From Latin America to Turkey, Eastern Europe to West Africa, emerging markets offer a panoply of investment opportunities. Yet while the financial crisis may have originated in developed Western markets, its impact has been particularly keenly felt further afield. If appetite existed amongst global banks to extend financing to corporates or sponsors in emerging markets prior to the crisis, that has largely disappeared since then. The funding gap therefore has become particularly acute.
Enter private debt. Well established in some emerging markets – the so-called ‘shadow-banking’ industry in China for example is thriving – it is only more recently that other markets have attracted private debt fund managers.
That’s not to say there aren’t veterans in the industry. Managers like Cordiant, Darby Private Equity, Shoreline Capital and Gramercy have been active for many years.
The relative scarcity of managers or other lending options mean private debt funds that do take the plunge in emerging markets can dictate terms in a way that would be implausible in a developed market.
Managers might for instance ask for collateral to be transferred to them from the borrower until repayment of the loan.
Ben Fanger, co-founder of China-focused distressed debt specialist Shoreline Capital, says his firm adopts this approach of seeking additional guarentees. “We often take a co-signer right on the [borrower’s] bank account, and also have a corporate seal in our possession so they can’t transfer assets out of the company,” he says. “These are not things that you could get a borrower in North America to do, because there are a lot of potential competitors in private lending in North America.
“In an environment where you have a lot more competition, and borrowers have a lot more options, the lenders don’t get to call the shots,” he continues. “And in our situation in China, the capital markets are very undeveloped, and there are a lot of places where lenders can’t get bank loans. They only have a couple of options. And when that’s the case, we get to call the shots.”
A key consideration for any manager is the legal environment, because it will affect the enforceability of any covenants attached to the debt. Investors in China, for example, have long grappled with this issue, as Fanger explains.
“Certainly the perception of China’s legal environment is that it’s far behind the enforceability and predictability of investments in more ‘emerged’ markets, such as the US or Europe. Those perceptions are well founded. You can do significantly fewer things in the Chinese courts with predictability than you can in a more developed market. The situation is improving however,” Fanger adds.
He’s had a front row seat from which to view the development of the Chinese market, having worked with the legal team that structured the first NPL acquisition completed by a foreign investor in China.
Most functioning markets tend to price in the level of protection offered, however. This certainly applies in China, where pricing of distressed or stressed debt has decreased to take account of the relative lack of protection on offer.
Fanger argues that while you could obtain a distressed asset for 10 cents on the dollar in China, that same asset would command as much as 50-60 cents in a more developed market because of the additional protections afforded.
“A lot of people think that risk means volatility of return, or of not getting our principal back,” Fanger says. “We’ve been doing investments in private credit and distressed debt in china for 10 years now, and we’ve never lost money on an investment, nor have we had volatility of return.”
It goes without saying that emerging markets, far more so than developed ones, demand an on-the-ground presence. The ability to speak the language and build networks helps both in originating deals and successfully bringing them to completion.
There’s also much to be said for taking a pioneering approach to new markets. The head start firms like those mentioned have, having been active for many years in emerging markets, will stand them in good stead given the high barriers to new entrants.