the fact that the outbreak was more contained in Asia means the companies affected are not as weak as in the US and Europe. The fact that leverage is generally higher in the US and Europe also exacerbates this factor.”
Asia’s resilience means investors are considering investing more in private debt there. “Our private debt fund portfolio is composed mainly of investments in North America, Western Europe and Central Europe,” says POBA’s Jang. “However, last year we committed to an Asia regional mandate for the first time. Asia has been less affected by covid, so we may look to invest more where we can.”
For Asian investors seeking to invest more in their home region, there are a number of barriers to entry – primarily the lack of funds and managers (either domestic managers or international managers with Asia strategies). PDI data show that Asia-specific funds made up only $5.4 billion, or less than 4 percent, of the $148.7 billion of private debt capital raised last year.
Other obstacles might include Asian LPs’ resources and capabilities. Tsutomu Ishida, deputy general manager at Japan’s Tokio Marine & Nichido Fire Insurance, says: “Right now we don’t have the resources to research Asian debt opportunities, but in the medium term we would like to explore the market and understand the market, the risk profile and which managers really fit our investment appetite.”
With a multiplicity of languages, currencies, economies, cultures and types of government, Asia-Pacific is a region that is harder for western investors to digest. Korea is as close to China geographically as Belgium is to Austria, but the two countries are radically different environments for debt investors.
Dipping a toe in troubled waters
A world turned upside down should generate distressed opportunities. But Asia LPs are cautious and wondering when these opportunities will crystallise
The economic upheaval generated by the pandemic and by government restrictions on activity is expected to generate distressed debt opportunities, and some Asian investors are taking the plunge.
Bev Durston, founder of investment consultancy Edgehaven, says: “For new funds [LPs are] looking at special situations and other opportunistic funds being raised to take advantage of the covid dislocations. Asian LPs have certainly invested in some US and European distressed funds this time around.”
However, investors remain cautious and PDI data show that only 16 percent of the capital raised last year was for distressed debt strategies, compared with 28 percent in 2019. So why are so many investors on the sidelines?
Tim Ridley, deputy chief investment officer at Australia’s Vision Super, says: “While we may consider distressed debt funds at some stage, the current level of company stress is not high in many industries, thanks to the very stimulatory monetary and fiscal policy being employed here and globally. In part reflecting this, we are not actively seeking to deploy capital in this area at this stage.”
Durston adds: “The sheer time that it will take – post Biden’s new support packages – for government support to be eliminated means that distressed may not be highly visible even in a three-year investment period from now.”
Distress is one potential avenue to deploy capital as part of a broader strategy selection within the asset class, says Edward Tong, head of private debt Asia at investment manager Partners Group. LPs may also target “niche, more focused strategies – for example, investing into software or technology companies”.
Lack of transparency
DBG Life’s Cheon adds that a relative lack of transparency in developing Asia-Pacific markets may also dissuade institutional LPs. “We have discussed higher return opportunities in Asian markets such as China and India,” he says. “But the problem is that they do not have the very solid legal structures you see in the US and UK, for example, and it is not as easy to access opportunities. However, these are growth markets with many growth businesses.”
At present, Asia-Pacific investors are relatively under-represented in Asia debt funds. A 2020 survey by the Asia Credit Council found that only 23 percent of the capital in Asia debt funds came from Asia-Pacific investors. The survey also found that, relative to North American and European funds, more of the investors were high-net-worth individuals and family offices, reflecting a region with fewer institutions.
Private debt investment came later to Asia than to North America and Europe, so naturally there are fewer investment managers available and in particular fewer ‘home-grown’ GPs. Furthermore, a number of markets – such as Japan – have strong and active banking sectors. Even the largest global investment managers tend to have smaller operations and fewer Asia-Pacific funds. For the moment, PDI data indicate little change, with Asia-Pacific strategies accounting for only 5 percent of funds (by target assets under management) in the market.
However, there have been some significant Asia private debt fund closes and launches, including some from Asian managers. Hong Kong’s ADM Capital raised $630 million for lending to mid-sized Asian companies, Australia’s AMP Capital launched an Asia infrastructure mezzanine fund and OCP Asia raised $500 million for a direct lending vehicle.
Many investors would like to invest with local or domestic firms if possible. “The picture is diverse but there is somewhat more capital being allocated to international GPs rather than domestic managers,” says Partners’ Tong. “International managers, at least at this point, tend to be larger and have capacity for more capital. That said, we’ve certainly also seen more regional peers emerge over the last five to 10 years.”
Huatai’s Chung says: “With Chinese institutional LPs, there are generally two buckets of private debt capital. [The first is] for international managers with strong reputations, track record, global strategies and significant AUM – the ‘tick the box’ bucket. Increasingly though, they will have another bucket for local/regional GPs. Chinese LPs will always have a certain base comfort level with indigenous GPs. The same applies with Japanese and Korean investors. They like GPs who understand their language and culture.”
Not all domestic managers are investing in their local markets. In Korea, local managers have found a role as intermediaries between domestic LPs and international GPs. Cheon says: “There are not so many Korean GPs in private debt but one of our debt investments is a fund of funds with a Korean manager, which invests into smaller European and North American funds.”
The diverse investor profile in Asia-Pacific means LPs are seeking different things from their debt investments. Wealthy Chinese individuals are prepared to take on far more risk than Korean insurance companies. Nonetheless, for Asian institutions, private debt investment is a matter of trading liquidity for yield and adding some lustre to historically low fixed-income returns.
“As we are insurance money, we are pursuing more stable income,” says Cheon. “Private debt offers us a return premium in exchange for illiquidity. The current super-low-interest-rate environment hurts insurance portfolios and we are 60-70 percent invested in fixed-income. So, we sacrifice liquidity and then we can expect to increase the return. From private debt we expect a total return of 7-8 percent.”
Tim Ridley, deputy chief investment officer at Australia’s Vision Super, says: “In aggregate, we expect the alternative debt portfolio will provide a return between listed equities and fixed interest over the medium term. It is expected to be both a source of yield, with lower volatility than listed equity, reflecting less risk as well less frequent pricing.
“It has a higher level of liquidity than infrastructure and property, and therefore provides some flexibility for adjusting the portfolio over time. In addition, the duration of the alternative debt portfolio is low, which provides some protection against rising inflation.”
Direct lending remains the most favoured strategy as it involves well-collateralised loans and relatively short durations for returns of between 6 percent and 12 percent.
“At this moment we feel that senior direct lending is more attractive than mezzanine,” Ishida says. “Senior lending offers more control, better covenants and can capture better returns. The direct lending market is becoming much bigger and with a broader range of companies involved.
“Mezzanine lending is taking more risk, but also tends to target larger companies, which are more likely to have access to the capital markets – which means tighter pricing.”
As well as mezzanine, Asia LPs are showing more interest in distressed strategies or special situation funds. However, the security of direct lending and the position of private debt in institutions’ portfolios means it remains first choice.
“Our approach to private debt is low risk, seeking to preserve our principal and generate cashflow,” says POBA’s Jang. “So direct lending works well for this, and our private debt allocation achieved what we had expected as a substitute for the fixed-income securities, even in such a challenging market situation. Over the longer term, our private debt investment has generally exceeded expectations.”
Jang notes that the prevalence of SMEs in direct lending portfolios has turned out to be a strength in recent months: “I was originally nervous about investments in small-to-medium-sized companies, about how they would survive such a severe situation. However, our GPs managed really well.
“From a risk-and-return perspective, we noticed that the low to mid-market performed very well, even under a covid situation, and some of our GPs really defended their portfolio very successfully. So, we are in the process of a re-up with a lower mid-market strategy.”
The upheaval of covid has also thrown manager performance into sharp perspective. “Last year the pandemic divided managers into two groups in terms of their response,” Cheon says. “Some made an effort to try to contact LPs very frequently and provide timely reports about the marketplace and the impact on their funds. However, others were harder to access and mainly focused on their investment work. But, as an investor, you need to know what is going on, so this has been a good learning experience for us.”
Even better than the real thing
Real estate is popular with Asian LPs and debt offers downside protection as well as distressed opportunities
It is axiomatic that Asian investors love real estate. From family offices to corporate pension funds and even corporations themselves, real estate is considered the prime means of wealth protection. “Real estate continues to be a core and growing asset class in Asia-Pacific, and so real estate debt continues to be very much a scalable opportunity,” says Isaac Wong, executive director, structured and principal finance at Chinese investment bank Huatai. “Plus, Asian investors understand and like real estate, so real estate debt is a logical next step in seeking strong risk-adjusted returns.”
Economic downturns tend to involve real estate distress, so for many investors the real estate debt opportunity is linked to the distressed debt opportunity. Bloomberg reports that $430 billion of US real estate loans are maturing this year, with the country still embroiled in the pandemic. “There are likely to be distressed opportunities in real estate loans, for example, as government aid programmes come to an end,” says BK Cheon, chief investment officer at Korea’s DGB Life Insurance.
Asian LPs, including Taiwanese insurer Cathay Life, are understood to have committed capital to Blackstone Real Estate Debt Strategy IV, which had a final close on $8 billion last September. The fund will target global opportunities from direct debt to special situations.
For some Asian investors, real estate debt enables them to get exposure to real estate, with fewer tax and hedging complications. This is very much the case for Korean investors, which have invested significantly in US real estate in recent years. More Korean LPs may target real estate debt as new rules, which come into place in 2023, mean they will have to secure additional capital against real estate investments.
Less is more
Investors in the early stages of their journey in private debt may also have tried a wide variety of managers. However, Jang says that in the days of ever-larger funds and a polarisation between large and niche managers, some LPs are looking to focus the number of GPs they work with: “At present we have quite a large number of GPs because we wanted to diversify and see which had the best fit with POBA. Over the years we have seen some outperform and some underperform and learned which have the best relationship with us. So, in the future, we will focus on those managers and seek to slim the number of GPs we work with.
“Some of our GPs are insurance companies which commit their own capital, which means a strong alignment of interest, so we would commit more, and in our alternatives portfolio we are also committing more to strategic joint ventures with global asset owners.”
Asia LPs tend to behave differently depending on how experienced they are in private debt and the amount allocated. Larger and more experienced LPs tend to be involved in a broader range of opportunities, which is partially a reflection of them being presented with more opportunities.
“I do think that investors who have a lengthy track record in private debt are more comfortable with the current outlook and have different views from newer investors,” says Durston. “Not only do they have a history of decent returns already, but they likely have well-performing vintages that are returning capital from which to fund new opportunities.”
There are somewhat differing views on the risks of private debt investment in the context of covid. Durston says: “I think private debt needs to produce higher returns than previously nowadays, as it is perceived as more risky today, if only from a sectoral diversity perspective. However, this is tempered with the vast amount of new money which is still entering this asset class as many investors initiate a foothold in less liquid debt for the first time.
“Particularly compared to the meagre returns available on bonds generally and the very low investment and high-yield corporate returns, the private debt market still looks attractive.”
Nevertheless, Vision Super’s Ridley says: “In general, our medium-term view of private debt has not changed as a result of the pandemic. That said, we are conscious that there is a risk that default rates could be higher and recovery rates lower than our central case view.”