Annual Review: Playing the numbers game in Asia

With China’s economic slowdown further entrenched, private debt funds saw more distressed debt opportunities in Asia last year and can expect that to continue in 2016.

“We saw last year and continue to see more opportunities on the distressed side, whether it’s companies having financing issues, or financial institutions that are looking to sell loan portfolios,” says Edwin Wong, chief investment officer of Hong Kong-based SSG Capital Management.

“This is one of the rare times when we see pretty large portfolios coming from global and regional banks that have to get rid of some of their more troubled assets.”

Last year, private debt fundraising focused on distressed debt strategies amounted to $830 million, more than double the $300 million raised in 2014, according to PDI Research & Analytics. Looking ahead, those opportunities are expected to increase.

“In a slowing economy, as well as in certain sectors like energy, there is no doubt that there will be more distressed opportunities,” says Joseph Chang, principal, private markets group at Mercer.

In China, non-performing loans (NPL) are on the rise. Ratings agency Standard & Poor’s estimated that Chinese banks’ NPL ratio stood at 2.2 percent as of end 2015, up from 1.7 percent a year earlier. The agency expects that ratio to reach 3 percent by the end of 2016.

The ratings agency said that so-called “special mention loans”, referring to those that are performing but vulnerable to adverse market conditions, have risen to 3.8 percent of Chinese commercial banks’ total loans as of September 2015, up from 3.1 percent at the end of 2014. Private debt funds saw more NPL portfolios for sale in 2015 but, for now, banks are unwilling to let those assets go at a deep enough discount.

“We have definitely seen more NPLs for sale by Chinese banks and asset management companies since last year, but I don’t think too many of them are attractive from a pricing perspective,” says Barry Lau, managing partner of Adamas Asset Management.

According to Lau, non-performing Chinese real estate loans, which are backed by hard assets, are on offer at around 90 cents on the dollar, while NPLs of manufacturing and industrial companies are offered at 30-40 cents to the dollar.

While he does not think these levels of discount are attractive, he says that banks could deepen discounts in the next few months. “The appropriate time to invest in non-performing loans could come in six to 12 months,” he adds.

Similarly, private debt player ADM Capital is cautious about buying NPLs. The firm invested in distressed debt back in 1997, but is now more focused on stressed companies that struggle to access to financing.

“We saw a lot of NPL portfolios offered to us last year, but whether the time is right to be getting into that space and buying it – we don’t think so,” says Sabita Prakash, head of business development at ADM Capital.

“Until we see the banks willing to let go of assets at cheaper prices, or more certainty of where the bottom-line for these companies are headed, we don’t think we will buy them.”

Prakash notes that commodities companies are still faced with freefalling prices and there is a lack of clarity on where their businesses are headed, which makes it difficult to invest into their securities.

NPLs are, however, a good barometer for the overall health of China’s economy and its banks. “NPLs provide us a gauge for market sentiment and pricing as well as the health of the economy as a whole,” says Lau.

China: the elephant

Private debt funds focusing on Asia-Pacific raised $5.5 billion last year, the highest amount since 2011 and a more than three-fold rise from 2014, according to PDI Research & Analytics. Nearly two-thirds ($3.4 billion) came from funds focused solely on China. This was a sharp rise from 2014, when there was no China-focused fund-raising.

Small to medium-sized Chinese companies are starved of capital, leaving a gap for funds to fill. Late in 2015, Adamas Asset Management launched a $500 million joint venture with Chinese insurance firm Ping An, targeting lending to mid-sized companies.

Adamas is also looking to finance Chinese companies in offshore acquisitions. “Overseas acquisitions have become the dish of the day in the last 18 months or so,” says Adamas’ Lau. “There may come a time, because of the all the outbound M&A originated by Chinese companies, we will follow them.”

Lau says that listed Chinese companies have access to funding but for the other remaining 50 million private businesses in China the only source of capital is from private debt funds, especially for overseas acquisitions.

As China’s economy shifts from being led by manufacturing to driven by the services sector, it has shaped private debt opportunities in China.

“The services component of China’s GDP is increasing, so increasingly, the opportunities in China have come from these sectors rather than traditional manufacturing,” says ADM’s Prakash. “We will see more deals related to the environment, food security and healthcare in 2016.”

While China was a key region in 2015, ADM Capital saw a growing diversity of dealflow. Based on PDI data, fundraising focused on “diversified regions” amounted to $530 million, while that focused on Australia and Japan chalked up $180 million and $810 million respectively. Those figures are up from zero capital raised for each of those regions in 2014.

“Before 2015, our dealflow was mostly from China. But 2015 was a year where things changed quite dramatically,” says Prakash. “We started to see more deals from Philippines and Thailand, as well as developed markets such as Australia and New Zealand.”

Growing traction

Asia’s under-allocated private debt markets attracted more interest from homegrown investors in 2015. In countries like Japan, where interest rates have moved into negative territory, the returns from private debt can be appealing.

“There was a lot more traction in the LP community in Asia last year than there has been in the past, particularly from Korean pension funds and larger Japanese funds,” says Adam Wheeler, co-head of Asia-Pacific private equity at Babson Capital. “That trend will continue and I expect new institutions will start to have permanent allocations to the space.”

When Babson closed its second mezzanine fund targeting mid-sized companies in Asia-Pacific in May 2015, it raised $177.2 million from investors. “We saw a number of investors who had allocated to mezzanine in other jurisdictions making first-time allocations to mezzanine in Asia-Pacific when we closed our fund,” says Wheeler.

The fund focuses on private equity- sponsored deals targeting companies with enterprise values of $50 million-$200 million. According to Mercer’s Chang, while interest in the region has been growing, global institutional investors have been slower to focus on Asia, compared with the US or Europe.

The region also lacks the sophistication in terms of deal structures. However, there were baby steps in this regard in 2015, as borrowers sought flexible funding packages that banks traditionally do not provide.

“We closed a couple of deals last year approaching what a unitranche structure in Europe would look like and they are getting traction with the private equity community,” says Wheeler.

Alternative lenders continue to make in-roads in providing performing credit in Asia-Pacific. But it is the distressed assets – public and private – that managers in the region are watching in 2016.

Public versus private: opportunity knocks
Private debt funds are showing more and more interest in the public markets.

The public bond markets are not an arena of focus for many private debt funds who sell themselves on accessing deeper, less liquid areas of the debt markets. However, given the sell-off in Asia’s high-yield bonds in 2015, funds have started to look more closely.

Mercer, which advises institutional investors on more than $12 billion of private market investments globally, has seen growing interest among private debt funds in the public markets, particularly in the commodity sector where bonds have been battered.

“For a lot of the energy or resources-related companies throughout Asia-Pacific, the high-yield bonds are trading at 40 to 50 cents to the dollar right now,” says Joseph Chang, of private markets group Mercer.

“Depending on your view on the underlying credit, the borrower may be able to pay back at par. I think right now there are a lot of private debt funds active in the secondary debt market.”

While the plunge in bond prices could be a function of broken balance sheets, companies with healthy balance sheets have also been caught in the sell-off as hot money flows out of the region.

“Some of the bonds don’t have the support that they would in a deep market like the US and have sold off for technical reasons,” says Edwin Wong of SSG Capital Management. “In a bull market, we spend very little time looking at the public bond market. But now, the pricing of some bonds has come down to very attractive levels.”

Wong says that SSG invested a small amount in high-yield bonds in 2015, relative to the total amount committed. He adds that the firm also sees opportunities to finance companies looking to buy back their stock, given how low share prices are.