2024: The Golden Age of Private Credit?
Asia-Pacific Private Credit Newsletter
In this Newsletter we discuss:
1.Thematic focus – We reflect on what the growth of global Private Credit means for the asset class in the APAC region
2.News centre – Some of the best content on Private Credit over the last few months
Where should LPs search to find their desired levels of return? Briarcliffe's report notes, "Many investors are seeking complements to mature, corporate credit exposure (i.e., direct lending) in other scaled credit markets". It highlights specialty finance (asset-backed/based) as an area of interest for its client base.
APAC offers relative value…
There is also the opportunity to expand and diversify direct lending books by geography. KKR recently published a primer on APAC Private Credit, which discusses the relative value appeal and potential diversification benefits of allocating eastwards. They "typically see a 50-100 basis point (bp) premium over the United States and Europe for direct lending deals," implying a net IRR of 9-11.5% for transactions in the upper end of the APAC middle market. For capital solutions (i.e. subordinated lending), the authors expect a premium of 300-500bps over the US or Europe, with the exact premium depending on "situational dynamics, local borrowing rates, relative complexity and other factors."
The region's diversity, the need for deep on-the-ground expertise in navigating the informational asymmetry that accompanies this, and the ability and experience required to navigate local legal systems and regulatory environments may all explain the premia. Equally, as KKR's primer highlights, and as we have discussed in the past, the degree of risk investors take is less than the premia might imply. The imbalance between the supply and demand for capital means less competition between lenders for deals. The reduced competition allows lenders to set favourable terms and exercise greater control over operations to manage downside risk.
… at a range of borrower sizes
Since the region began to re-open in mid-2022, we have seen Apollo, Blackstone and KKR (re)launch their APAC lending businesses, focusing on the upper middle market and large-cap borrowers. As KKR argues, "[the] growth of the private equity market in the region and the shift from minority and growth investments to control leveraged buyouts therefore underpins the growth of direct lending." Naturally, the largest firms are approaching APAC Private Credit with the intention of shaping it in their image via large funds and sponsor-driven deals.
But their emphasis leaves a lot of money on the table, both for borrowers and investors. As discussed in previous newsletters, SMEs are the heart of the APAC economy, driving growth, employment, and regional exports. Many face significant challenges in accessing suitable financing as international banks (Credit Suisse being the latest) retrench from APAC lending, and domestic banks not equipped to manage the complexities of, for example, cross-border deals.
While LBO activity is increasing in developed APAC, most SMEs' financing needs are non-sponsored, and many of these enterprises are based in parts of the region that the non-VC PE industry has yet to impact, such as Southeast Asia and India. Such deals tend to be smaller than sponsored deals (think US$30 - 80m) and support various activities such as bridge financing, last mile financing, growth capital funding, etc.
Moreover, given the situational/opportunistic basis of many of these non-sponsored deals, the documentation is much tighter and comparable to bank lending relative to the standards seen in other regions. As the norm, debt maintenance covenants and operational controls are onerous for APAC non-sponsored SME direct lending. This promotes a lender-favorable risk environment compared to the more significant proportion of covenant-lite arrangements in the US and Europe. As we covered in our July newsletter, structuring deals via jurisdictions like Singapore should give borrowers comfort on creditor rights when investing in deals in emerging APAC economies.
Senior secured, first-lien direct lending deals in this space can offer gross IRRs of around 15%+ on an unleveraged basis, with most of the return coming from cash coupons and the return of principal.
Investment Return Components for a Senior Secured, First Lien Direct Loan
Mill Creek Capital Advisers’ Nora Pickens offers a succinct overview of the current US Private Credit landscape
Stay on top of private market industry trends with Preqin Global Reports
Sovereign investors are stepping into the breach as banks further retrench
“It is a great time to be in private credit.”
Highly Recommended: KKR’s Asia-Pacific Private Debt Primer
It’s fair to say KKR like Asian credit at the moment
Podcast: Odd Lots interview Ben Emons from Newedge Wealth
Actis redefine investment market taxonomies in an interesting way…
… and their 2024 outlook is worth a read too
Nikkei Asia initiates coverage of APAC Private Credit
BlackRock’s Private Credit Primer
Nuveen make the case for the US and Europe
Academic Gold Mine on Private Credit!
Podcast: S&P interview Rohit Sipahimalani, CIO at Temasek
If you have an article on Private Credit that you think is interesting, please send it to us at firstname.lastname@example.org
"I've got a feeling
This year's for me and you."
The Pogues, "Fairytale of New York"
"It is a great time to be in private credit."
(Briarcliffe Credit Partners, December 2023)
The growth of private credit continues unabated
2023 - in financial markets terms at least - was better than it might have been. Last January's newsletter shared the anxiety of many that something - somewhere - was going to break, given the prior year’s dramatic rise in borrowing costs and inflation rates and the amount of outstanding debt stock in the world.
The collapse of several US regional banks in spring offered a warning of a deleveraging, contractionary credit environment. However, by autumn, the market narrative had shifted towards growth, and surging long-dated rates, before the year end saw markets rally and bond yields fall on the prospect of US interest rate cuts as inflation continued to move towards target ahead of schedule. Despite geopolitical risk becoming even more pronounced and ugly through the return of conflict in the Middle East, consensus investor sentiment appeared hopeful that financial markets had managed to dodge the downside risks posed by the higher rates and higher inflation environment.
Throughout this rollercoaster year, global enthusiasm for private credit strengthened unabated. According to Pitchbook data shared by Mill Creek Capital Advisors, fundraising likely exceeded US$200 billion for the year, overtaking venture capital as the second most popular private market strategy. This was against a general backdrop of slower fundraising momentum in private markets. Throughout 2023, we digested bullish forecasts from market participants. Two examples (both based on Preqin data) are shown below:
Within the next decade, the $100 trillion institutional market is projected to increase its average portfolio allocation to private credit from 3.8% today to 5.9%. That, combined with the $178 trillion private wealth universe – in its early stages of allocating to alternatives – could bring total private credit AUM to more than $5 trillion, or nearly the size of the private equity asset class today.
We maintain a similarly bullish view on the growth of the global Private Credit asset class. The drivers are primarily structural: a continued contraction in the supply of bank credit (only further accelerated by 2023 US regional bank turmoil) and shifts in public capital markets, which increasingly only serve large borrowers.
On the investor side, we are aware that there is a growing trend around Private Credit being considered as a permanent, standalone asset class, either as part of a broader private market allocation or, as we covered here, within higher yielding credit portfolios. In the past, Private Credit would have been viewed more as an opportunistic allocation within a fixed income allocation or a private equity or broad "alternatives" bucket. According to Preqin's June 2023 Investor survey, the prospect of a reliable income stream, strong risk-adjusted returns, and diversification from other income-bearing assets at the whole portfolio level are cited as primary reasons for committing more capital to the asset class.
While these factors are common across all regions and a wide variety of Private Credit strategies, the global asset class is unevenly distributed, as the Preqin data shows. Direct lending accounts for around 46%, and North American direct lending accounts for 26%, of global Private Credit AUM. Although this mix shifts through time in line with the broad economic cycle (e.g. investor preferences will move towards distressed lending opportunities in an economic downturn), it is safe to assume that if Private Credit is to fulfil its AUM promise, most new capital will be deployed in direct lending and the US. These are the areas with the required scale to digest ever-greater flows.
These trends should be self-reinforcing, especially when considering the significance of top-tier private equity firms as financial sponsors in these markets. To partner with these firms, private credit managers need to be highly established and able to provide financing scale via, among other factors, larger fund sizes. This, in turn, leads to more standardised deal terms. The good news for LPs is that this forces fees down - the most prominent players' rate cards for US direct lending are fast approaching levels more associated with active fixed income mandates.
However, the greater scale also tends to moderate levels of alpha - for these larger scale funds, expected net IRRs are now in the high single digits. According to the latest Bellwether survey by Briarcliffe, a US-based placement agent that specialises in Private Credit, such returns are below the expectations of experienced Private Credit LPs:
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.
BlackRock expect global private debt AUM to reach $3.5 trillion by year-end 2028
Source: BlackRock, Preqin. Historical (actual) data from Preqin, as of each calendar year-end, through March 31, 2023. 2024E to 2028E are BlackRock estimates.
Source: Briarcliffe Bellwether, December 2023.
Source: Zerobridge Partners. Data is illustrative.
Deals also tend to be shorter in tenor than European or US equivalents, with principal returned within 18-36 months. These characteristics offer a portfolio component that can provide meaningful diversification on multiple planes and return enhancement. This also allows managers to redeploy the portfolio to different sectors or geographies as the macro environment changes.
Specifically, for portfolios invested in US and European private credit, APAC non-sponsored SME direct lending offers diversification through time through shorter tenors and through geography, which is enhanced through the post-COVID divergence of economic cycles in APAC and the West.
For portfolios already invested in APAC Private Credit through the big names doing large, sponsored deals, non-sponsored SME direct lending offers a potentially higher return plus diversification through company size, deal source, geography and tenor.
For portfolios invested in Asian high yield credit, for a sacrifice in liquidity, APAC non-sponsored SME direct lending offers a potentially higher return, further up the capital stack, plus diversification across industry and country.
The Top 5 Components of ICE BAML Asia High Yield Index (AHYI) vs Zerobridge Partners’ Advisory (ZPAD) Pipeline
Finally, as we discussed last year, diversification by vintage will continue to be essential for portfolios already invested in our asset class. The higher interest rate environment and ongoing pockets of distress in Chinese real estate will continue to be challenging to lenders who underwrote deals 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.
Closing thoughts: As the pie gets bigger, diversification will become more important
For LPs who need to maintain current return levels from their Private Credit allocations, we expect diversification will be a crucial next step in 2024 and beyond.
Investors seeking mid-teens IRRs have several alternatives. One is to move down the cap stack and find deals and managers offering riskier credits (second lien, mezz, hybrid, etc.). While this solves the return issue, subordinated deals offer little genuine diversification as they are usually just riskier slices of corporate credit risk.
Another alternative may be to allocate to specialty finance areas (such as litigation, and asset-backed) which offer defensive characteristics given their proximity to the assets (either financial or real) they are lending on. However, such strategies are often niche by virtue and, therefore, difficult for LPs to scale as Private Credit allocations grow.
APAC non-sponsored SME direct lending offers a similar return profile on a senior secured, first lien basis, with potentially broad industry diversification. However, such a commitment does require additional legwork for LPs, given the research time and additional travel required to understand the direct lending market in the region.
But this additional effort makes the most sense at present. During 2024, as well as the asynchronous cycle offering business and interest cycle diversification for global portfolios, a change in the direction of Fed policy should prove a tailwind for APAC through lower borrowing costs and a potentially weaker US dollar. Add to this the important structural reforms we see in India and the ongoing emergence of “Supply Chain Heroes” in Southeast Asia, and one can make a strong argument that the region offers Private Credit investors a compelling reason to step outside of their home markets.
Source: Preqin, September 2023.
Source: Briarcliffe Credit Partners, The Private Credit Compass: Charting the broad and bright horizon, May 2023.
Scale breeds scale… but does it generate alpha?
As we see elsewhere in financial services, scale breeds scale, and we expect the benefits of ever-larger flows will accrue to the most prominent established managers in Europe and the US. We expect this trend to only strengthen as the world’s largest LPs, particularly sovereign wealth funds, increase their allocations. Historically, we can see scale already at work - in both regions, the largest five managers have raised over a quarter of the capital over the last ten years. Average fund sizes have also risen by 1.5-2.0x over the same period.
Sources: Zerobridge, ICE BAML, KKR. GICS Sector, except for Consumer Discretionary and Real Estate, where GICS Sub-Industry is used. Any GICS Sector or Sub-Industry below 10% is aggregated in "Other" for ease of presentation. For ZPAD, Real Estate Development is part of the Real Estate GICS sector classification; Manufacturing is part of the Consumer Discretionary GICS sector classification; Professional Services is part of the Industrials GICS sector classification. For AHYI, Casinos and Gaming are part of the Consumer Discretionary GICS Sector classification and Real Estate Development is part of the Real Estate GICS Sector classification. "Other" includes 8% in certain other real estate sub-industries.
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