Asia-Pacific Private Credit Newsletter
Environmental, social and governance (“ESG”) may define this decade in the investment industry as much as monetarism or quantitative easing has previous eras.
But definitions are still fluid across multiple asset classes. In this Newsletter we want to examine the merits of top-down and bottom-up approaches to integrating ESG at the total portfolio level and the implications that these perspectives have for private debt financing in Asia-Pacific.
Spotlight on India
India is one of just 18 emerging economies that achieved robust and consistent high growth over the past three decades (Source: McKinsey Global Institute, or “MGI”). Real GDP growth has averaged 6.8% annually since 1992, with nominal per capita GDP rising 18-fold and real per capita GDP by a multiple of 3.6x (Source: World Bank).
Diversity becoming a key aspect
The critical role of RDB in the COVID-19 crisis and the need for credit in EM
Climate change is at a crucial stage according to Bill Gates
Sustainability and private markets converging
India becoming a private credit hot spot…
Big money moves
We share the view that, over the longer term, asset prices will come to reflect the realities of a lower carbon path. However, we worry about the implications of investors taking a purely top-down approach to ESG factors.
CMAs are the key input in the formulation of strategic asset allocations (SAAs) which determine large capital flows. While it is possible to allocate capital by prioritising industry sectors over regions, it is impossible to neutralise the regional impact of doing so - hence reduced CMAs for EM debt.
The implications of adhering solely to a top-down perspective are huge for the Asia-Pacific region – especially for developing markets and for the SMEs that comprise 95% of the region’s economic activity.
On an asset class level, equity is widely understood as an ownership stake which confers more governance control than debt holdings.
This perspective does not necessarily reflect the true nature of the asset class and how deals are structured. A typical deal in our pipeline will enjoy multiple control mechanisms: from first lien and floating charges over all borrower’s assets; share pledges; right up to board seats. The extent of lender influence is stronger compared to what is seen in private debt in other regions, other forms of public and private debt securities, arguably even publicly traded equity in the case of most shareholders. Not only does this help us in our fiduciary goal of getting our clients’ money back but it also has positive implications for influencing Asian SMEs’ adherence to ESG factors.
Given that the SAA is the correct starting point for most investors, the integration of ESG factors is an important step forward. At the same time, investors must recognise that, while complex multi-asset portfolios normally start with a top-down perspective, the reality of the construction process normally reflects a more blended approach. The evolution of integrating ESG factors is no different and is supported by leading ESG policy organisations’ guidance on the integration of ESG across multiple asset classes.
Global Insurers looking at private credit for return, diversification and downside protection…
Pensions can benefit from APAC private credit…
Investors allocating to Asia…
Relevant role in EM after the crisis
The horns of a dilemma
An Asia economist friend of ours recently highlighted the example of Indonesian palm oil companies. These are "easy to ignore on claims of virtue since they are only but a tiny part of the investible universe and the tracked indexes…[while] further afield we have electronic vehicle producers noisily advertising their vegan interiors while punting in crypto currencies that consume more energy than a medium-sized country".
What about palm oil companies that can convert the pollutants into biofuel feedstock? We would argue that denying capital to these projects only prevents industry innovation and the opportunity to contribute to renewable energy targets. As the most widely used vegetable oil in the world, outright denial of additional capital to producers will not eradicate the pollution problems that emanate from the industry. Quite the opposite. The companies will be incentivised to cut corners and likely pollute more. Bottom-up capital allocation can advance ESG outcomes where a top-down approach may merely avoid.
The top-down view: When ethics meet econometrics
Asset managers have begun to incorporate ESG into long-term capital market assumptions (CMAs). One leading firm assumes that the transition of the global economy to a lower carbon path consistent with Paris Agreement goals should result in a superior long-term growth outlook. Taking that path will result in an upside boost; not taking that path will result in, “a cumulative loss in global output of nearly 25% in the next two decades”, the manager estimates.
The manager argues that these potential growth paths will drive return dispersion at the sectoral level - with technology and healthcare the likely beneficiaries and energy and utilities lagging. Translating these views into CMAs creates a stronger preference for developed market (DM) equities, at the expense of high yield and emerging market (EM) debt.
INTEGRATING ASIAN PRIVATE DEBT INTO MULTI-ASSET ESG PORTFOLIOS
A top-down allocation away from Asian SMEs could create unintended systematic social risks. As we discussed in our December 2020 newsletter, the absence of adequate debt financing to Asian SMEs resulted in a USD4.1 trillion funding gap even before COVID. Now, as international banks retrench further, this presents a genuine recovery risk to the economy in Asia-Pacific. Unless lenders can step in and reduce the gap, we believe there is a real risk of structural unemployment in communities across the region. This risk is measurable and, by definition, systematic. It could also be captured in a set of CMAs.
Unlike public asset classes, private investments are deal-driven, lumpy, and nearly impossible to replicate systematically. ESG analysis therefore needs to be done on a bottom-up basis, deal-by-deal.
A manager like Zerobridge, screening a set of Asian SMEs, will find some very interesting renewable deals. Equally, there are some industries that we will flatly avoid, such as thermal coal. But there are many areas of nuance in this investment universe, and this leads Asian private debt managers into some interesting ESG dilemmas.
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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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In this Newsletter we focus on key trends that are impacting the Asia-Pacific private credit market:
Source: Spotlight on Responsible Investment in Private Debt (Principles for Responsible Investment)
Source: Global Use of SASB Standards (SASB)
Matching Responsible Investment Implementation with Private Debt
Asia-Pacific Still Catching Up: SASB Reporting by Region
Like risk management, investors’ approaches to ESG will be enriched by taking multiple perspectives. Ideally, asset allocation professionals should retain the strategic agility to consider asset classes that may be excluded or overlooked once the optimisation (or similar) analysis is concluded. Private debt managers should continue to commit to improving higher standards of transparency on their portfolio investments, including sharing material insights with the LPs and other ESG stakeholders. This is one of many ESG commitments Zerobridge Partners make. If you would like to discuss this topic further with us, please get in touch.
At USD2.9tn GDP, India is now the sixth-largest economy globally and is expected to be in the top three economies over the next decade with expected future annual growth rates of 6-7% .
To finance this growth, India continues to seek foreign capital - MGI estimates the total requirement at around USD2.4 trillion in 2030, with SMEs alone needing access to more than USD800 billion. Much of that capital needs to come in the form of credit – in 2019 India’s domestic credit to private sector as a percentage of GDP ratio was at 50%, whereas in Australia, and UK this ratio was around 135%, China was 165% and the US, over 190% (World Bank).
Significant opportunities exist in private and structured credit, distressed assets and public credit with many global investors accelerating their shift into the market – a Global SWF report from January 2021 estimates that investment from sovereign wealth funds and pension funds totalled USD15.8bn into Indian private assets in 2020, triple the amount directed at China during the same period.
They have perhaps been encouraged by regulatory developments in India to encourage foreign investors and create efficient structures for them. For credit investors particularly, the introduction of the Insolvency and Bankruptcy Code in 2016 enhanced creditor rights and reduced resolution time while at the same time almost doubling recovery rates. Perhaps more importantly, it has created a step change in credit culture as noted family-backed groups lost control of certain companies due to defaults on their loans.
With underdeveloped credit capital markets, especially for SME credit after the decline in the Non-Banking Financial Company business model, bank lending constrained due to NPA ratios of c10% and strict rules on use of proceeds for loans, foreign private credit investors can participate in this growth story and earn superior risk-adjusted returns across a range of credit strategies.
As always, the key to successfully deploying and realising private market investments in an emerging economy is having the right partner. Sourcing, structuring, and managing these assets is complex and requires local knowhow and experience – this is especially in the case of private and structured credit where platforms that can execute is limited and the talent pool is shallow.