Long COVID?

Asia-Pacific Private Credit Newsletter

July 2021

Global Recovery Continues

The global economy continued to rebound in the first half of 2021, with the IMF projecting 6% global growth, based on extraordinary policy measures and an anticipated vaccine-powered recovery in the second half of the year.

The pandemic continues to create uncertainty but the accelerating pace of COVID-19 vaccinations in US and the UK supports global growth expectations. The US in particular appears to be roaring back, supported by a record high household savings rate, pent-up demand and a US$1.9 fiscal stimulus package. Year on year to June, the unemployment rate has dropped from 11.1% to 5.9%.

The corollary of this rebound is the increased risk of higher inflationary pressures and interest rates. While the Fed has indicated that it does not have any short-term plans to tighten policy, investors are watching for indications that stimulus will begin to be reduced, beginning with a tapering of bond purchases. The latest inflation data in the US and UK accelerated unexpectedly, challenging policymakers' view that inflation will be "transitory".

It is also worth bearing in mind that the pandemic is ever-evolving, with the “delta variant” appearing resilient to current vaccines. It is still too early for the world to call victory against COVID.

APAC still locking down

Despite the positive global momentum, the sustainability of recovery in Asia-Pacific is hampered by slow vaccination rollouts and intermittent lockdowns are still a feature of the region. Activity for the region is about 4% below trend levels and consumer demand is subdued, even in China, where retail sales are barely back above 2019 levels.

Equally, as global economies open up, we expect to see a shift in consumption patterns towards services/away from goods which may reduce the currently strong APAC export growth story.

Regional credit conditions remain exposed to environmental and geopolitical risks. As we discussed in our March newsletter, global investors' ever-increasing focus on environmental, social and governance risks poses threats as well as opportunities to businesses in emerging Asia. The escalating strategic rivalry between China and the US is also likely to create further financial, regulatory and trade risks within the APAC region and between the region and economies elsewhere.

A more divergent outlook for private credit

Demand for private credit remains high from borrowers and lenders globally. US companies in industries impacted by the pandemic will likely require more financing solutions as forbearance ends while European companies with COVID related liquidity needs may be hit by banks' increasingly stringent credit standards as NPLs rise. In APAC, we continue to see the slow, secular retrenchment of bank lending to SMEs and expect divergence in the need for capital similar to other regions.

This demand for financing solutions is set against a background of lower debt recoveries and weaker credit structures. Moody's expect US companies that default in the current downturn will likely return less to investors than those that defaulted during the GFC. Cov-lite first-lien only structures soared since last recession, and first-lien cov-lite debt cushions fell. While APAC private credit risk has so far appeared in line with that of the US and Europe, we would continue to note that the deals tend to have tighter documentation, better covenants and lower financial leverage levels.

ASEAN economies are exposed to tourism revenues and, while developed APAC economies continue to restrict the outward movement of their citizens and/or demand extended quarantines on their return, the sector is likely to remain moribund.

REGIONAL DIVERGENCES AND THE RISKS OF "LONG COVID"

Fresh capital is required by both borrowers and lenders. US middle market companies face a maturity wall as debt matures in the next few years while private credit distributions peaked in 2013 globally and are now rising again.

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In this Newsletter we focus on how a "Long Covid" scenario could be impacting the APAC private credit markets:

1. Thematic focus - Regional divergences and the risks of "Long COVID"

2. News centre - Links to several articles and white papers we found interesting

Tourist Receipts as a % of GDP

Anchor 1

Anchor 2

ZEROBRIDGE PARTNERS

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.

Data from S&P suggests credit quality is stabilising, with the net outlook bias of APAC issuers continuing to improve. Downside risk persists due to slow vaccination rates and a resurgence of infections leading to fresh rounds of restrictive measures. This drags on revenue recovery and impedes the unwinding of amplified debt, particularly for segments most exposed to the pandemic (e.g. tourism, gaming and retail).

Cov-Lite and First Lien Debt Cushions Fell

Private Debt: Annual Capital Called up, Distributed, and Net Cash Flow, 2000 - Q2 2020

These conditions present a strong case for allocating additional capital to APAC private credit, especially considering the potential for gross IRRs of 15%+ versus 7-10% for the US and Europe for an unlevered portfolio (see here).

APAC private credit investment strategy in an age of divergence

As we start the second half of 2021, the environment for APAC private credit is one of clear capital demand from borrowers. This is driven by structural retrenchment from banks and from the as yet uneven and divergent nature of the recovery from the pandemic.

Many sectors are seeking capital to maintain operations before they can operate normally again (think discretionary leisure, gaming, tourism and travel). It is important to consider the cost disciplines of such businesses - while the short-term outlook may be negative, lean and well-disciplined businesses in these sectors also have the potential for strong upside through operational leverage in the medium term and deals can be structured accordingly.

We also see some opportunistic deals, where companies are seeking to expand and take advantage of a favourable input cost environment - for example, restaurants, retail and services businesses in certain parts of the region are still able to operate at reasonable capacity levels while seeing rents fall.

The final divergence factor we identify is between industries and companies endowed with productive real and fixed assets that can be pledged against borrowings versus asset-light businesses seeking to borrow on projected cash flow. Given the uneven nature of this recovery the former model will be much more attractive to private lenders, outside of the stressed and distressed space.

The keys to success in this environment will be to maintain a disciplined underwriting to assess risk, aligned with careful structuring and strong covenants. While this should always be the case, the current outlook means these factors will be doubly important in coming quarters.

Net Outlook Bias of APAC Issuers by Sector, May 2020 vs. May 2021

Vaccination Rates by Region