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The lure of private credit in Asia-Pacific
PRIVATE debt is rapidly emerging as an asset class in its own right, driven partly by investors' search for attractive yield and an asset class not correlated with traditional stocks and bonds. We speak with Neeraj Seth, head of Asian Credit within BlackRock's Asia-Pacific Active Investments Group.
What is the rationale for an exposure to private credit in a portfolio, in particular private credit in Asia-Pacific?
Asia is an attractive market for private credit investments for three key reasons:
• Risk premium: Returns in private credit are driven by a combination of credit, liquidity and complexity risk premium. Given the nature of complexity and lower competitive intensity, potential returns in Asian private credit are higher than in developed markets.
• Growth of asset class: While private credit markets in Asia are nascent, this asset class is growing at a rapid pace, given higher nominal growth rate as well as secular and cyclical drivers. Its growth rate is higher than that in developed markets, making Asia an important market for global investors and one that's difficult to ignore in the medium term.
• Diversification: Private credit offers portfolio diversification due to the differences in underlying economies and growth drivers, as well as a lack of synchronisation in the credit cycle.
How risky is private credit and where do valuations stand?
Private market assets play a critical role as portfolio diversifiers, given their potential to generate alpha or above-market returns. Private credit tends to have further risk factors in addition to credit risk which offer additional risk premium and portfolio diversification benefits for investors.
Multiple individual factors have low correlation with one another historically and will likely perform differently at various points during an economic cycle, providing investors with a potential source of diversification and return exposures to which they haven't had access. The loans are typically senior secured in the capital structure or collateralised. Relative to senior unsecured bonds in the public markets, they offer a yield premium due to other risk factors and are typically conservatively underwritten with maintenance covenants.
The transition away from bank financing represents a permanent structural shift, and institutional private credit will gradually become a mainstream investment for many institutions. For investors willing to accept illiquidity, private credit can complement traditional holdings.
Over the past 20 years, Asia ex-Japan has been the economic engine of the world, with an annualised nominal GDP growth of 10 per cent. China is now the second-largest economy globally and the region has a combined economic output larger than the US.
We are moving into the late stage of the credit cycle but Asia's economic growth remains high with forecasts of 2019 real GDP growth for India, China and Indonesia at 7.2, 6.2 and 5.1 per cent respectively.
Corporates require capital to grow at a time where bank capital is getting constrained. Credit to non-financial corporates now totals U$36.6 trillion, recording a CAGR of 13 per cent over the past 20 years. Historically, the majority of corporate lending has been provided through the banking system. With financial disintermediation through the capital markets and private credit underway, bank credit has fallen from 89 per cent to 78 per cent in the same period, led by China.
Private debt in the region is still small and the estimated dry powder is currently around US$35 billion. We expect sustained demand for Asian private credit due to the need for capital in rapidly growing Asia, coupled with financial disintermediation, rapidly improving insolvency regimes and the complexity of the region's credit markets and legal jurisdictions.
The region's middle market loans tend to be smaller, more customised than those in the US and Europe, and are often sourced directly from business owners. Consequently, relationships and a deep understanding of the credit markets and the legal jurisdictions in the respective countries are important capabilities. We continue to find opportunity to structure bespoke loans with stronger security coverages and at higher contractual yields as compared to the US and Europe.
What is the most efficient way to get exposure to this asset class?
Structuring considerations could make it challenging for individual investors to partake in distinct private issuances, given the lack of homogeneity across jurisdictions in Asia. We see opportunity for co-investments for larger institutions with fund structuring capabilities, typically for larger deals.
For smaller deals sourced by managers, the lack of capacity for these deals means that the scope for individual investors to access the deal is limited and that fund structures are the way to go. In addition, private credit requires that capital providers conduct a comprehensive, time-intensive due diligence process owing to the loans' bespoke characteristics. Hence, it is not uncommon for a lender to rigorously evaluate a borrower's entire ecosystem (suppliers, customers, competitors and regulators) to create custom loans characterised by stronger covenants, favourable loan-to-value ratios and other investor protections.
Manager selection is critical for private credit and investors should look for managers with these key characteristics:
• A robust, multi-channel pipeline into the private markets;
• A rigorous due diligence process, coupled with the ability to structure, execute, monitor and service loans effectively;
• A strong and diverse platform that can meet the needs of high-quality borrowers.
What are the most attractive themes in this asset class?
Within Asia, India provides one of the most attractive private credit opportunities due to the credit gap in the system. The banking system in India lacks capital and the slow pace of recapitalisation has kept banks challenged.
Non-performing loan levels remain high at 9.5 per cent (albeit it has fallen from 10.8 per cent over the past year). Gaps in capital available to SMEs are further constrained by the tightening of liquidity for non-banking financial companies. We see signs of pick-up in credit opportunities across various industries such as infrastructure and real estate across the capital structure.
We are positive on the new bankruptcy law as it has led to ongoing improvements in the creditor protection framework in India. Lenders now have 180 days to implement resolution plans on bad debt, failing which default resolution must go through the National Company Law Tribunal. The new bankruptcy law is one of the two most important reforms from the current government (GST and Insolvency and Bankruptcy Code). Coupled with a very active regulator, we see an attractive pipeline of opportunities in India. For the rest of the region, we see credit gaps in Indonesia and parts of South-east Asia, providing attractive risk-adjusted return opportunities. W