Sidelines to frontlines: Private Debt in Asia
- Kenny NG, Ningzhe KOW
Private debt can be viewed as a “mid-risk, mid return” type of investment when compared to private equity which typically offers above 20% returns on an annualized basis.
Within the private debt space, there are many sub-sectors ranging from senior infrastructure debt, subordinated debt, general private credit, and distressed debt, which range anywhere between 2% to mid-teens returns.
Although deal activity in Asia involving private credit still lags that in the US and Europe, interest in this asset class has risen significantly in recent years.
According to a Global Private Debt report by Preqin in 2020, the number of private debt investors in Asia had increased from 115 to a record 477 over the past 5 years, with AUM doubling to USD 57 billion in 2019 from USD 27 billion in 2014.
This thirst for capital is partly driven by resilient economic growth from a booming middle class and a burgeoning small-medium-enterprise (“SME”) market, resulting in a shift from traditional bank financing towards private credit.
David Fowler, Country Head, Singapore at Sanne, speaks to Anulekha Samant, Tax Partner at KPMG; Sabita Prakash, Managing Director at ADM Capital; and Yusun Chung, Private Assets Director at Schroders, about their insights on how this asset class is developing in Asia amidst a post-COVID financing landscape.
One continent, many systems.
“On the one hand, you have developed markets like Australia, Singapore, Hong Kong, Japan, etc. and on the other you have core emerging markets, India and China… and you have frontier markets, like Myanmar, Cambodia, Vietnam, etc. And each of these have such different regulations, different cultures, different investment perspectives…”
Asia can be conveniently classified as a single region, yet, the ecosystem in this region is highly idiosyncratic, with each country characterized by its own unique risks and opportunities.
Differing perspectives, business practices and regulations such as capital controls increase the complexity of deal making and maximizing returns at both the fund and transaction level.
At the fund level, Anulekha also believes that managers need to account for differences in taxation laws across different countries. Given how funds in Asia are structured based on varying potential income streams such as interest, capital gains and/or equity kickers, these need to be taken into consideration over the life cycle of the investment.
Managers should also strategize and plan for a tax efficient structure at the onset. In addition, other issues such as foreign currency controls and fluctuations are also important aspects. Due to the multiple jurisdictions involved, investors in Asia generally require a relatively higher return to offset this risk.
People and relationships matter, especially in emerging Asia
At the transaction level, some jurisdictions in Asia prohibit foreign ownership in assets, precluding even debt investors from being able to use those assets as collateral. It is therefore important to have a deal appropriately structured and documented in accordance with the local regulations.
While watertight contracts and agreements are able to cover some blind spots and allow investors to seek recourse under a legitimate legal framework, it is almost equally, if not more important, to be able to forge strong relationships with the local sponsors in order to mitigate any potential downside risks.
“…oftentimes the collateral is property, so if we were to foreclose and take the property, we are not able to hold on to it because this is not allowed under the laws. The challenge is to understand the nuances of these countries – one is the legal aspect, the other is the cultural aspect.”
Anecdotal evidence also suggests that structuring personal guarantees tend to also be effective, not for their ease of implementation, but because sponsors in Asia will generally ‘do what it takes’ to ensure that they repay their debts on time to avoid ‘losing face’.
“What is important in relationships or having people on the ground, is to tell you what NOT to invest in, rather than what to invest in.”
At ADM Capital, Sabita believes that the ability of colleagues to learn from each other allows the team to collectively formulate and “transplant” actionable solutions for a specific region based on precedent deal experiences drawn from other parts of the world.
This is especially important for the private credit space due to the complex nature of the transactions. The strength of local relationships cultivated and accumulated over the years, coupled with qualified professional staff on the ground are the most crucial ingredients for executing a successful investment.
How has COVID-19 changed the landscape for private debt?
“Digital, Diversity, Debt moderation and Determination (the four Ds)” – is what we learned as a result of COVID-19”
Digitally enabled businesses have outperformed their traditional counterparts due to restrictions on physical contact. Digitally disruptive businesses with improved operating efficiencies will be well placed to tap into not only equity capital from venture funds but also into the private debt market.
Many businesses will be compelled to diversify their revenue streams and resources across geographies and sectors to hedge against uncertainties in the new geopolitical climate. This diversification effort will result in a lower risk profile and pave the way for debt investors.
Debt moderation will be key. The current economic environment will test not only the commercial viability of businesses, but also the sustainability of cash flows and their ability to repay their debt obligations. It will also create a litmus test for identifying the winners that are poised to survive and thrive in key growth markets.
And ultimately, it comes down to personal determination. Businesses which have the resilience and agility to re-invent themselves and discover fresh ways to overcome these obstacles will eventually emerge as the winners in their industries.
Several bright spots in the private debt space have also emerged as a result of the pandemic, and one of these is infrastructure.
According to Yusun, there has been increased demand from infrastructure debt resulting from COVID-19, largely because infrastructure assets are typically more resilient, especially when it comes to loans to operating projects. The underlying assets are usually characterized by contracted cash flows which are stable and highly visible, making them extremely attractive for private debt funds in times of market volatility.
Ample room for growth
Historically, based on Preqin reports, activity for private debt deals in Asia has lagged the market, with 15% of mandates issued by LPs in 2019 being targeted at Asia, as compared to 40% for markets in Europe and 39% in the US.
This gap implies that there is still sufficient room for Asia to catch up with relatively more established private capital markets. In certain regions such as South Korea, there is already evidence of growing LP interest to step-up exposure within private debt to hedge against economic volatility.
Beyond investments into large scale infrastructure, the private debt market will also be driven by growth in the SME segment which continues to be under-served by banks as well as shadow banking systems present in many jurisdictions. Smaller firms which are looking to shore up liquidity are likely to explore alternatives to venture capital and private equity funding, providing the necessary catalyst for a more sustainable growth in the private debt market.
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