Temasek unit prices US$510m PE fund bonds amid strong demand

Singapore

A unit of Temasek Holdings has priced and launched US$510 million in bonds that expose investors to a US$1.14 billion portfolio of 34 private equity (PE) funds invested in more than 590 portfolio companies.

This is the first offering of listed PE bonds in Singapore and possibly across Asia, said Azalea Asset Management Pte Ltd on Wednesday.

While Temasek's strong brand name and the environment of low interest rates likely contributed to the strong demand for the issue, analysts said the most important factor for investors ought to be the quality of the underlying collateral; they noted that PE exposure comes with relatively high risks and potentially poor disclosure.

The bonds, issued by Astrea III which is sponsored by a wholly-owned unit of Azalea, were subscribed by more than eight times. They came in four classes:

The Class A-1 and A-2 bonds have been rated "Asf" - essentially "A" grade for structured finance; the Class B bonds have been rated "BBBsf". Class C bonds are unrated.

These will be listed on the Singapore Exchange, except for the Class C bonds; an Azalea spokesman said the listing is expected to occur the week after July 8.

The listed bonds can be traded by accredited investors, which includes institutional investors and sophisticated investors.

About a third were allocated to private banks; 29 per cent went to fund managers, including hedge funds; 29 per cent went to corporates, endowments and others, and 10 per cent to insurers.

Azalea chief executive Margaret Lui said in the statement that Temasek's goal was to broaden its co-investor base and Azalea was "actively exploring" opportunities to eventually let retail investors subscribe to PE bonds.

It wants to offer PE bonds to retail investors because it is a good asset class, she said, while stressing that Astrea III's bond issuance was not a capital recycling exercise for Temasek.

Speaking at a briefing at Temasek's Dhoby Ghaut office on Wednesday, she said that offering PE bonds to retail investors would be "not unlike when we (Temasek) list companies and allow the public to subscribe".

"In this case, we're listing the notes ... Azalea still retains equity interest."

A retail offering of PE bonds could start off with the lowest-yielding bond class, she said. She noted, however, that the current regulatory environment was not ready for that and said she did not know what that timeline would be like.

"We will have a dialogue with regulators to see how this fits in" with the current listing framework for bonds, she added.

She said: "This portfolio of 34 funds - if I were to put it up in the market, there would be many buyers, because it's very good. I could recycle that more easily and very quickly. Likewise, I could leverage it through the banks, whether it's in the US or Europe, where they're very familiar with this asset class and give good credit for it."

She added that there was nothing comparable in the Asian market, but that Azalea had structured the bond classes in such a way that the residual return would "make sense" to equity investors.

She declined to reveal Azalea's internal thresholds.

Chue En Yaw, head of PE funds at Fullerton Fund Management which manages Astrea III, said: "Given that this is a very new asset class ... we hope to set some benchmarks."

Fullerton is a wholly owned and independently operated investment management subsidiary of Temasek.

Market watchers had earlier flagged the high risks of PE investment, saying that the returns from a PE bond may not justify the exposure.

But Mr Chue said the bonds' underlying portfolio was diversified; he noted that the biggest individual portfolio company out of the more than 590 accounted for just 2.2 per cent of the portfolio's US$1.14 billion net asset value (NAV).

The portfolio's biggest segment is consumer discretionary (23.4 per cent), followed by information technology (22 per cent), industrials (14.5 per cent) and healthcare (14.3 per cent).

He disclosed that Azalea had performed a stress test on the portfolio by simulating a three-year drought stemming from a financial crisis; it did so using data from 1990 to 2012, and determined that the Class A-1 and A-2 bonds would still be able to repay investors before their final maturities.

Analysts said that Temasek's branding likely lent some shine to the bond offering, particularly in the current environment of low interest rates. But they added that the most important factor for investors ought to be the quality of the underlying collateral and whether investors can properly understand the product.

Aberdeen Asset Management Asia credit research analyst Henry Loh said: "On a more general level, we believe the Astrea product provides an interesting opportunity for investors to get involved in the private equity space, with reasonable protections in place for investors in the higher tranches.

His colleague at Aberdeen and fellow credit research analyst Henry Loh said the pseudo-Temasek branding and success of previous issuance also brings some comfort in the quality of the product, as does the strong credit rating.

"That said, we did not participate in the deal. At Aberdeen, we believe in having a solid understanding of what we invest in. For an ABS (asset-backed security) structure, this means understanding the underlying assets in the pool, which can be difficult in the case of dealing with a fund of funds, where disclosure can be poor or challenging to obtain. Nonetheless, we see this as a unique development for the market."

He added: "Retail investors should be fully aware of the risks that they are investing in, should they choose to take part in a product like this. Investor education remains key to the development of the local bond market."

While acknowledging a lack of suitable benchmarks, some analysts said the coupons were lower than what they had expected.

Terence Lin, assistant director for bonds and portfolio management at iFAST Corp, said he had originally estimated that the A-1 bonds would be priced at 4 to 4.1 per cent and the A-2 bonds, at "a high 4 per cent to low 5 per cent".

"We also ventured a guess at a double-digit return for the Class Cs, which are structured most similarly to a typical PE investment and offer some equity upside.

"Our basis for this was that PE investors typically demand an IRR (internal rate of return) in excess of the 15 per cent required by the sponsor of the new Astrea III notes (before profit-sharing applies), and the notes would sit above equity in the overall structure. In our opinion, a return of around 10 per cent would be seen as fair for such a structure," he said.

"That being said, noteholders of the Class Cs could still see a double-digit return eventually ... if the profit-sharing mechanism kicks in, subject to several conditions being met."

He said the structuring of the bonds into four classes was a useful form of "financial innovation", but such structures have earned a bad reputation from the experience of the 2008-2009 subprime mortgage crisis. "Ultimately, the important thing to focus on is the quality of the underlying collateral."

Singapore's 10-year government bond yield is about 2 per cent.

Analysts also flagged extension risk and liquidity risk.

An OCBC Bank Credit Research team spokesman said: "As the cash flows generated by the underlying collateral pool is dependent on the pace of exit of investments by the PE funds, there remains the risk of the PE funds not exiting investments quick enough to pay down the Class A-1 tranche at expected maturity in 2019.

"In terms of credit risk though, given the 55 per cent of NAV retained as equity subordinated to the Class A-1 tranche, we believe that there is significant buffer for investors in the Class A-1 tranche."

CMC market analyst Margaret Yang added that while Temasek's branding was quite attractive, investors should also consider trading liquidity, given that the size of each of the four classes was relatively small.

Amendment note: An earlier version of this article incorrectly referred to the bond issuer as 'Azalea III' and said a stress test had found the A-1 and A-2 bonds would be able to repay according to their scheduled maturities. In fact, the issuer name is 'Astrea III' and the stress test found the A-1 and A-2 bonds would be able to repay before their final maturities of 10 years but not necessarily by their scheduled maturities. Temasek has also clarified that Astrea III is sponsored by a wholly owned unit of Azalea rather than by Azalea, and that Ms Lui actually meant to refer to the current listing framework for bonds in general rather than the new one recently announced. The article above has been revised to reflect these.