Mid-market special report: Navigating risk in Asia

Markets hate uncertainty but, for many, 2016 has been a bumper year for unpleasant surprises. Twice, the Western world has faced the unexpected, first with Brexit, and again with the election of Donald Trump as president of the United States. With the stability of two of the world’s most mature credit markets thrown into question and low yield prevalent in the global fixed income market, some investors are wondering whether they might be better off taking a punt on private credit in Asia’s emerging markets.

The private credit space in Asia is still fairly nascent and, in fundraising terms, the region still accounts for just a small fraction of global activity. That said, 2015 was a banner year with around $5.51 billion collected from the close of 14 Asian private debt vehicles. 

The most recent data for the first half of 2016 show that 2015 may have represented a peak, but with four Asia Pacific-focused funds raising a combined $931 million between them, there is still plenty of room for growth.
Appetite may yet improve in the second half of 2016. Investors will need to consider carefully whether such a diverse region can generate sufficiently attractive risk-adjusted returns.

Regulatory gauntlet 

Tom Holland, head of frontier markets at ADM Capital, notes that a lot of scepticism about Asia stems from the various regulatory regimes across its jurisdictions, and the enforcement issues private debt investors in the region face.

“Legal jurisdictions in Asia are good in theory, and oftentimes judgments are in creditors’ favour, but ultimately the concern is in enforcement, which makes practical implementation difficult,” says Holland. “Going to the court is last resort for investors, so there are a few things that investors would be aware of, depending on the country they are investing in, to avoid that situation.”

Echoing Holland’s sentiments, Timothy Hia, a Singapore-based partner at international law firm Latham & Watkins, points to Indonesia as an example of a country where international investors face several regulatory pitfalls. Known for its rising economic nationalism, Indonesia’s negative investment list and local component requirement have been discouraging overseas investment.   

“You have to look at the regulatory regime in Indonesia now, it is very much against an overdependence on offshore debt,” says Hia. “The real focus is developing a domestic debt market, therefore, loans from offshore investors tend to be more scrutinised.” 

On top of that, there is a real push from the government to focus on the domestic market. Over the years, there have been regulations like the currency and language laws to promote the rupiah and Indonesian as the default currency and language. 

This has made the execution of deals more complicated for foreign investors. This reality has been particularly stark in the mining industry. Hia points to foreign investors such as Newmont Mining and BHP Billiton which were forced to leave the country by selling their mining assets to local players this year. 

“[Indonesia] has learnt a very painful and important lesson from the Asian financial crisis and it is trying very hard to make sure onshore enterprises are not going to overload on debt if there’s a downturn in the exchange rate,” Hia says. Banks in Indonesia therefore have been conscious about requiring domestic entities to obtain a credit rating before they can tap the offshore debt market.

On the flipside, Indonesia is a fledgling economy, with a sovereign rating significantly lower than its peers, and there are still opportunities for offshore investors. Hia also believes that with the country’s protectionism, extending loans will be easier than obtaining equity because the latter will almost certainly come under greater restrictions.

Timing it right  

But regulatory issues are just one part of the picture. ADM Capital’s Holland emphasises the importance of getting in at the right time, particularly with newer frontiers like Vietnam, which Holland believes is still in the middle of a multi-year growth cycle. 

“Timing the cycle is as important as finding a good deal. Even bad deals can become good ones when the cycle is turning. Likewise, good deals may not be able to find an exit if the cycle is moving against you,” says Holland.
He notes that a country like Mongolia, which is at the bottom of the cycle, has the potential to yield attractive deals. 

Until recently, the country was the darling of Asia’s frontier markets by virtue of its rich natural resources. Since the commodities downturn, the country has suffered from chronic economic crisis, a looming sovereign debt default and a spiraling currency. The big challenge for fund managers looking to tap these opportunities is convincing their LPs.
“[Mongolia] is a great place to negotiate deals given that the cycle is turning, but we still don’t have enough investors who have gotten themselves comfortable with it,” says Holland. 

He adds that one way managers are gaining access to deals – and obtaining the requisite comfort for investors – is by partnering with development finance institutions when investing in the frontier markets in Asia. By doing so, investors are aligning their interest with the locals and the government. By doing so, private debt investors face a better chance of their creditors’ rights being enforced. 

A nation apart  

From the steady growth of non-bank lending and private credit issuances to rising corporate defaults, China looms large in the world of Asia private debt. Not only does this giant economy set itself apart from its neighbours, but it is practically an ecosystem itself. There is a huge gap in the GDP per capita between top-tier and lower-tier cities. While the country as a whole is a developing economy, places like Beijing and Shanghai have more in common with Western economies.

Michael Wang, chief executive at China-focused manager Abax, has been focused on the leading cities, demonstrating that picking the right asset class is essential in China. 

Specifically, the firm, which has made both equity and private debt investments in China since 2007, targets stable cashflow sectors such as healthcare, consumption and education. 

“There is a direct correlation between credit worthiness and how advanced the local economy is,” says Wang. “By and large, the majority of investments we do is still in the more developed cities where we get better protection and businesses there tend to be bigger in scale.” 

At the same time, Abax avoids the country’s real estate sector, which is broadly seen as overheated. Bloomberg data show that developers that accounted for 13 percent of the bankruptcy in 2016 with many developers kept afloat by having access to record-low yields when selling bonds onshore and offshore. Bond issuance has reached the equivalent of $89.5 billion in 2016, exceeding last year’s $87.8 billion, due to developers aggressively taking on leveraging without having a sufficient understanding of the sustainability of the sector. 

For Wang, the greater opportunity for private debt lies in China’s growing affluence and changing demographics.
“You have to ride with the demand from the whole Chinese middle-class upgrade,” he adds. “It is largest emerging middle class in human history and already the size of the US population.”