Direct Lending: Asia-Pacific makes its mark

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Private debt funds expect direct lending to grow in Asia as regulatory changes force banks to cut back on riskier assets, pushing credit-starved companies to seek alternative capital.

Non-bank lending currently makes up 9 percent and 12 percent of China and India’s financial system assets, respectively, according to Capital Partners. This is still a far cry from the US (31 percent) and euro area (33 percent), but many observers look to South Korea as to how the class could develop.

There, non-bank lending makes up 27 percent of the financing market in a country with established non-bank finance companies and strong creditor protection. “There is no question that alternative credit and direct lending continue to be substantial opportunities in Asia,” says Robert Petty, co-founder of Clearwater Capital. “It is growing relative to what it has been.”

Eric Marchand, senior vice-president and investment director at Geneva-based investment manager Unigestion, is also optimistic about the asset class’s future in the region.

“The appeal of private debt in Asia is that it can offer contractual internal rates of return of 15-20 percent without the uncertainty of an exit that comes with private equity investments,” he says.

But, in a world of low interest rates where investors are looking for yield, the fact remains that private lending has been slow to take off in Asia for reasons ranging from legal concerns to dealflow.

Private debt funds say that in order for the market to flourish investors need more certainty over their claims in a bankruptcy. Unfortunately, creditor protections vary from country to country.

“Investors are willing to accept a lower absolute return for more predictable returns. But to get that, you need to have a legal regime and framework where you know you can enforce as a lender,” says Christopher Heine, head of Asia-Pacific at Intermediate Capital Group.

Creditor protection has improved in some countries. In November 2015, following lengthy discussions with market participants, the Indian government published a draft bankruptcy code to facilitate orderly exits. This has been welcomed by private debt funds, which have played a role in pushing for reform.

“In India we have been very actively advocating to the government to have a better enforcement infrastructure and better bankruptcy-related procedures,” says BV Krishnan, who looks after KKR’s capital markets and third party credit efforts in India. “The proposed new bankruptcy code is a good step forward.”

Private debt funds also grapple with different tax regimes and a lack of clarity over the tax treatment of income. Typically, direct lending has thrived in countries where the tax laws are transparent.

“Limited partners also look for predictable tax regimes, where it is clear what the difference between tax on capital gains and tax on income is,” says Heine. “This is the case for some tax authorities such as Australia, Japan and Singapore, but not every country.”

VOLUMES: A VIRTUOUS CIRCLE

The other problem the region faces is a lack of dealflow. While it may sound like a circular argument, decent dealflow is essential to reliable capital deployment which, in turn, attracts investors at the fundraising stage. No matter the asset class, investors gravitate to regions where there is robust dealflow.

“Volume drives deployment, which, together with LPs’ desire for yield, drives the need for the asset class,” says Heine. Australia is also often held up as the one place where there is plenty of volume combined with strong creditor protections, which has allowed senior direct lending to thrive.

In Japan, where there is a confluence of a legal protection and yield-hungry investors, mezzanine funds have flourished. Examples include ICG’s joint mezzanine fund with Japanese bank Nomura. The fund was launched in late 2013 and reached a final close of ¥46.5 billion ($393 million; €362 million) in December 2015 with 30, mainly domestic, investors.

According to Heine, Japan has a “2 percent yield fixed-income environment”, so by comparison the 10 percent return that domestic mezzanine debt offers is considered high, though it would not feed foreign mezz investors.

The fact remains, though, that in much of Asia, there is a dearth of dealflow. For example, the leveraged loans market, the space where private debt funds are traditionally most active in the US, is much smaller in Asia. The total volume of leveraged loans in Asia, excluding Japan and Australia, stood at $20.8 billion compared with $96.1 billion in Europe and $138.7 billion in the US for 2015, according to Dealogic. Leveraged loan volumes in Australia and Japan were $12.7 billion and $4.7 billion, respectively.

Mezzanine is private debt providers’ traditional initial market access point and an instrument that has always attracted funds and institutional investors. In Asia-Pacific, however, mezz is an exception, rather than an established financing tool.

Leverage levels for leveraged buyouts in Asia have remained more conservative than in the US or Europe. However, that could change if financial sponsors push for more aggressive structures, allowing private debt funds to participate.

“If you look at the average leverage levels in Asia, it is about three to four times compared to much higher levels in the US,” says Siong Ooi, head of Asia-Pacific syndicated and leveraged finance at Bank of America Merrill Lynch. “Over time, we could see more mezzanine debt being injected into the capital structure as sponsors demand an additional layer of capital.”

ACTIVE LENDERS
Private debt funds have also been less active in the region because there is less of a gap to be filled. The Asia-Pacific banking market was better capitalised than the US and Europe during the 2008 global financial crisis and, as a result, lenders did not retreat as much.

“In a world where banks are retracting, arguably it is taking place later in Asia than the US or Europe, and that is probably the largest reason for seeing less direct lending here,” says Clearwater Capital’s Petty.

For now, there are few signs of that changing. Lenders say that the region remains awash with liquidity. Chinese lenders in particular have been aggressive in financing local corporates as they make offshore acquisitions. And bank lenders have been keen to mop up any leveraged loans in the market.

“There is plenty of bank liquidity at the moment, so it’s not as if there is a big gap in the market that direct lenders would be able to fill,” says Phil Lipton, head of loan syndication Asia-Pacific at HSBC and chairman of the Asia-Pacific Loan Market Association.

“Banks are still keen to lend but loan volumes are down, which adds to the liquidity out there.”

However, the future will bring increasing regulatory pressure on banks. Under Basel III regulations traditional lenders will have to hold more capital against loans, making lending less profitable and potentially leaving a gap for direct lenders. This is especially true in countries such as India where banks are already battling with non-performing loans (NPLs), which has crimped their ability to lend. India’s state-run banks are eyeing equity capital fundraisings to boost their capital but the potential dilution of the government’s stake is holding some back.

“With Basel III, Indian banks will need to raise more capital. A clear parliamentary mandate regarding government ownership in banks will help with this process,” says KKR’s Krishnan.

“Estimates for a combination of NPLs and stressed, restructured assets are about 12 percent of gross banking assets. Tactically, freeing these up creatively will make bank capital available for more productive use. This will also help banks raise capital at better valuations.”

The US Federal Reserve has sought to limit banks’ exposure to risky credits by introducing leveraged lending guidelines that discourage banks from doing deals more than six times levered. While leverage in Asia rarely reaches those heights, US banks operating in the region are expected to adhere to the Fed’s rules and could face more scrutiny on the kinds of deals they can take on.

“There are more regulatory constraints in terms of the deals banks can do, and that will precipitate other nonbanks filling that gap, as we are seeing in the US and Europe,” says Ooi. In the US, the Fed’s rules have resulted in companies transferring their leveraged loans business to unregulated players, allowing investment banks like Jefferies to grab more market share.

POCKETS OF OPPORTUNITY
Despite the challenges that direct lenders face, they see plenty of opportunity. In India, which is KKR’s top lending strategy in Asia, the private equity firm looks to finance mid-cap companies that typically do not have access to the bond or loan markets. In India, good access to capital markets is typically reserved for large cap companies such as Reliance and Tata, and public sector companies.

“Traditional Indian mid-market companies do not have access to long-term flexible capital,” says Krishnan. “That’s a segment that we think in the long run will be a significant growth engine for a $2 trillion economy like India. Today, access to capital, both from the bank market and from the capital markets, is severely restricted for this segment.”

Since setting up in India in 2009, KKR has lent $3 billion to a host of mid-market companies that have difficulty getting bank lines. In 2015 alone, KKR provided close to $1 billion of structured credit to Avantha, GMR Infrastructure, Bhavya Cements and Enzen Global. According to market sources, it also backed Ameera Shah, the chief executive of Metropolis, in her purchase of private equity firm Warburg Pincus’s 27 percent stake in her company.

In India, banks are encouraged to concentrate their lending on financing capital expenditure, projects and working capital.

The regulator’s strict laws on lending also provide opportunities for private debt funds. “There is a clear requirement for private lending in India,” says Krishnan. “We are trying to address that through multiple vehicles: an NBFC [non-banking finance company], a local credit fund through the AIF [alternative investment fund] format. In 2016, we look forward to addressing the market requirements similarly through multiple platforms.”

Hong Kong-based Clearwater Capital sees multiple opportunities to provide direct lending in markets such as Korea, India, China and Australia.

In India, last year, it teamed up with Minneapolis-based Värde Partners and the Abu Dhabi Investment Council to invest $300 million in special situations lending, acquisition financing and growth funding through a vehicle called Altico Capital, which focuses on real estate-backed loans. In China, Clearwater Capital expects the percentage of non-bank lending to rise, particularly with the growing prominence of homegrown distressed debt asset managers.

China’s largest distressed debt management company, Huarong Asset Management, together with its peer Cinda Asset Management have both gained market profile with initial public offerings on the Hong Kong Stock Exchange last year and in 2013 respectively.

“Seventy percent of China’s corporate lending is from the banks and that percentage will be lower looking forward,” says Clearwater’s Petty. “Therefore lending opportunities abound and will continue to grow from the $4 trillion in alternative credit in China today, certainly growing in the trillions of dollars over the coming five years.”

So while there are still challenges to the stuttering attempts of direct lenders in Asia-Pacific, there’s a slow continental drift of factors in their favour.