Over the course of the last decade, emerging markets have attracted unprecedented interest from investors seeking to tap the trends of strong GDP growth, urbanisation, and the rise of a new middle class to generate compelling returns. Indeed, from 2006-2013, data from the Emerging Markets Private Equity Association (EMPEA) show investors committed $330 billion in capital to emerging market-dedicated private equity funds, which grew to 21 percent of funds raised globally in 2010 and 2012.
In the wake of the European debt crisis, however, the composition of the private funds marketplace appears to be changing. Enhanced capital adequacy requirements and the need to restructure funding models have compelled global banks to deleverage, with numerous non-core business lines — in many instances those extending credit in emerging markets — receiving the chop. Amidst the yawning financing gap that has ensued, promising, productive enterprises in emerging markets frequently find that their growth initiatives remain stuck in the starting blocks.
Investors increasingly appear to recognise that private credit funds are poised to fill the breach. To take just one example, preliminary results from EMPEA’s 2014 Global Limited Partners Survey reveal 37 percent of participants plan either to maintain or expand their commitments to private credit funds focused on emerging markets.
What is driving this increase in interest, and for those limited partners that have yet to take the leap, what is holding them back? Beyond its position in a firm’s capital structure, how is private credit in emerging markets different from private equity? How is private credit as practiced in emerging markets distinct from that in North America and Western Europe? And how viable is this business in the face of tightening global liquidity conditions?
EMPEA recently sat down with several members of its newly launched Private Credit Council to discuss these questions and more. As a group, the participants’ firms have executed transactions in the emerging markets of Africa, Asia, Central and Eastern Europe, the Commonwealth of Independent States, Latin America, and the Middle East; and they employ a variety of strategies including direct lending, distressed/restructurings, and stressed credits on a single or pooled basis.
EMPEA: Let’s begin with some historical perspective. What are some of the key developments or factors that have led to the emergence of private credit funds in emerging markets?
Patrick O’Brien: In emerging Europe, the formation of capital really only began after the Berlin Wall came down in 1990. The deposit base at the time was incredibly shallow, but we began to see some privatisations of property as well as the introduction of capital markets. However, in the financial crisis of 1999 local banks were in crisis, and the most recent global crisis in 2008 again damaged the banking system. Increased foreign ownership of the banking systems across the first and second wave of accession states to the EU in the 2000s meant that the impact of the last crisis was amplified by the withdrawal of these banks, which were suffering from problems in their home markets. The result of all this has been a systemically weak banking system across the region delivering an uneven application of credit—where it is available. Today, there is significant demand from borrowers in the region to source capital, both debt and equity, and that demand cannot be satisfied by the local banking systems.
Anton Douglas: Thinking back to when I started doing emerging markets private debt at Credit Suisse in the late 1990s and early 2000s, we were largely originating and structuring deals for our own proprietary books. Over time, we saw greater demand from emerging market borrowers being met by greater interest from the non-bank investor side, primarily hedge funds, which were also exploiting their access to leverage, which increased the number and size of deals significantly. As we went through the global financial crisis, a lot of the fund managers that were focused on more liquid strategies, relied on leverage from the banks, or dabbled in one-off deals in emerging markets pulled back from the credit space, leaving only the more dedicated emerging market funds in the space, which in turn gave rise to new opportunities with attractive returns and structures.
EMPEA: It does seem that emerging markets private credit has received increased attention in the last two to three years. What is driving investor interest in this space?
David Creighton: The retreat of the banks is what got everybody’s attention. We’ve always been in more of a quirky, niche space; but with the headlines of bank deleveraging, a lot of institutional investors have determined that there’s an opportunity to take advantage of these dislocations, and as a result, we’ve popped up on their radar.
The other dynamic that has taken place over the last year is the significant capital appreciation in stock and bond markets, which is prompting LPs to rebalance their portfolios. In the past, the scale of pension fund liabilities — at least in North America—led to aggressive return targets; so while LPs were interested in our strategy, they were looking to take on more risk in the hope of generating higher returns. Following the public markets’ performance last year, lo and behold, a number of pension funds that were significantly underfunded are now actually flat. As a result, they’re much more willing to lock in the type of strategies that we employ.
Ultimately, the big investors are looking for diversification and non-correlation, and they buy into the fundamental underlying growth that’s taking place in emerging markets, as well as the strategy that we have to tap into it.
EMPEA: That’s quite interesting, as one of the sticking points seems to be how private credit fits within an LP’s traditional asset allocation model. Is this a sentiment that you encounter while on the road; and if so, how do you respond to it?
David Creighton: This has always been the challenge. The basic issue we’ve had until recently is that LPs often say, “You’re a private investment, therefore you should go into the private equity bucket; but you’re not generating a high enough return.” Alternatively, if we’re sent to the fixed income manager we hear, “Well, we need the liquidity.” What’s happening now, though, is that some of the big institutional investors are starting to talk about how they allocate to private debt. One investor has been quite outspoken saying that private debt at the senior end of the spectrum fits into their fixed income portfolio, and it then starts to move toward the alternatives bucket as leverage or subordination is introduced. Right or wrong, at least it is a template.
Sofya Alterman: We have found that some institutional investors over the last couple of years have actually created an “opportunistic credit” bucket in their portfolio. While for some it was a means of efficient portfolio allocation, for others it was a way of bringing more attention and organizational focus to the private debt strategies. The private/opportunistic debt strategies do not quite fit in the fixed income book but also cannot necessarily go into the private equity portfolio, which gets benchmarked to the buyout/growth investments. While these LPs are still few and far between, there are important conversations taking place across the industry regarding best ways of allocating to, and benchmarking, the alternative debt strategies.
EMPEA: EMPEA produced a report on European bank deleveraging in October 2012, and at that time, European banks—which constituted 63 percent of total foreign claims on emerging market countries—had reduced their claims by $274 billion over the preceding year, impacting credit conditions in each emerging market region. Have you seen local banks picking up the slack in lending to corporates?
David Creighton: It’s spotty. In countries such as Panama and Colombia, and in various countries across Southeast Asia, savings are growing, and as a result the banks are flush and willing to lend. In Eastern Europe, corporate lending really did close down, though we have seen some of the foreign-owned banks filling a bit of the gap. But across the board, smaller companies are feeling the pinch; over the last couple of years the bond market has taken up a lot of the slack for the larger corporates, but there’s a scramble to find capital at the next rungs down.
Anton Douglas: We see that too, but it also depends on the level of the capital structure at which people are looking to borrow. Many banks have retreated from mezzanine or subordinated structures. In Asia, some of the banks have pulled back from family share-backed financings. We’ve also noticed that when banks have limited capital and risk appetite, they tend to curtail lending (typically short-dated or working capital facilities) to more volatile sectors such as commodities, natural resources, and agriculture. This also makes term capital from a private lender attractive.
Sofya Alterman: To add to Anton’s point, in China and India, local banks are specifically prohibited from lending to certain industries. For example, in both countries banks are not allowed to extend credit to real estate developers at the outset and until a certain set of permits is acquired, meaning they are prohibited from lending against a land acquisition. And if you cannot buy land, you cannot start building. So developers have to rely on private sources of capital to finance this growth. In the case of India these are non-bank finance companies (NBFCs), which step in as a source of liquidity; in China, the non-bank lenders on the institutionalized side of the shadow banking license spectrum serve this need. Clearwater is actively involved in lending in both of these regions, providing high coupon, short-term debt solutions.