Intelli-bytes Episode: Zeroing in on a New Bridge to Direct Lending in Asia-Pacific

In response to LPs’ requests for sharing our virtual research meetings, we bring you Intelli-bytes– video-recordings of our interactive dialogues with managers of interesting opportunities. Our live conversations with managers are not scripted but curated from a research perspective to help our sophisticated LP audiences learn about niche investment opportunities, strategies, relevant manager skills/experiences and personalities, just as they would if they were interviewing the managers themselves. These conversations are neither meant to be product pitches nor staged to allow a manager to give canned presentations that they could perhaps give on their own behind a camera or in podcasts behind the scenes.

Intelli-bytes brings you raw, uncut, recordings of just how it happened- with our uhms, ahs, laughs, gaffes, interjections, objections, disagreements, distractions, bloopers and more!

This is as real and personal as it could get for you without you having to attend yet another zoom call or webinar or scan a dense pitchbook or take a manager meeting.

So, whether you are at your desk, in your car, or on a treadmill or anywhere else, transport yourself into the scene, jot down (mental) takeaways (not notes!), make inferences, get a feel for the manager, but don’t draw conclusions just yet till you have vetted it yourself or engaged with us (directly or through our comprehensive due diligence reports) to complete your own due diligence!

We return with the latest episode of Intelli-bytes after a hiatus of a few months only because we were knee-deep helping LPs across the globe, complete their own due diligence leveraging our investment audits on some managers and opportunities that we had conducted previously. In the interim, we met and saw many new alternatives’ opportunities with varying levels of conviction. With heightened all-round uncertainty, we thought it better to bring you this time, a “wrap up meeting” of a full due diligence of a strategy/manager as opposed to a preliminary meeting of an idea pending a full investment audit.

Intelli-byteslatest conversation is with Rahul Kotwal, Founder and CIO of Zerobridge Partners Asset Management (ZPAM), an emerging HK based manager who spent most of his two-decadelong career on the ground in Asia as “Key Risk Taker” for UBS’s Special Situations Group, HK, primarily providing senior credit facilities and direct loans aggregating over $40 billion to big and small corporations across the Asia-Pacific.

Synopsis: Zeroing in on a New Bridge to Direct Lending in Asia-Pacific

While Asia’s economic potential needs no introduction, it can be forgotten in the growing din around escalating recessionary fears and everything else from a resurgence of inflation and interest rates after four decades, to rising geopolitical risks, to environmental and social concerns, to a lingering pandemic, to a nuclear threat, and more, which we would collectively label as the “new abnormal”.

Home to ~60% of the world’s population and ~40% of global small and medium enterprises (Source: Statista 2022), Asia-Pacific (APAC) enjoys natural economic tailwinds to offset any global headwinds. Intra-regional trade, manufacturing, tourism, natural resources mining and processing, consumer staples/discretionary, healthcare, education, financial services, and technology are a few key sectors that continue to enjoy secular domestic demand which sustains itself despite moderating economic influences from China or globally.

In ~12 investment-worthy countries (ASEAN 6 + China+ India+ South Korea +Japan+ Australia+ New Zealand) in the region, regulatory changes and policy reforms continually spur business activity across a broad spectrum of sectors including clean energy, digitalization, urbanization, sports and entertainment, etc.

Therefore, Asian SMEs, (many of which are family-controlled) operating one or more businesses across various sectors, constantly need credit for growth needs such as acquisition, expansion, capex, etc. However, banks in the region are constrained by regulation and their own risk tolerance to satisfy borrowers’ (often cross-border) credit needs beyond mainly working capital or trade finance.

The reluctance of banks to finance SMEs’ growth needs creates a structural demand for private debt or transition capital (in the absence of other financing alternatives to traditional banks). Direct lenders on the ground seek to capitalize on this secular demand for growth capital by charging a premium for borrowers’ urgency and complexity when customizing senior secured lending structures around borrowers’ pricing biases and their available collateral.

Attractive that the opportunity is, it also poses huge barriers to entry. Sourcing quality borrowers across culturally disparate locales within Asia (in contrast to relying on PE sponsors for deals as in the West), and understanding local insolvency laws, structuring and repatriation rules, are often difficult to overcome especially by US and Europe direct lenders who often arrive with a Western mindset.

Besides a limited inflow of overseas capital, private credit as an asset class has also not attracted a lot of attention thus far, from local Asian pensions and insurers who have historically preferred more liquid bond markets. Therefore, unlike a hangover of dry powder faced in US and Europe from large fund raisings, Asia direct lending is “less mature” affording rich premiums (low-mid-high teen returns based on how managers position themselves and execute) to the few (but growing) on-the-ground direct lenders who are able to leverage their prior knowledge and experience with local business practices and culture, their local networks and infrastructures and above all commitment to the region.

In a “new abnormal” the barriers to entry and need for a “relentless focus on underwriting” are even higher, warranting a more strategic approach to monetizing the opportunity!

In this regard, ZPAM is an emerging Asia-Pacific focused direct lending manager with a new playbook laced with caution for a “new abnormal”, that aims to provide senior secured loans primarily to sponsor less SME borrowers for growth opportunities, structured with collateral in offshore lending vehicles targeting 12-14% net (US dollar) unlevered IRRs.

Ironically, we find that global LPs are paring back their return expectations (below median ~9 IRR% delivered across 2009-2017 vintages Source: Pitchbook) even though base rates are rising due to concerns around tough competition for deals in US/Europe middle market lending and impending credit losses from loans underwritten with loose/light covenants. We also find that some are reallocating to junior/mezzanine debt i.e. taking additional credit risk in deteriorating economic and market conditions to generate higher returns.

We think, LPs need not necessarily pare back expectations or change tack because the primary appeal of a visible stream of senior secured contractual income from middle market companies in US and Europe, even though now clouded in the evolving economic environment, can continue to be realized at mid-teen IRRs by a more structural direct lending opportunity in Asia-Pacific.

ZPAM believes that its launch is timely to tap into APAC borrowers’ increasing growth needs in a tightening environment for capital that bodes well for better deal flow and return premiums. ZPAM also believes that with a “completely clean slate” and a new “conservative” playbook for a new investment paradigm, it is better positioned to meet the growing demand for credit from small Asian businesses when many of its peers in Asia and overseas are distracted with managing/restructuring legacy positions or gearing up to diversify into distressed debt opportunities.

In this wrap up due diligence call (toward completing our Confidential Investment Audit Report), investors will learn about the manager’s take on:

  • A new investment paradigm and a reason for being “cautious yet excited”
  • Local tailwinds driving Asia-Pacific’s middle market real economy businesses amidst a global economic slowdown
  • Structural demand-supply gap for credit in APAC widening in a new investment era
  • Managing execution risks by separating deal origination from underwriting
  • Focus areas for a conservative underwriting amidst rising costs and US dollar
  • Deal structures to “protect, grow, and gain priority access” to borrower cash flows and allow for multiple exit routes
  • Opportunity for a creditor (distinct from a quasi-equity investor) to charge liquidity and complexity premiums to generate 15-18% gross unlevered IRRs
  • Structures (especially in developing Asia) to avoid creditor/enforcement risks to protect principal as also in adverse geopolitical situations e.g. China-Taiwan
  • Importance of restructuring/work-out experience to resolve deteriorating credit situations

LPs are welcome to reach out to us at [email protected] with questions, comments, or requests for more information/Investment Audit Report on ZPAM or any other manager or alternatives strategy of interest.

GPs with compelling value propositions who wish to be featured in future episodes of Intelli-bytes and/or considered for a full investment audit, are also welcomed to reach out with a profile of their firm, strategy, and related fund.

Take a listen and stay tuned.

Yours truly,

Kamal Suppal, CFA

Chief Investment Auditor

September 26, 2022

The above content including the recording of the video-call is for information purposes only and should not be used as a basis to make investment decisions. This content is intended for sophisticated audiences as in institutional investors or family offices to help qualify an opportunity for further due diligence. Any theme or idea discussed above is not an offer to buy or sell any investment. All opinions expressed in the video-recording are the managers’ and not of Emerging Markets Alternatives.