Asia Bi-Weekly: Controlling Your Fate (May 4-16)

Long ago and far away, a deeply cynical editor once told me that there was a simple trick to writing financial trend stories: If you wait three years, he said, you can recycle each one of your stories, because markets will have forgotten that you ever wrote them. (Whether this three-year period directly correlates to the short-term memory of financial markets, I have yet to discover.)

Sadly, the deeply cynical editor may have been, if not wholly, at least partly right. Taking direct lending as an example, over the roughly 10 years since I first wrote about the growth of the strategy in Asia, the topic has been regularly recycled.

Every couple of years, a fresh batch of data shows how much more dry powder is available for investment through direct lending, how many more funds have been raised for credit strategies and how much deal volumes have risen. Headlines dutifully emerge to tell us that the direct lending market is taking off in Asia.

The truth is that the direct lending market was well established in Asia and populated with funds long before I stumbled upon it. Equally, though, it’s true that the strategy has evolved, deal volumes have risen consistently over successive years, and funds and their dry powder have expanded.

A further truth is that Asia remains under-penetrated for private credit and direct lending strategies compared with North American and European markets, as panelists noted at the recent FTLive/Reorg conference on private credit held on May 4 and 5.

(Yes, I know, I’m recycling my trend story. But there are extraordinary circumstances. Bear with me.)

Private credit dry powder in Asia was estimated at $16.2 billion in 2019, up from $6.1 billion in 2009.

Also in 2019, the Asian Development Bank estimated there was a $4.1 trillion funding gap for SMEs in the Asia region.

These of course are pre-Covid-19 numbers. But the impact of the pandemic has increased demand for private capital leading to more new fund launches over the last 12 months.

Asia is of course a diverse set of countries, cultures, currencies and legal and financial jurisdictions, offering a wide array of opportunities and drivers for a credit driven strategy, both for performing and stress-related strategies.

The GFC and subsequent Basel 3, of course, has long created funding problems for SMEs in Asia, but bank caution has been exacerbated again in the wake of the Covid pandemic, due to uncertainty over the market environment. Against that backdrop, India’s current GDP growth – as one example cited at the recent conference – is fostering demand for private capital to finance performing credits.

Meanwhile, despite border closures, Australian real estate private capital deal-making, meanwhile, rebounded to reach $27.4 billion in value in 2021, up from a low of $15.8 billion in 2020 under the impact of Covid-19, according to recent Preqin data. While still below the $29.3 billion recorded in 2019, the figure is not far off pre-pandemic volumes of 2017 and 2018, when deal values of $27.6 billion and $20 billion, respectively, were recorded, as Preqin noted.

Australia’s private capital industry overall grew to $89.9 billion AUM, up 11% from $81.3 billion in December 2020 and 42% higher than $63.5 billion in December 2019, Preqin also reported.

Now, current macroeconomic and geo-political tailwinds and a pervasive risk-off sentiment in the region are generating further opportunities for private credit solutions, as normal sources of capital supply are shut off, both in regional and domestic markets.

Asia primary bond issuance has fallen off a cliff this year, and the region’s syndicated loan markets just posted their worst first quarter volumes since 2012 in the aftermath of the GFC.

High-yield bonds have been largely shut out of the market in Asia this year following the collapse of China’s real estate market. New Issue Concessions (NICs) have risen from the previous 0-5 basis points to as high as 20 basis points. Reoffer prices are well below par on many new issues.

The impact of China’s “Three Red Lines” policy and China Evergrande’s slide towards what could be a restructuring – or a dismantling – cannot be underestimated. Evergrande has over $300 billion in liabilities and accounts for 16% of China’s high-yield bond market.

But it’s not just Evergrande, of course.

On May 5, the day I moderated a panel at the FTLive/Reorg conference, the “Asia real estate outlook for private debt investors,” out of 391 China real estate developers’ high-yield bonds, more than half were priced at 30 or below, according to Refinitiv data.

The same regulatory crackdowns that have driven high-yield bond pricing on many real estate developers into the teens and the 20s – the “Three Red Lines” policy and the reining in of the shadow banking sector not least among them – have created an environment where capital providers or solutions providers can negotiate not just higher returns, but more importantly more downside protection through lower LTV ratios, greater collateral, additional guarantees and controls over cash flows and sources of repayment.

It’s important to draw a distinction here between offshore unsecured high-yield dollar bonds of Chinese real estate developers, and senior secured private loans onshore in China, funded in RMB.

While low dollar price entries on generally unsecured offshore dollar bonds may offer an attractive entry into a long-dated restructuring, the attraction of private credit right now – and the reason for a growth in China-focused credit funds of various strategies – is the ability to perfect onshore senior secured first lien real estate loans in RMB against real collateral, for those funds that have the personnel, connections and experience onshore.

The attraction of the strategy is that the loans themselves provide not only stable, high percentage returns in the high teens to 20% and above, but they offer downside protection – as panelists again noted, in an event of default, private credit investors who have perfected security can take enforcement action, leading to quicker recoveries.

That protection empowers investors, allowing them some control over their fate.

–Stephen Aldred, Managing Editor