South East Asian Private Credit - Trends, Opportunities, Future Outlook and Investment Strategies in Distressed Situations and Beyond
By David Chew (Partner, DHC Capital)
Introduction
Private credit is in a boom phase. Media articles on private credit are being published daily and bigger and bigger new fund launches are becoming common place.
With a perfect storm of market volatility and record high interest rates, private credit has filled the gap left open by the banks to fund businesses that otherwise wouldn’t be able to receive loans from banks or tap the public markets.
In this article, we examine the key trends, investment opportunities and outlook of private credit in the region and the investment strategies in a down-market.
What is a private credit?
Private credit refers to privately negotiated loans between a non-bank lender and a borrower.
Private credit can be classed into 4 distinct sub-sets:
· Direct Lending: Sponsor backed; Corporate (typically mid-market companies); SMEs
· Mezzanine Debt: Junior debt that combines elements of both debt and equity with the expectation of higher returns than traditional senior debt holders
· Distressed and Special Situations: Rescue financing; Working capital financing; Bridge financing; NPLs; Event driven
· Specialty Finance: Equipment financing; AR financing; Real estate finance; Asset-based finance; Venture debt
Key trends in South East Asian private credit market
Current landscape
The private credit market in Asia is experiencing rapid growth. The market has doubled in size over the past 5 years [1] . The Asian market size is estimated at US$124 billion [2] . The size of the private credit market allocated to South East Asia by global GPs as at June 2022 is estimated at US$65 billion, up 52% from US$43 billion in 2020 [3] .
The private credit market remains relatively small in Asia compared to the loan and bond market, especially compared to US and Europe. It is estimated that 70%-80% of borrowing is funded by banks.
Drivers of growth
The growth in private credit has been primarily driven by regulatory changes. As banks have retreated, there has been a pullback in risk appetite, which has resulted in banks focusing on top tier investment grade credits and corporate / SME clients with clear cash flow and collateral visibility.
Growth has also been driven by in the increasing familiarity and awareness of the benefits of private credit by South East Asian corporates and SMEs. These benefits include: (i) speed and certainty of funding, (ii) flexibility on terms as an overall package - balancing pricing, leverage, amortisation, PIK interest and covenants and (iii) confidentiality.
Rise of specialist lenders
The growth in the industry has seen an increase in specialist lenders focusing on private credit. These include: (i) large alternative asset managers raising large / mega sized private credit dedicated funds (e.g. KKR, Ares, Blackstone); (ii) small and mid-sized private equity funds expanding into private credit (e.g. Navis, BPEA) and (iii) traditional financial institutions partnering with private credit funds (e.g. UOB Kay Hian / Tikehau, DBS / Muzinich).
Industry sentiment
The perception in the market is that private credit is complimentary with banks. Banks remain the primary source of funding for SMEs and corporates (e.g. as providers of overdraft, trade financing, FX line, SBLC).
Investment Opportunities in the South East Asian private credit market
Deal opportunities
The deal opportunities for corporate and SMEs include:
· Growth capital (fast growing companies with limited track record for working capital, business expansion or strategic acquisitions)
· Specific situations involving asset heavy cash constrained companies, bridge financing pre-sale, pre-IPO and share backed financing
· Pockets of opportunities in distressed and special situation deals
The deal opportunities in the sponsor market include buyout deals, uni-tranche and junior debt financing. These opportunities arise due to higher base interest rates (higher for longer thesis) and market need for providers of flexible capital (e.g. terms relating to lending to opco/holdco, senior/junior, PIK and PIYC structures).
Country specific
The country specific opportunities across South East Asia include:
· Singapore: Lots of liquidity for top quality credits. Pockets of opportunities in growth and asset rich situations
· Vietnam: Real estate developers in distress. Banks exposed resulting in higher provisions and reduced risk appetite
· Indonesia, Malaysia and Philippines: Event driven opportunities
Risk / return profile
South East Asia is a collection of different countries with different legal regimes across each country providing different levels of creditor protections and enforcement rights for onshore and offshore creditors (i.e. developed South East Asia and emerging South East Asia markets).
Emerging South East Asia markets such as Indonesia and Vietnam provide unique risks for private credit lenders. In Indonesia, there is still a risk of Fortress Indonesia approach and “bad behaviour” by debtor companies going through a restructuring process around (i) claims process and recognition of claims, (ii) phantom and friendly creditors and (iii) selective application of the rules.
Having strong relationship with sponsors and borrowers, effective structuring and strong credit underwriting is key to mitigate risks. We are starting to see Indonesian companies use offshore jurisdictions to restructure (e.g. Singapore schemes) amid a growing recognition of the need for a “final” solution.
Emerging sectors
We highlight below emerging sectors across South East Asia:
· Healthcare, education and schools: Consumer led
· Technology: Fast and hyper growth situations
· Energy transition: Moving away from fossil fuels
· Sponsor market: Following and backing GPs around the region on M&A deals in South East Asia
What does the future hold for South East Asian private credit? Future is bright – The best years are ahead
We highlight below 5 key factors supporting the growth of private credit in South East Asia.
Despite strong fundraising and ample dry powder, private credit is in its infancy and still relatively small compared to loans and PE market.
Demand for financing will increase driven by expected GDP growth in the fast-growing emerging markets in South East Asia.
There is a funding gap in the market as banks have retreated. Borrowers that are not well covered by banks or not able to tap public bond markets are looking for other sources of capital to meet funding needs.
Private credit offers flexibility in terms (e.g. covenants, tenors, size, type of collateral) and acts as a capital solution provider to fill the funding gaps in the market and support the varying needs of borrowers that banks are not easily able to lend to.
The opportunity for lenders and investors in private credit funds remains attractive. The funds are seizing the opportunity where the banks cannot provide a loan to a borrower with good credit standing in exchange for outsized returns relative to risk with good deal structures, terms and protections in place.
What does the future hold for South East Asian private credit? Future is cloudy – Is the golden age over?
We highlight below 9 key concerns and challenges facing private credit.
The macro-outlook is uncertain. Geo-political factors (elections, trade war, wars), uncertain interest rate environment (higher for longer) and recession fears are just a number of factors impacting the outlook for the global economy.
There are an increasing number of new fund launches. The banks are also fighting back by forming JVs to offer private credit to its clients. This dynamic creates increasing competition as the lender market expands and chases the same borrowers.
As competition for deals intensifies, there are risks that borrowers will be able to exploit the competitive landscape and negotiate looser deal documentation terms and use these provisions to raise new capital by creating new lending vehicles or reallocating collateral.
South East Asia is a collection of different markets and having localised infrastructure (e.g. local licenses, entities, teams on the ground) and good governance (e.g. monitoring framework, marking, reporting loan performance, portfolio diversification) is a significant competitive advantage.
Having established credit underwriting processes and staying true to these standards, whilst maintaining strong relationships with sponsors and borrowers is essential to picking the winners in South East Asia.
Moderate economic stress in the economic cycle could lower credit quality of borrowers with weaker profiles. Having strong credit monitoring process to identify the early warning signs will be imperative to avoid credit losses. These processes should include stress testing portfolio companies to identify potential weakness (liquidity, headroom over covenants).
Private credit funds may not have the credit risk and workout teams in house that typically one would expect to see in banks. This may present challenges when dealing with defaults and engaging borrowers in a restructuring discussion. Private credit funds should be considering - How prepared are they to lead negotiations with defaulted borrowers and senior banks on restructuring? How prepared to ask borrower to cut dividends, cut costs, sell assets and defer capex spend? Possible debt restructuring options that could be available include negotiating with the sponsor or major shareholder to inject fresh equity, amend and extend terms and use of PIK interest structures to preserve cash.
Private credit funds need to be ready to take appropriate action to recover funds in an event of a default scenario and should be considering - How prepared to enforce over collateral in South East Asian jurisdictions? How prepared to take the keys to the company?
Private credit loans are illiquid by design. They are closely held by a small number of private lenders to maintain confidentiality and for speed of execution. The lack of liquidity compared to public markets could lead to sharp losses if a quick exit required. This could create pressure at the fund level if the fund is using back-end leverage.
Investment strategies in a down-market environment – Opportunities in a distressed cycle
The type of opportunities that may arise in a distressed cycle include:
· Rescue financing: DIP loan – new money backed by super priority Court order
· Liquidity provider to distressed borrower: Working capital loan, bridge loans or debt refinancing
· Funding acquirers: Funding to PE or strategic buyers for control positions in distressed assets (either pre or post insolvency)
· NPLs – Secondary debt initiated: Loan to own strategies (acquiring debt at discount and converting to equity – fulcrum position); Credit bidding (acquiring property using debt to offset)
We believe that the winners will be able to deploy capital that is flexible and have ability to fund across the capital structure on a primary or secondary basis.
[1] Preqin, Private Debt Q1 2024, as at April 2024.
[2] Preqin, APAC Q1 Quarterly Update, as at April 2024.
[3] Preqin, MAS.