Interest in Asian private debt is growing. But while there are opportunities to be had, consultants suggest that investors proceed with caution. “We have observed more interest in Asia private credit than in previous years, as investors look to diversify their credit portfolios and gain access to a region which is regarded as having compelling secular growth characteristics,” said Sylvia Owens, senior portfolio advisor, Aksia, an investment consulting firm. “There is increasing investor interest as LPs (Limited Partners) try to figure out the best way to tap into the market, but capital flows have been light vis-a-vis the size of the opportunity sets,” she said. “There are fewer GPs (General Partners) focused on the space, and not many of them have track records and institutional quality teams. But it could be a big opportunity set if you think about it in terms of the region more broadly, as well as the possibility for more distressed activity in the future.”
The Asian private debt markets are underdeveloped overall and, as such, hold exciting opportunities, according to Tom Carr, head of private debt products at Preqin, a private equity research firm. He said investors who may now be concerned about their exposure—or overexposure—to the U.S. and Europe are looking to diversify their portfolios. “They are concerned about market timing, and where we are in the market credit cycle currently, and are asking, ‘If markets turn, am I over exposed?’” Carr said. He added that “we are [hearing] increasing proportions of investors say that they believe assets are overvalued and due for a correction.”
Asia has become an area of interest, because the U.S. private debt market has gotten crowded.
Where the deals are
Owens said there has been a lack of traditional bank debt available to many private companies in the region, as a whole, due to the importance of local relationships and reliance on complicated collateral requirements, such as non-local assets and personal guarantees, leaving many investors scratching their heads about how to best tap the Asian private debt market. “The areas drawing the most attention from investors are China, India and Southeast Asia, though many have held off investing in country specific funds,” she said.
Eric Denneny, senior consultant, global private equity research at Aon, by contrast, has found that “the more developed countries, such as Australia, Japan, South Korea and Taiwan, are positioned better to support a direct lending strategy with Western-style laws in place. While China and India are growing markets, they still lack a consistent approach to how their laws protect creditors,” he said.
According to a recent survey released by Preqin, more than 900 institutions are currently seeking private debt investment opportunities in Asia. Thirty percent of respondents to the survey said they thought Asia represented the best opportunities in 2018. By comparison, 44% said the best opportunities are in North America and 59% said the best opportunities are in Europe. The 30% figure represents a large climb from June 2017, when just 13% of private debt investors cited Asia as presenting the best opportunities.
“For such a small industry that number is big,” Carr said. “Asia has become an area of interest, because the U.S. private debt market has gotten crowded. People are looking now at where else to find relative value, because Europe too has become statured,” he said. “It affects eventual returns, because investors in those markets are competing for assets.”
As of June, 2018, there were 31 Asia-focused funds in the market, seeking a total of $11 billion from investors. Of the 927 institutions seeking investment in the region, just 12% are Asia-based, while 69% are in North America, according to the Preqin survey.
“Interest in Asia is growing, but when you look at the availability of funding, historically, it continues to be heavily dominated by the U.S. and then Europe,” according to Niels Bodenheim, senior director, private markets at the London-based consultancy bfinance. “When it comes to considering Asian private debt funds, investors need to look at the differences in insolvency proceedings, and foreign investors have to deal with foreign exchanges and local taxes, so it poses a little more value leakage than anticipated. You may find attractive yields in Asian markets, but it could be a balancing out of that yield with the cost of foreign exchange,” he said.
Also, “returns for Asia-focused private debt are not necessarily expected to be higher than those of U.S.-focused or European-focused private debt strategies, despite having additional risks,” Denneny said. For that reason, Aon is currently not recommending that their clients invest in Asian-focused direct lending strategies. “However, we have considered Asian-focused special situations and distressed debt strategies, previously, as there may be some diversification benefits to having exposure to Asian-focused private debt investments that could perform differently than U.S. or European-focused investments through a credit downturn,” he said.
“Looking at both historical returns and expected future returns, there are risks in Asian markets that are not as prevalent in the U.S. or European markets (i.e., governmental and legal) as well as an expectation of a higher volatility spread between the upper and lower bounds of returns,” Denneny stated. “However, we are not saying that returns cannot outpace the U.S. or Europe—as it could be possible for investors to benefit from diversifying their exposure to private credit with Asian-focused investments,” he said. Owens concurred, noting that “from our experience, Asian senior lending managers typically target higher returns than U.S. and European GPs,” she said.
A word of caution
The bottom line is investment in Asia may not necessarily be a tea party. Natural concerns for investors center around “’If things go badly, how do I get money out?’” Carr said. “Investors are looking at how they would recoup their investment were a business to default on its loans. It will require strong legal institutions to ensure that the seniority and security of their issues are respected and enforced,” Carr said.
“Restructuring a loan in Asia is very different from U.S. bankruptcy law or European insolvency proceedings,” Bodenheim observed. “This could pose a risk when it comes to loan recoveries when deals need to be restructured. As a result, this would create a different level of loss recovery, which impacts returns much like hedging costs and taxes,” he said.
“The market for distressed or special situations funds is stronger than that of direct lending funds, which are relatively new to that market,” Denneny added. “We would expect direct lending strategies to take a few years before investors are comfortable that an appropriate legal framework in Asian countries can support the rights of creditors,” he said.
To that end, investors must be vigilant when looking to invest in this arena, said Denneny. “We are still a bit cautious in terms of Asian debt strategies, and the reason has to do with lots of players who have not been around as long as the players in Europe and the U.S.,” he said. “There is definitely potential for attractive strategies, as Asian markets become more mature, and there is more growth in the space,” he noted.
You have to be cautious when looking at any private credit investment, and you need to really think about the GP’s competitive advantages.
Deep due diligence on GPs
Another issue holding investors back from realizing their investment ambitions in the region is the difficulty in finding GPs to access the asset class in an institutional way, Owens said. Owens suggested that investors conduct rigorous due diligence on general partners. “You have to be cautious when looking at any private credit investment, and you need to really think about the GP’s competitive advantages,” she said. “Some managers opportunistically raise capital to take advantage of investor demand,” she explained. They think: “’Let me start an Asia strategy to complement my other business,’ so it’s important to ask, ‘Are they creating an Asia fund just to target Asia? What are their core competencies?’” Owens said. “Having local presence matters, due to jurisdiction issues and related to creditor rights, which vary substantially across countries,” she added. “Also, the origination pipeline is particularly important in Asia, since the market is less dominated by sophisticated sponsors and debt advisers than it is in the U.S. and Europe.”
For those investors that are looking to expand their exposure to the region, private credit could be worth considering as a complement to existing investments in private or public equity. “Investment in Asia can be spread across other asset classes as well,” Owens said. “It is interesting as a region, and the best way to tap it may not be just be in private credit,” she noted.