Asia-Pacific Private Credit Newsletter
Portfolio construction is the process of understanding how different investments and their expected returns, risks and weightings impact each other. Speaking to LPs across the globe, we understand that every conversation is in part about this. We are evaluated based on our potential contribution to their current portfolio’s risk and return.
A classic model for understanding portfolio construction is Grinold and Kahn’s “Fundamental Law of Active Management” (the “FLOAM”). Written formulaically as:
Nobel Prize winner Harry Markowitz is claimed to have said that, “diversification is the only free lunch in investing”. However, with all due respect to Harry, he did not work in APAC private credit. While diversification is important, the appearance of breadth will not save us.
APAC has breadth, but there's no free lunch...
APAC is endowed with regional breadth. There is a wide range of economies, industries, and borrowers to select from. But APAC is a much more fragmented market than the US or Europe and the legal and regulatory landscape is stratified across the region.
APAC developed markets (“DM”) demonstrate a robust rule of law, effective institutions, good corporate governance, and debtor behaviours. Funds can make new loans without onshore banking licenses (except Taiwan), can negotiate interest, fees and other renumeration freely and can hold directly all security granted.
Next, there are the middle-income, high-growth jurisdictions - APAC emerging markets ("EM"). For the most part, these are less lender-friendly jurisdictions than DM APAC and corporate governance and debtor behaviour is mixed. There is also the potential for public sentiment against foreign creditors, as has been witnessed during past EM crises.
Last, there is a tail of APAC countries which would be considered "frontier" markets in development terms. These jurisdictions tend to be less developed from a political and legal perspective. We do not invest in these but monitor their development on the view that some will converge eventually to full "EM" status. A good example where we expect convergence is Vietnam which has witnessed rapid economic growth, supported by political and economic reforms and deep integration with the global economy.
CONSTRUCTING AN APAC PRIVATE CREDIT PORTFOLIO
Information Coefficient and Transfer Coefficient: Selection and Structure
APAC private credit portfolios are lumpy. In the case of Zerobridge Asia-Pacific Credit Opportunities Fund I (1), we are targeting USD350mm – this equates to around 12 separate deals (USD20mm-40mm each) when fully invested. A good manager in this asset class must work hard on deal selection, along with enhanced due diligence. Even in a broad region like APAC, the manager will have a very limited number of positions so these need to be the right ones. In other words, the IC needs to be very high.
But the final element is the ability to implement these deals and exit them efficiently (the “TC”). Effective structuring really brings regional breadth and good deal selection together because it allows private credit managers to take risks and capture returns that could not be accessed otherwise.
Portfolio construction for us is a balancing act between DM and EM jurisdictions. Generally, in DM APAC, minimal structuring is required to mitigate legal/security risks. However, outside Australia, these markets typically offer less compelling deals and IRRs are potentially lower than in EM APAC. We would leave a lot of money on the table if we only invested in DM.
In EM, returns are potentially higher, but many have restrictions or regulatory requirements on how offshore lenders can invest in the country. For example, repatriation of proceeds from recovery may require regulatory approval. Significant structuring is required, and deals may require additional offshore collateral, especially in some jurisdictions.
Structuring seeks to equalise the risk between DM and EM deals in the portfolio by improving the likelihood of recovery in an enforcement scenario. Multiple exit routes must be identified and established for every deal.
Finally, we have a strategic focus on cross-border transactions, as we expect APAC countries to further increase trade between themselves and other regions. This trade dynamic is where DM and EM meet so again structuring will be important.
Cross-border deals provide less competition and diverse cash flows, as well as collateral pools, for investors. By facilitating better structured deals of this kind, we hope to be able to offer our LPs a differentiated strategy which in turn improves their own portfolio construction via improved insight, diversification and structuring.
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In this Newsletter we focus on key aspects to consider when constructing an APAC private credit portfolio:
Stratified Legal and Regulatory Landscape
Knowledge on the region is key to deliver results
Insurance companies looking for rules easing and higher yields
Strengthened lender protection for assets in Mainland China
Higher returns are not a free lunch
The danger of a looser documentation and the capital structure...
Strong market appetite towards private credit
Looking beyond home markets to boost returns
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.
The FLOAM expresses the risk-adjusted value added by a portfolio manager (information ratio, or “IR”) as a function of forecasting skill (information coefficient, “IC”), the number of markets to which it can be applied (breadth, “BR”), and the ability to implement views (transfer coefficient, “TC“).
A key takeaway is that breadth (i.e. diversification) is a manager’s friend. If two managers have the same investment skills but one follows an investment strategy that relies on a higher level of breadth compared to the second, the first is more likely to outperform. The FLOAM is associated usually with public market strategies but is also a useful anchor to illustrate the issues we must think about when investing a portfolio of APAC private credit. The IC is about deal selection and due diligence. The TC is about using structuring to balance portfolio risks. Breadth is… breadth.