If only a deal could be struck with China to make this world a better place. But alas, it remains a far-fetched dream. Till it materializes (IF, at all) our investing world is likely to remain a living hell with all round uncertainty stalling business decisions from capex to hiring and everything in between. And then the rest could follow- productivity loss, unpredictable earnings/consumer confidence/spending (demand), etc. Little wonder, the specter of the R-word is on top of most minds triggering a flight to safety in government bonds thereby plumbing yields to everyday lows down into negative territory. Politics does not just stop at US-China trade wars, but this time around it has also morphed into other ugly forms e.g. tech and currency wars, no-deal Brexit, South Korea- Japan spat, threat of Peronist policies in Argentina, democracy protests in Hong Kong, etc. striking all at once even before we have resolved aging trade tensions. The combined forces threaten to distort economies, businesses and capital markets, keeping investors on tenterhooks. We can probably dispense with the need for a gory recount of human tragedies and market shocks witnessed this summer for probably no one has been spared the red-ink spilled in tabloids, op-eds, blogs, tweets or whatever is one’s source of news feed. Bottom-line: the world has become a scary place and investing is no longer for the faint of heart!
With scars from the collapse of the global economy’s circulatory system about a decade ago, still fresh in our minds, we all are quite aware how financial decisions get impaired when banking channels and capital markets freeze. While we are not there yet, concerns are mounting, and we are hoping against hope that the worst is averted, or we escape it with little suffering. Fearful, investors of all stripes are hunkering down pivoting to cash, government/corporate bonds at abysmally low/negative yields, defensive stocks, gold and other proxies of fear. Others, with a greater appetite for illiquidity and to avoid market volatility, are piling into GIANT private equity funds (e.g. Blackstone, Vista, Advent, etc.) in DM, who are transacting at insane valuations (11x EBITDA) with crazy leverage (7x EBITDA). Capitalizing on LP penchant for PE, Blackrock’s “perpetual capital” vehicle, Long Term Private Capital probably will keep investors waiting for returns into eternity. Those investing in venture capital are counting on a robust IPO market to continue, for deal-making by Big Tech (Alphabet, Amazon, Apple, etc.) remains suspect now that they are subjects of strict scrutiny by regulators (e.g. Federal Trade Commission, Justice Department/Antitrust) and States for data privacy and anti-competitive behavior. Direct-lending, the investing world’s nirvana since the financial crisis, is now a battleground for crowded deals (amid poor origination) prone to compromised underwriting/covenants. Public market investors, therefore risk losing the power of compounding (while still exposed to volatility) in the current climate, and private market investors are in many instances on borrowed time before deals sour.
Professional investors/market pundits and their followers are perplexed by the turn of events driven by unprecedented politics desperately trying to infer strategy prescriptions from the past. Some prognosticate new fiscal stimulus in DM (e.g. Germany) and/or continued benevolence of the Fed and other central banks to maintain easy monetary policies to prime the economy or prop up risk assets into the future even if economic conditions remained sluggish. However, many investors now candidly also admit, that forecasting markets has become a fool’s errand! So, unless one has super powers to divine markets, rational responses to today’s ensuing investing climate are getting fewer by the day. Lacking divining powers, our humble but keen observations, lead us to reinforce our convictions in a few key areas.
For starters, the growth story in emerging markets, sold on practically everyone, remains intact even in an overall slowing world. Vast consuming populations (including Millennials, a distinctive market force), urbanization, healthcare needs, education, etc. are fundamental growth drivers for EM that most can easily relate to. Adding to the mix is new optimism, (one of the unintended consequences of trade wars), in reorganization of supply chains from China to other South East Asian countries like Vietnam, Indonesia, etc. providing newer opportunities to smaller economies. Though counter-intuitive, domestic Chinese suppliers to technology companies are also gaining market share due to import substitution to avoid potential supply disruption in the wake of an export embargo from US. Hence, smaller EM companies driven more by local factors and less influenced by global macro factors become attractive stock picks.
However, as we all know volatility is par for the course in emerging markets and jumping in “long only” small cap with both feet to partake in the growth upside is almost suicidal. High frequency traders dominate the volatility landscape and can rattle even domestic names. Hence, it is imperative that public market investors adopt a low to variable market (net) exposure to manage downside volatility. Considering liquidity concerns in EM, a lower gross exposure (longs plus shorts) is also prudent. As discussed previously in our blog, Not Coming Up Short in EM, there are just as many stocks that are likely to be victims of a business slowdown or have pure shaky fundamentals or questionable governance practices to begin with, as promising ideas, that make good alpha shorts, thus expanding the opportunity set. Lastly, long thematic bets on small caps also might be at risk of local capital markets and banking conditions that can threaten both consumer and business spending, as is currently being debated in India. Also, long country bets on say, Mitsotakis’ Greece today (up 35% YTD Source: Bloomberg) and can always turn out like flailing confidence in Macri in Argentina or AMLO in Mexico.
The potential in corporate bond-land is similar given the credit binge by EM corporates led by Asian corporates including Chinese property developers over the last decade. Wider spreads to US equivalents, shorter durations and mostly investment-grade quality, make EM hard and local currency corporates an interesting area, especially when overall yields are falling. Up to three years of locked capital can also afford those credit specialists with trading capabilities to buy dislocated but performing credit (baby thrown out with the bath water situations) for 20-25% discount to par thus providing an instant yield pick-up with potential for the credit to reprice. With reduced dealer-inventories, market liquidity suffers in market sell-offs affording those with capital buffers to profit from widening spreads.
Stretching across the liquidity spectrum, our conviction has grown only stronger around yielding strategies in EM, in the current climate. We have written copiously in the past on EM private credit (see: The “Private” in Private Debt and EM: Real Solutions in Real Economy for Real Money) and reiterate that private credit in emerging markets remains one of the few real deals in a world of no-deals! Our conviction finds root in the fundamental fact that providing timely liquidity to small and medium borrowers strapped for funds from traditional channels, commands a premium. Moreover, transaction pricing/investment returns are secured by offshore/onshore collateral and governed by contractual agreements, that if drafted prudently, account/provide for potential business conditions, credit risks, jurisdictional risks and currency fluctuations, and remain well-insulated from market outcomes. In other words, there is greater tangibility and visibility for return of and on principal. In a low return environment devoid of cash yields, EM private credit stands out as a real deal, especially when DM direct-lending is suffering from a glut of capital faced with deal origination challenges driving down net returns to mid-single digits. For context, as of July end there were over 200 direct lending funds, mostly from North America and Europe, seeking ~$100 billion in capital when dry powder (uncalled commitments) has risen to ~$100 billion, and 5year horizon IRRs (to Sept 2018) have plateaued at ~4% (Source: Preqin).
While private credit in DM is mostly (~50% per Preqin) direct lending, EM affords a broad array of sub strategies across the private credit-risk spectrum. Small and medium enterprises abound in EM from Asia to Africa, each pursuing local opportunities. Be it expansion capital to commission a new project, acquire mining concessions, expand markets or market share or acquire a downstream or upstream player, capital from traditional banking channels gets even scarcer when banks get even more conservative with weakening business conditions. Alternative credit providers who can finance urgently against a package of varied collateral-both onshore and offshore (that banks are loath to lend against) can command a premium in the form of 8-10% coupons, redemption premiums, make whole provisions, upfront fees, etc. coupled with equity kickers like warrants, royalties, share of marketing fees, etc. aggregating to net mid to high teen IRRs. As business conditions worsen, stressed borrowers could offer even bigger risk premiums for rescue financing to bail them out of situations. Those structured creditors with longer term capital and good restructuring capabilities can even extend into distress situations to earn a further premium just as they could by buying pools of non-performing loans off banks. We would however, caution that local bankruptcy laws, often evolving in nature (e.g. Insolvency and Bankruptcy Code in India) need to be understood and applied pragmatically. To add to our skepticism, recent political unrest in Hong Kong, well-regarded for its adherence to Common Law and offering strong jurisdictional protection to creditors, is now under threat to lose its status to China’s Civil Law practices and State intervention. All said, investors who remain predisposed to private credit and plan to allocate more to the space should probably re-orient their thinking and pivot from DM to EM, on the back of more thorough due diligence that EM warrants. Finding multiple such “real deals” in EM even though small, is probably worth the effort than complacently allocating to one large DM or EM private manager expected to unravel local nuances and get into niches.
Besides corporate credit, private infrastructure debt is also interesting given the huge (core and digital) infrastructure needs in emerging markets. Though headline-grabbing woes of Chinese property developers cast a cloud over real estate lending, the regulatory changes across EM makes lending to the real estate sector attractive. For instance, The Real Estate (Regulation and Development) Act, 2016 (RERA) passed by the Indian Parliament seeks to protect the interests of home buyers and boost investments in the real estate sector as also evidenced by a growing REIT industry, highlighted previously in our post EM: Elect-Shuns!
On the other end of the risk-reward spectrum, the speed of innovation across EM is mind-boggling driven by visionary entrepreneurs across South East Asia, India, LATAM. Spurring a digital revolution across consumer marketplaces, fintech, edutech, health care, is smart phone penetration. Enterprise software in IoT, cloud services, cyber security, AI, AR/VR, etc. are equally compelling areas of investments for local venture capitalists. Influx of corporate VCs, large venture capitalists (Softbank, Tiger Global, etc.) and bigger players along the food chain create exit routes. Those less-willing to take equity risk, can participate in a smaller capacity through venture debt that is fast gaining ground in EM and expanding the scope of private debt.
Whether it is long/short small caps, private credit of any type or venture capital in EM, manager selection is key just as one would advocate security selection in public markets. A blind embrace of any strategy especially in EM where DM definitions are misleading, is a recipe for disaster. Each manager needs to be examined for the specific opportunities that he/she wishes to pursue. Execution capabilities and running sustainable and viable operations are equally important as are sound fund management practices. All of these are subjects of intensive due diligence that cannot be considered complete by just reviewing manager pitch books or standardized DDQs or walking through a manager’s electronic data room remotely. Since many of the EM opportunities are very local in nature from origination to execution to completion, local nuances need to be fully understood to recognize what’s the real deal i.e. key success and risk factors.
In this regard, ÊMA continues to offer independent investment audit/due diligence (a 360-degree examination of investment strategy, execution, business operations and fund management) on various such EM private equity/credit/venture capital managers who can deftly and timely strike deals with various counterparties to the benefit of LPs’ portfolios. Stay tuned.
Kamal Suppal, CFA
Chief Investment Auditor
August 20, 2019
The above content is intended for sophisticated audiences as in institutional investors or accredited investors. Readers are advised that any theme or idea discussed above is not an offer to buy or sell any investment.