The “Private” in Private Debt

There is probably nothing private about private debt anymore for it has widely staked its claim as a legitimate and effective asset class in institutional portfolios. As the recent Alternative Credit Council of AIMA study points out, private debt/credit has enjoyed an explosive growth of 20% CAGR over the past 10 years so much so that it is today a $600 billion plus asset class and growing. However, what investors’ “chase for yield” has fueled, probably should give investors some pause. The torrid flow of capital into private debt funds especially in US and Europe, is now finding fewer opportunities to deploy with sourcing of new opportunities admittedly becoming a big challenge. With competition heating up managers are beginning to “covenant-lite” loans (like their leveraged loan cousins) with lower pricing and lengthening tenors thus shifting the balance of power from lenders to borrowers. This is a problem particularly in middle-market lending ($25-75 million EBITDA) which is the backbone of private debt especially in developed markets. In order to maintain their economics, smaller firms are probably more nimble stretching into the lower-middle market like their bigger brethren who are polarizing to the top end, writing bigger checks.

However, this need not be the case if investors were to pivot to the still “private” i.e. less advertised parts of the private debt markets. Investors could diversify away from middle market lending in developed markets into developing markets and further diversify by borrower needs, financing structures/instruments and other areas experiencing shortage of traditional capital. As the above cited study points out, Asia Pacific accounts for less than 10% of this growing asset class today. This suggests Asia still carries untapped potential for private debt and as discussed below, is positioned to offer new and diversified opportunities with greater visibility, stability of cash flows and in some instances even attractive risk premiums (unlevered).

Asian small and medium enterprises (SMEs) outnumber other regions globally (per IFC) often seek not just flexible and urgent growth capital but also discreet capital (especially if borrower is a reputed family) to pursue strategic initiatives like an acquisition or fending off a takeover threat. This could often be against collateral located offshore that might further place it outside the comfort zone of traditional lenders. This opens up another avenue for premium pricing. Also, Asian borrowers are not a homogenous group, but with attitudes toward paying coupons and equity dilution varying from Indonesia to India to China and across, thus affording different pricing structures.  Creative corporate finance experts (probably a different mind-set from pure lenders where again competition is growing) can vary financing structures from straight fixed-coupon debt, to deferred coupons/PIK to debt plus warrant structures. While the mentality of being “senior-secured” rules across developed markets, it takes creative negotiation and structuring to gain seniority by first and foremost creating alignment of interests with borrowers and attaching collateral most valuable to the borrower. The pricing and by extension premiums also vary by a borrower’s needs which could range from typical growth needs, to acquiring a competitor, to bridging an IPO, to financing a promoter’s stake in a rights issue. Of special note, is a current need of Chinese acquirers looking for offshore financing to buy “approved” (e.g. tech/biotech, value chain integration etc.) assets overseas when onshore financing has become restricted in the face of stricter capital controls. A big and valid investor concern is creditor rights and bankruptcy laws which an experienced manager is well-versed to navigate (by re-locating collateral and enforceability in stronger legal jurisdictions or creating robust onshore lending platforms) provided its skilled investment team is well-complemented by an equally strong legal bench (in-house and external counsel).

Outside of Asian SME lending there are other attractive options without compromising credit quality be it from an Asian or developed world standpoint. If one were to pare back one’s credit risk and accept lower current income but driven by more predictable and visible cash flows (which would still be deemed “higher yield” in today’s environment of 4-5% high yield from all kinds of traditional assets) there are other “private” opportunities awaiting investors. Longer than the boom in private debt has been the story of the “rise of the middle class in emerging markets” that portends a massive wave of consumerism. What it brings along is a new and growing trend of consumer credit in various forms e.g. residential mortgages, auto loans, credit cards, personal loans etc. Arising from cultural values that have long espoused cash on delivery over levered assets, household credit to GDP has a long way to grow in most of Asia (except perhaps Korea) before borrowing behavior deteriorates resulting in concerning levels of delinquencies and charge-offs (as presently afflicting US credit cards, auto and student loans). Enter western world securitization techniques (more conventional than recently witnessed whole-business securitizations e.g. Domino’s Pizza) to overcome Basel III restrictions on bank lending to consumer finance companies, and voila, there’s a whole new pool of asset-backed securitization born offering high single to low double-digit (unlevered) dollar returns. Yes, though present-day practices of analyzing mobile payment behavior by the likes of AliPay (Sesame Credit) and WePay attempt to overcome the absence of consumer credit bureaus (like a FICO), it still would probably lure only a few first-movers who have adapted developed world traditional credit analysis of loan pools to local markets.

As with SME lending and securitization of consumer credit, Basel III also restricts lending for providing working capital to sellers of goods to finance the flow of goods through global supply chains. Moreover, the larger commercial banks have concentrated their trade finance activities in select clientele, geographies and products. This leaves trade finance needs of a broad cross-section of the market, unmet. This is quite acute in Asia which according to the Asian Development Bank accounts for almost a quarter of global trade finance needs. Sellers often are impacted by the lag in payment from buyers and concurrent obligations to their suppliers creating an opportunity for private lenders (especially in Asia) to provide short duration collateralized and secured (by insurance) loans. Also, the space is rapidly evolving creating opportunities for value-added (higher margins) trade finance solutions e.g. cross-border working capital, capital for logistical and supply chain improvements, structured financing etc. to existing relationships for dollarized high single/low double digit (unlevered) current yields. Not to undermine the inherent risks, trade history often serves to get a good handle on credit default risk which is further mitigated by pursuing enforceability in stronger legal jurisdictions.

In a nutshell, when middle-market lending in developed markets is looking over-stretched, it would pay to seek the real “private” in private debt markets where Asia given its size and prominence across small businesses, consumers and trade carries a special appeal. The appeal is stronger when stability and visibility of cash flows offer safer harbors in an evolving climate for increased stress. Interestingly that too brings its own share of attractive opportunities with a different set of return drivers which begs a separate discussion at another time. ÊMA shall remain responsive to investors’ continued hunt for yield to locate opportunities (and associated risks) in more fertile areas as above. Stay tuned.

Till next time…

Yours truly,

Kamal Suppal, CFA

Chief Investment Auditor

October 18, 2017