ADVISORY
The Workout
April 2021
APAC Private Credit: Better Risks, Better Returns
APAC middle market lending offers meaningful returns over US and Europe equivalents. Investors can expect unlevered, gross IRRs of 15%+ versus 7-10% for the US and Europe.
When we discuss these returns with prospective LPs researching the asset class, we are often met with surprise, even scepticism. What lurks beneath the surface for APAC to be priced this way – are credit risks higher or structures weaker than in other regions?
Comparing Structures
Deals in APAC tend to have tighter documentation and better covenants than comparable transactions in the US or Europe and with lower financial leverage levels. This results in higher quality deals with stronger downside protections.
In the US and Europe returns and loan quality are being pushed down by a surplus of capital chasing fewer deals and covenants in both markets are getting even more "lite". This has led to plenty of recent commentary around the potential mis-pricing of risk in private credit markets.
APAC private credit is playing a different game. Few deals are PE-sponsored and starting point for documentation, covenants and tenor are all more conservative:
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Facilities are mainly secured, with borrower and third-party collateral and guarantees
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Covenants are strong with strict cashflow ringfencing and commonly containing EBITDA maintenance, interest coverage and debt service metrics
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Deal tenors are typically 2-3 years, versus up to 7 years seen in the US and Europe
Pricing Risk: Default and Recovery Rates
Is this enhanced return profile in APAC driven by disproportionate risks versus other markets? Comparing default risk - we used Moody's default rates on high yield non-financials as a public market equivalent to compare risk of default across the three major regions and over the last decade. APAC default rates are on average in line with Europe and below the US.
To get a complete picture of potential portfolio impact, default rates should be reviewed in conjunction with loss given default (LGD) and time to resolution data (using GCD large corporate borrowers as a proxy). LGDs over the last three years have moved between 23% and 24% for the US, 20-22% for Europe and remained stable throughout at 28% for APAC. In addition, time to resolution data is marginally more favourable for APAC (between 1.6-1.9 versus 1.9-2.1 years for US and Europe).
Given the above data, this leads us to conclude that APAC private credit is of similar risk when compared to the US or Europe.
Explaining the Return Premium
APAC's higher returns from a deal perspective really comes down to two differentiating and connected factors - the scarcity of funding and the complexity of the deals. In addition, investors get an incremental return to compensate for the additional illiquidity of the deals in the region.
Despite the economic growth of the region, APAC SMEs faced a US$4.1 trillion funding gap pre-COVID and many international banks are retrenching from lending in this space. Private credit has an important gap to fill but deals must be highly structured and bespoke and there is a scarcity of talent available to do them.
The APAC region offers global investors higher risk-adjusted returns while increasing portfolio diversification.
Complexity and Scarcity
APAC is a diverse and fragmented regional market with high barriers to entry, including language, culture, regulation, tax and longer origination and execution periods. Investors in the regions operate in over 10 different jurisdictions, ranging from lender-friendly developed markets to middle income, high-growth "emerging APAC" countries. EM APAC creditor rights continue to evolve closer to DM APAC but, if deals are not structured correctly there is risk to the overall portfolio.
This is a stark contrast to the US with a single legal and business framework and highly sophisticated financial services infrastructure. European private credit falls somewhere in between, as there are differences between countries, especially those in northern versus southern Europe but is a more sophisticated marketplace.
APAC private credit is playing a different game to the US and Europe. Capital is not chasing deals, but rather the other way around and active management genuinely matters. Deal origination, selection and structuring, along with experience in multiple jurisdictions and workouts are all critical to ensuring successful outcomes.
Creditor Rights Across the Region
Zerobridge Firm Profile
Zerobridge Partners Asset Management (“ZPAM”) is supervised and regulated by the Securities and Futures Commission in Hong Kong. ZPAM takes advantage of the less developed banking and capital markets in the APAC region, and capitalises on strong proprietary deal flow to deliver low volatility, uncorrelated alternative credit strategies with a focus on capital preservation via funds and separate accounts. Investments will be made primarily through bespoke, privately negotiated deals, however secondary transactions will also be opportunistically considered.
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