A new environment for Asia-Pacific private credit
Asia-Pacific Private Credit Newsletter
As has been the case since the pandemic, Asia’s economic, inflation and interest rate cycles are out of sync with those of Europe and the US. We see this as encouraging for global investors looking for regional and temporal diversification in a period where they may be less optimistic about their home markets.
Regional macro fundamentals look relatively sound compared to the rest of the world. While Asian exports are contracting, and vulnerable to further contraction if the US and Europe go into recession, there is little evidence of the major imbalances that have historically put the region into dangerous territory. Public debt and foreign borrowing are both broadly manageable across the region, currencies are cheap and equity market valuations are mostly reasonable.
Inflation is rising, which is causing discomfort for food and fuel importers, but the region was monetarily more cautious during the COVID era. It has also been slower to reopen, which will likely help ensure that inflation is less entrenched. In aggregate terms anyway, Asia still has lower inflation than Europe and the US. And this is against a background where the region’s two largest central banks, the People's Bank of China and the Bank of Japan, are, in their different ways, much looser in policy (we will step aside from a discussion of the BoJ’s yield curve controls).
Asia-Pacific offers positive economic growth in 2023, albeit at a slower rate relative to its recent history. (Note that these IMF data were published in October 2022, so likely present a more optimistic forecast than a more “real-time” picture).
In this Newsletter we discuss:
1. Thematic focus - How higher borrowing rates are changing the game for APAC Private Credit
2. News centre - Zerobridge on YouTube, plus other media we found interesting
However, the bank lending environment is getting tighter for companies seeking hard currency loans, especially for non-domestic business opportunities. The next chart shows the change in the Hong Kong interbank lending rate over the last 12 months:
A sea change is under way in markets (Howard Marks, Financial Times, 14 December 2022 – subscription may be required
… and what it means for portfolios
Regime Change: The Benefits of Private Credit in the ‘Traditional’ Portfolio (KKR, 13 December 2022)
History Lessons: How “Transitory” Is Inflation? (Rob Arnott, Omid Shakernia (Research Affiliates, November 2022 – registration may be required)
Risks in public corporate debt markets
US junk loan investors brace for increase in downgrades and defaults (Financial Times, 3 January 2023 – subscription may be required)
Blockages in the leveraged loan market
Wall Street’s Lucrative Leveraged-Debt Machine Is Breaking Down
It’s a great time to be in private credit
Briarcliffe Bellwether - Our Proprietary Institutional Investor Survey (Briarcliffe Credit Partners, 19 December 2022)
Thailand’s public health minister says Chinese tourists won’t be discriminated against (The Thiager, 5 January 2023)
If you have an article on Private Credit that you think is interesting, please send it to us at firstname.lastname@example.org
While risk and growth assets have got off to a flying start in 2023, we are sceptical that such buoyancy can be maintained in the face of the dramatic rise in borrowing costs witnessed in 2022. This is especially because of the amount of debt stock there is outstanding in the world today.
Regardless of when and where central banks find their terminal rates, the era of cheap money appears to be over for now. Even if recent US inflation data shows a slowing across key components, we expect it will likely take the Fed around two years to wrestle inflation back to near target. For some, even this timeline would appear wildly optimistic. As bottom-up investors, we try to avoid getting too involved in precise macro forecasting but we think it is fair to assume that – compared to the 2010s – inflation should display a “higher resting heart rate” for some time.
Many commentators see the last 12 months as marking a “sea change” where capital markets move from an era of low returns into one where risk is more fully priced. We are sympathetic to this view and we anticipate that this new environment will alter both borrower and lender attitudes to credit risk, in favour of direct lending globally.
Furthermore, we are cautiously optimistic that this new environment will favour Asia-Pacific direct lending strategies specifically. There are several reasons for this, which we will examine in more depth.
To us, China is the fulcrum for economic growth regionally (and globally). We expect a fair amount of “revenge spending” from Chinese consumers over the next few quarters. Most of the region eagerly anticipates the return of PRC tourists who, pre-COVID, accounted for 30-50% of regional arrivals. For instance, Thailand expects 300,000 Chinese visitors during Q1 2023. Chinese students have also been significant consumers of education services in the broader region.
Within our current deal pipeline, we can see this theme has increased in intensity since the Russian invasion of Ukraine, as countries and companies in the region begin to focus on energy security and “friend shoring”. Outside of natural resource and renewables companies, we see the theme play out in areas such as data centres and logistics providers. From an underwriting and structuring perspective, we believe these areas can deliver steadier contractual returns and offer a more robust mix of quality collateral.
The current global environment is skewed in favour of non-bank lenders. As a result of commitments made to fund buyouts in the previous lower interest rate regime, many banks are now constrained in their ability to commit to new loans. Higher loss-based reserves force banks to hold more capital and issue fewer loans. This takes a toll on leveraged loans (drop in Debt/EBITDA levels) for sponsored lending.
Concurrently, high yield bond markets are no longer as attractive for debt financing after a spate of borrowings in the recent past. 13 months ago, this Newsletter described a world where the US high yield bond index was averaging a yield of 4%, and new issuance was in the 3s. Today these securities are trading in the 8s and above which, we can assume with some confidence, is not as attractive for prospective borrowers. In Asia, the stress caused by the disproportionately large weight of the China real estate sector in the high yield market has led to little issuance as investor sentiment has soured.
As a result of these conditions, we expect (reduced) deal activity to seek new avenues of capital. Larger direct lenders should move to fill the gap in credit for larger sponsored deals. It works to their advantage to overcome the overcrowded middle market and lend to larger credits with tighter covenants. We expect the secular trend of non-bank financing to extend further in 2023 and, as on-the-ground participants, we are witnessing the pie grow in Asia-Pacific too.
At the macro level, Asian bank balance sheets are generally in better health than their Western counterparts and can therefore better accommodate any increase in demand for credit.
This recent experience, and the realisation that central banks’ battle against inflation may be waged over years, not months, supports the argument for increasing weight to credit as a standalone asset class, with its own unique payoff profile. Due to its priority in the capital stack, credit offers a higher degree of capital preservation ("margin of safety") than equity. Credit instruments also tend to have shorter duration than government bonds. These are important “buffer” characteristics in a world where equities and government bonds no longer offer a natural hedge to each other.
The strategic case is supported by current valuation dynamics in public markets. In segments such as high yield, there’s an argument to be made that credit appears cheaper than equities.
Zerobridge Partners Asset Management Limited is focused on giving institutional & high net worth investors globally access to APAC alternative credit opportunities. The strategy seeks to take advantage of the less developed banking and capital markets in the APAC region and capitalize on our strong proprietary deal flow.
Zerobridge Partners Advisory Limited is a debt advisory firm focusing on raising new capital, creditor negotiations and debt restructuring for companies in Asia-Pacific. We come with deep investment banking experience and a strong track record across multiple credit cycles in Asia.
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Reason #1: Asia and the West are out of sync (and that’s a good thing)
Source: IMF, World Economic Outlook, October 2022
Source: Australia Bureau of Statistics, Japan National Tourism Organization, Department of Statistics of Singapore, Ministry of Tourism & Sports of Thailand, U.S. National Travel and Tourism Office, October 2022
However, our conviction in a strong post-COVID tourism rebound is lower than some other commentators. Given the somewhat abrupt nature of the end of China’s restrictions and the cautious response with which the changes have been received internationally, we do not expect an instant snapback to the pre-pandemic era. What is more, significant outflows of Chinese citizens can often equate to corresponding outflows on the current account. Add this to an expected decline in net exports and we may see constraints on outbound travel as Beijing seeks to manage any balance of payment risks. We do expect a China-led tourist recovery, but we anticipate it will be bumpy.
Taking “all-in” bets on tourism and consumption recovery at this stage would, in experience, likely involve adding more equity participation risk than either we, or LPs, would be comfortable with. We have written previously about the potential operating leverage on offer in these businesses but they tend to end up structured as hybrid deals and therefore really only fit the margins of a direct lending mandate.
We prefer to play an Asian relative value theme through a diverse portfolio of industries exposed to secular themes such as intra-regional trade.
Reason #2: The Direct Lending pie is growing – globally and locally
Source: Hong Association of Banks, Data from 4 January, 2022 to 4 January, 2023
Due to the US dollar peg, Hong Kong provides the starkest example of how regional financial centres are obliged to import rapidly tightened US monetary policy. This is even though the economy has been shrinking due to COVID restrictions and has experienced little inflation itself (although try telling that to landlords).
Given these conditions, we are seeing larger companies approach us with more extensive loan requirements that, until recently, they would have taken to their commercial banker. Direct lending suddenly doesn't appear as expensive to larger companies, with some bank loans now priced in absolute terms in double digits. Asia’s Total Addressable Market (TAM) for direct lending is growing at the expense of higher bank lending rates due to base rate increases.
Furthermore, given the structural inefficiencies of the lending market in the region, which we have discussed often, Asian SMEs are battle-tested in borrowing in hard currency at mid-teen rates. This is not necessarily the case for equivalent European borrowers who have, up until now, exploited an environment of cheap money and strong investor demand to reduce covenants.
For US-based LPs, seeking geographic diversification away from harsher macro conditions and towards less vulnerable underwriting situations, APAC may represent compelling relative value over Europe.
Reason #3: A favourable backdrop for adding to credit exposure
While we expect the supply pie to increase, we also expect demand for credit strategies to remain strong. Reading practitioners’ portfolio construction commentary, the broad credit asset class appears to be in favour with asset allocators.
The negative correlation between equities and bonds was a defining feature of the post-GFC “risk-on/risk-off” landscape, whereby government bond duration provided a hedge against equity risk. This correlation turned strongly positive as monetary policy was overtightened to rein in inflation. In turn, 2022 witnessed the worst performance for the traditional “60/40” equity-bond portfolio in almost a century.
Source: Bloomberg, Zerobridge Partners, 60-day correlation of the S&P 500 Index and the Bloomberg US Aggregate Bond Index, Data from December 2019 to January 2023
Source: Bloomberg, Zerobridge Partners, US High Yield Index YTW versus S&P 500 Earnings Yield, Data from June 2007 to December 2022
There’s certainly an argument for trading the potential convexity currently available in public credit. But we don’t believe that there is sufficient robustness to the fundamentals to make a long-term allocation case. This is especially true in APAC where, as we have shown in prior Newsletters, Asian public credit markets are concentrated even in their indexed form.
For instance, consider this popular ETF invests in the Asian high yield bond market:
Source: BlackRock iShares, Data as at 4 January, 2023
Despite receiving credit “beta”, the index composition means owners are heavily exposed to indebted Macau gaming companies and banks, which are over-committed with loans to State-Owned Enterprises. And that’s even before we start picking through the Chinese real estate developers. (Many of these firms are included in the Financial Other category in the data shown above).
With a more diverse and growth-oriented opportunity set, and more conservative underwriting and structuring, APAC private credit still offers superior access to the regional economy than public equivalents.
Reason #4: Vintage and manager selection will be important
We expect 2023 to be a positive year for credit allocations; we expect Asia to be attractive relative to other regions. We see the TAM for APAC Direct Lending increase as larger companies seek private, non-bank financing solutions.
Couple these factors with a financing environment favouring lenders over borrowers, and 2023 should be a strong vintage year for our asset class. Investors who understand the importance of linear deployment year after year in long-term private asset performance should take note and make sure APAC Direct Lending is on their shopping list.
However, this time around, deal selection in a new operating environment will be key - as opposed to coming along for the ride on club deals or leveraging others’ underwriting. It will be essential to identify businesses that have sustainable cash flows less disrupted by demand pressures, shrinking margins, higher debt servicing costs, geopolitical disturbances, etc. Having unique insights into how businesses are preparing to meet newer operating conditions will also be important.
The privilege to select quality deals/borrowers that present steady cash flows, adequate collateral coverage and responsible management to navigate a new operating environment can only be enjoyed by direct lenders who are positioned to receive a constant flow of deals from various sources. Fortunately, our debt advisory business has formalised contractual deal sourcing arrangements to generate a constant flow of quality deals even through the depths of the pandemic.
A new operating environment can bring unforeseen distraction for direct lenders who underwrote deals in recent times when easy money lifted all boats. Addressing stressed legacy positions while keeping the focus on tight underwriting in an untested new environment is a tall order even for established private credit firms.
Conservative underwriting and customising robust collateral packages become equally paramount to success while also possessing workout experience just in case. Our collective experience in working through various credit cycles, coupled with our debt restructuring expertise, enables us to execute deals diligently even when the rules of the private credit game are changing.
Our YouTube of the Year!
Intelli-bytes Episode: Zeroing in on a New Bridge to Direct Lending in Asia-Pacific (A live recording of Emerging Markets Alternatives’ due diligence wrap meeting with Zerobridge Partners’ Founder and CIO Rahul Kotwal, 23 September 2022
Readers interested in taking a deeper look at the opportunity and inherent risks in APAC direct lending and our strategy may contact EMA directly for a FREE copy of their full Investment Audit Report. Please note that we are not privy to the contents of the Full Report and have no access to it. EMA shares its Report directly with qualified investors upon their request or on an introduction from us.
Source: Asian Economic Integration Report 2022, Asian Development Bank, February 2022