An alternative route into Asia

The journey may not have been as smooth as in Europe or the US, but private debt is slowly finding a place as an asset class in Asia.

Having suffered a financial crisis 10 years before the global meltdown, banks in Asia-Pacific, while not immune, were in a better position than their counterparts in the West as Lehman Brothers fell. The resulting funding gap was much more pronounced in Europe, which is predominantly a bank market, says Joseph Chang, a Hong Kong-based principal on the private markets group at Mercer Investments.

Segments of the institutional investor base entered this space and have an increased appetite for private debt, including Asian insurance companies, says Chang. “Some finally have a mandate to invest overseas and they want to get the yield premium that private debt offers. So there is definitely interest, but whether they will get there in terms of allocation is uncertain.”

However, most Asian institutional investors are new to the asset class and still accumulating knowledge about the different yield and liquidity profiles on offer. While some have tasked their private equity or alternatives teams, others are using their fixed-income units to study private debt.

In conversations with institutional investors and consultants, it is clear that interest in private debt among Asian LPs is on the rise.

The data bear out the trend too. In July, Towers Watson published its global alternatives survey, showing that investor allocations to illiquid credit in Asia-Pacific had jumped to 3 percent of overall allocations to the asset class, compared with less than 1 percent recorded a year earlier. Europe still wins the vast bulk of investment, but the increase is a not insignificant grab for market share by Asian managers.

“I guess one of the key things investors are worried about is volatility in the market (mainly equity markets), and they have an eye out on the investment environment,” says Edward Tong, senior vice-president for private debt at global alternative asset manager Partners Group. “But private debt as an asset class is really interesting for them as it provides good downside protection.”

Chang agrees, saying that a few Asian investors are beginning to invest in private debt because of the high yield premium they can get. “Private debt is interesting to investors as its risk-return profile sits somewhere in between public debt and private equity, whereby it provides a higher return vis-à-vis public debt but is less risky than private equity,” he adds.

Christopher Heine, head of Asia Pacific at Intermediate Capital Group (ICG), which is currently in the market for its third Asia fund targeting commitments of $1 billion, says that about half the capital the firm raised for its second and third funds has come from LPs based in Asia-Pacific.

In Asia, ICG invests across the capital structure and mixes debt and equity instruments to find solutions for SMEs, using mezzanine as one kind of means to invest.

Australian LPs are among the more prominent Asia-Pacific investors in private debt and Heine says their credit appetite is increasing. The key to unlocking that capital, however, are the consultants such as Tower Watson or Mercer who advise superfunds considering opportunities outside Australia. The country’s Future Fund, which held A$117 billion ($85.3 billion; €75.3 billion) in assets under management as of 31 March 2015, is committed to managers such as Centerbridge Partners, Oaktree Capital Management and Sankaty Advisors.

Japanese institutional investors, among the largest in the region, are also investing in private debt. Hideya Sadanaga, general manager of the global product division at Nissay Asset Management, the investment management arm of Nippon Life Insurance, which manages assets of about ¥8.7 trillion ($72.8 billion; €64.3 billion) on behalf of about 300 institutional clients, says there has been a consistent, healthy demand for infrastructure-related debt, while investors have also been interested in domestic mezzanine.

Besides infrastructure, it is hard to talk about any notable increase in appetite for other kinds of debt, Sadanaga says. “Japanese institutional investors are huge buyers of US corporate debt, be it the banks or the life insurance companies. There’s a lot of money going into US corporates, but I don’t think it’s going into private debt for tax reasons among others,” he adds.

Besides Australia and Japan, investors from the other mature Asian markets such as Singapore and South Korea, Malaysia and Brunei are established and either already invest in private debt or are looking at the space closely. Korea’s 500 trillion won ($441.8 billion; €392.3 billion) National Pension Service, for instance, has 9.9 percent of its assets invested in alternative investment strategies; and around a fifth of both its real estate as well as private equity exposure is to different varieties of private debt, with managers such as ICG, Oak Hill Capital Partners and Oaktree Capital Management.

DEMAND DRIVERS

Real interest rates are negative in Europe, and interest-rate increases are expected in the US. “The biggest high-yield bond market is the US – presumably investors will have a lot of exposure into the traditional bond market, so they will want to see how they can protect value on some of those bond positions going forward in this environment of increasing interest rates,” says Tong.

He adds that in the private debt market “pretty much all the loans we make employ a floating rate”, so when Libor goes up, investors can benefit from that uplift. In fact, he says, investors are already benefitting from a Libor floor from deals in the developed markets, so that could lead to more investors coming towards private debt opportunities.

Moreover, the risk-weighted returns that managers have shown and are showing are relatively attractive to investors, says Tong, adding that private credit returns versus high yield are “pretty compelling” when stacked side by side.

Heine says that many LPs – both Asian and otherwise – are worried about the historic returns from private equity in Asia. “Speak to LPs and you’ll see that they are very concerned about the pace of deployment of capital in private equity, the number of deals available, and the valuations being too high,” he says, adding that private debt as an asset class is “seen as being more predictable and less volatile”.

Australian LPs, on the other hand, have their own reasons for looking at private debt. Barring a few sophisticated investors with comprehensive programmes, not many have actively invested overseas because of “great returns” they have made at home in the Australian dollar, says Heine.

“But now, they are starting to look at alternative asset strategies outside Australia and several of them are expressing interest in direct lending strategies in Asia,” he adds.

JUGGLING JURISDICTIONS

Chang says the key Asian markets are China, India and certain parts of Southeast Asia, particularly Indonesia. However, opportunities even in these markets are skewed in terms of sectors. “In China, the focus is still on real estate and real estate-related companies; in Indonesia it is natural resources-driven; and in India, it is little bit of a mixed bag,” he says.

These investments tend to be related to the growth of companies. And as opposed to investing in or lending directly at company level, Asian investors prefer to access private debt through funds or, if they are big enough, separate accounts with managers. Besides a bias towards their home markets, they still predominantly invest in private debt outside Asia because of the greater number of opportunities and market size in those regions.

Asian investors also seem to be most interested in the performing debt of companies, mostly through a mixture of direct-lending and mezzanine on the primary side, while some is highly structured, investors say.

BIG IN JAPAN

Sadanaga adds that there has been “quite a lot of demand” from institutions such as regional banks for domestic mezzanine loans given the low interest rate environment. “A few domestic mezzanine funds raised over the past year were so popular that we had to win our allocations,” he says, adding that in Japan there is demand for higher yielding investments, especially in Japanese yen.

Acknowledging this opportunity, ICG and Japanese financial services conglomerate Nomura, partnered to offer Japanese institutional investors access to domestic mezzanine investments. The vehicle is investing from its first fund, which is targeting commitments of ¥50 billion.

Heine says Japan is a market with relatively large buyouts, most of which are local and do not involve foreign sponsors, and there is appetite for mezzanine. “Our Japanese strategy with Nomura is aimed at Japanese yen investors looking for Japanese yen growth through their investments,” he says. “There is a lot of mezzanine appetite for the kind of risk-returns that we are targeting – 10 percent growth and 1.3x multiple.”

This needs to be put in the context of a 2 percent fixed income growth environment, Heine adds.

Sadanaga says Nippon Life Group invests in mezzanine funds as part of its private equity portfolio and has done so for many years now. However, he adds that he is also aware of a few Japanese investors who are “weary” of investing in domestic mezzanine funds, but willing to invest in US mezzanine funds to achieve yet higher returns. All in all, he says, private debt investors in Japan are a sub-set of the private equity LP base.

Private debt has emerged as an interesting play for the large institutional investors that want exposure to a different kind of risk-return profile from both private equity as well as public debt. Investors say it has become an asset class in its own right, and particularly looking at its fundamentals – with rights and a lower risk-return strategy – it is starting to become an important part of Asian LPs’ asset allocation and portfolios.

What is not clear is whether those already investing in private debt intend to double down on the strategy.