Decoding special situations in Asia

Private debt and special situations investors play an important role in providing financing to fill both structural and cyclical gaps in the bank-centric Asian financing market. Such investors require a unique combination of expertise and skills in order to successfully make investments in the complex and locally differentiated Asian markets. A study of private capital supply in Asian markets will typically reveal the following elements: a ready supply of equity capital, an active (but skewed) bank lending market and a strong correlation between debt and equity valuations. 

While this generalisation may not do justice to the entirety of the Asian market (e.g. developed Asia vs. emerging Asia), capital supply in the region is largely growth-oriented and carries with it an equity risk profile. As a consequence, the bank lending market largely favours scale borrowers over SMEs. This market inefficiency inherently is an advantage for large borrowers, but marginalises small and below investment-grade borrowers, even in times of growth and stability.

This structural inefficiency has been studied in detail due to the importance of SMEs for national economies. According to the Asian Development Bank’s Asia SME Finance Monitor 2013, SMEs account for 66 percent of the labour force in Asian economies and contribute 38 percent of GDP. However, loans made to SMEs only accounted for 25 percent of total bank lending. Furthermore, 70 percent of Asian SMEs struggle to access debt finance. This credit supply-demand gap has been a key driver for the rise of Asia’s non-bank financing industry or shadow banking industry.

Enter special situations and private debt capital, which addresses these structural inefficiencies in the region. While a conventional interpretation of ’special situations’ may involve distress, in markets such as China, India or Southeast Asia, access to capital itself can sometimes be the operative theme. “We often see and help solid companies with good management and healthy growth prospects, which are not able to access bank loans easily” states Edwin Wong, chief investment officer of SSG Capital Management, which was recognised as Distressed Debt Investor of 2014, Asia-Pacific by Private Debt Investor.

In addition to Asia’s structural opportunities, the credit cycle may increasingly offer additional opportunities to private debt investors. Asia’s regionally segmented markets and above-average economic performance has been a safe harbour for investors and issuers alike in the post-global financial crisis (GFC) era. However, as the ’crisis policy’ mentality in the west and its associated liquidity begin to sunset, private debt may soon become more important to fill some of the resulting supply gap in financing Asian corporates.

The low interest rate regime of the last six years, coupled with record lending and issuance volumes, has kept economic growth afloat, but has also led to record levels of leverage in Asian economies, which may curtail the capacity for further stimulus. In China’s case, total debt (government, corporate and household debt) as a percentage of GDP has increased almost 1.5x since 2007 just before the GFC and reached 220 percent in 2013.

As the Federal Reserve looks to lift interest rates from the near-zero regime as early as mid-2015, a global re-pricing of risk may lead to capital outflows and tighter credit conditions for Asia. At the same time underlying economic growth in the region is moderating slightly. As the macro environment evolves in the post-QE world, sectorial distress and cyclicality will likely create additional opportunities for special situations and private debt investors alike.

Investing in Asian special situations is a uniquely demanding process. The fundamental value proposition requires a combination of origination, structuring, execution and asset management skills and experience. Depth of local market knowledge and experience is critical: oftentimes the difference between solving a given problem and getting stuck in a suboptimal situation hinges on the ability to bring a resource to bear – be it structuring experience, a strategic relationship or simply a well-placed insight. This asset class demands perseverance to deal with non-vanilla structures, multiple stakeholders, complex regulations and a plethora of other challenges. Its successful execution requires a team with a depth of resources and investment skillsets across credit and equity products. Wong elaborates: “A lot of work goes into creating an edge to shape the risk-reward profile of an investment, to go the extra mile on diligence or structuring and to create an opportunity from seemingly complex or incomprehensible situations. All these translate into true alpha for investors.”

Origination is one of the most important differentiators for a fund manager. Experience suggests that adverse selection is a recurring problem in many brokered opportunities, and the recent emergence of packaged primary-money deals should give pause to investors. Original ideas and the ability to engage with investee companies directly are key to originating successful special situations investments with compelling risk-reward profiles. Wong explains: “We invest a lot of time and effort to source investment opportunities directly from business owners. These tend to be the more attractive investments.”

Complex regulatory hurdles are inherent to markets such as China and India. Whole industries of intermediaries exist to provide investors with on/offshore arbitrage but at the expense of investment economics. Yet the true, latent, costs of the resulting complexity and reduced enforcement options in a downside scenario are often ill-understood. To that end, local infrastructure – while expensive to maintain – is an important part of a practitioner’s repertoire, through which risks such as currency exposure, collateral perfection and legal enforcement can be mitigated to a significant extent. As an example, in 2014 SSG Capital Management acquired a 49 percent stake in an asset reconstruction company in India, an entity that wields much greater power and flexibility in dealing with distressed loans.

Local regulations and other local market challenges create barriers to entry and favour local investors. Familiarity with local issues and a network of strategic relationships in the target market are of great importance when sourcing, structuring or analysing investment opportunities.

International alternative asset managers have also taken note of the growing Asian special situations opportunities. For example, several global players are strengthening their Asian special situations teams for this reason. It will be interesting to see how international managers will adapt to the local challenges and complexity involved. Certainly, increasing amounts of capital targeting the private debt opportunity in Asia are indicative of growing interest by international investors. According to Wong: “Limited partners are becoming more and more knowledgeable about the Asia private debt space. Many have recognised that the asset class offers a significant yield pick-up from comparable strategies in the US and Europe, and an attractive diversification from Asia private equity strategies.”