Introduction
Private Credit has experienced unprecedented growth in the past decades, emerging as the third largest asset class in the alternatives space, behind private equity and real estate. Asia, in particular, has emerged as the world’s fastest-growing credit market, having grown by ~30x in the last two decades to over USD 90bn.
Yet, 80% of credit for businesses in Asia is still allocated by banks significantly less than the proportion in US (25%) and EU (50%), representing significant opportunity for private credit and its investors.
It’s not all high risk
Private Credit in its simplest form is a debt asset class that is characterized by the source of capital being ‘non-bank’ and the type of investment being a ‘private market’ investment. While Private Credit may perhaps be seen as more novel, what it is not, is ‘simply riskier credit’.
Private credit strategies range from 5% returns to 20%+ returns, in USD terms. At each point on the yield curve, it incorporates an illiquidity premium for the non-public, non-liquid nature of the product. More importantly, in situations where private credit solves for non-availability of capital, it also earns a ‘solution premium’[1] making it very interesting for investors everywhere. This asset class holds potential to provide investors with resilience in stressed environments, mitigated risks and superior risk-adjusted returns.
A flexible asset class
This asset class encompasses at least globally a range of different risk and return profiles across (i) investee companies and sectors such as SME & mid-market, large corporate, sponsor (read private equity owners), real estate and infrastructure, (ii) various points in the capital structure being senior, mezzanine, junior and hybrid, unitranche as well as debt at holding companies versus operating companies and (iii) end-uses such as growth, buy-outs, leveraged buyouts, distressed work outs or special situations.
Theoretically, all permutations and combinations are possible, but a good classification of various strategies would be performing credit strategies that largely pertain to (i) growth capital (direct lending) via senior, unitranche or mezzanine investments across a range of borrower types, (ii) buy-out, promoter or leveraged funding (hold co level investments) again across private sector promoter owned companies and private equity owned companies (iii) special situations strategies addressing specific M&A or bridge / liquidity related needs and (iv) distressed capital investments.
During the pre-Covid era, most readers would be surprised to note that while special sits and large buy- outs attract most media attention, direct lending to mid-market firms formed nearly half of the overall private credit pie in the largest private credit markets globally, and provided the largest yield pick-up in Emerging Asia compared to other credit strategies[2].
A new debate
Alongside strong growth and interest in this asset class, it is important to understand the extent and need for regulation of private credit markets. To make efficient asset allocation decisions, investors need to ask the following questions. What is the risk in this large and burgeoning asset class? Is there a risk of contagion and if so, by who and how should this asset class be regulated?
US is the largest private credit market, with total AUM of close to a trillion USD. Presently, it occupies a larger share of corporate debt than banks, and has been dominated by Holdco lending to sponsors typically at 5-6x leverage. Despite significant leverage on underlying loans, private credit funds in the US incorporate further fund level leverage to boost returns. Furthermore, there is far more dry powder (close to half a trillion dollars) than any other market. To top it all, the Fed has persisted in raising rates to well beyond 500 bps and has signalled ‘higher for longer’ in its efforts to tame a surprisingly persistent inflation in the US. All this, in an economy that grows at 2-3% annualised rate and with alarmingly high debt levels of 250%+ of GDP. The questions around risk and regulation are warranted. Against the backdrop of (1) high deployment pressure and competition (2) high leverage environment and (3) low real growth, questions around risks and regulations are warranted.
Looking eastwards to Asia however, private credit remains an emerging asset class in its first decade of existence. The nuances around the drivers of this opportunity and the role private credit in Asia are very significant. Private Credit is a tremendous opportunity for this region which encompasses among the fastest growing economies globally. Understanding the Asian context is essential to allowing Private Credit to develop to its full potential and play a meaningful role in the Asia growth story.
Private Credit in Asia - a trillion-dollar idea?
Private Credit’s swift rise in Asia is in part due to its compelling value proposition to issuers, including providing wider access to financing to underserved segments not adequately covered by the banking sector for reasons not related to credit or risk such as collateral or regulatory capital.
Traditional banks are often constrained by regulations and capital requirements, leading to a greater allocation to collateral-based lending and large cap companies. This inherently results in an under- allocation to asset-light businesses (e.g. business services, healthcare, tech) and mid-cap firms, with compelling and demonstrably resilient business models.
More importantly, Private Credit in Asia brings in a much needed and distinct source of new capital to the debt needs of the region. Global pension funds, insurance companies and endowments are in constant need of long term, moderate and stable returns, and have historically allocated significantly more to fixed income than equity. Capital in closed ended debt funds is not exposed to the same flight risk as portfolio investors’ capital in equity markets. Savings and investment capital of large Asian family offices and Asian sovereign wealth / pension funds and insurance companies can also make calibrated yet meaningful contributions towards this asset class. The need to diversify the funding mix for corporates and to develop Asian debt capital markets has long been a goal for many Asian economies. This, in turn, we believe also benefits the Asian banking sector, which has evolved, globally, into a wholesale lending model, focused on homogenous and granular asset pools, with more predictable ‘expected risk’ and ‘credit loss’ profiles.
Private credit funds have created an independent and distinct asset class for international and domestic investors. Firstly, in Asia, these are largely targeted at sophisticated investors through the requirement of a minimum capital investment / Networth (e.g. Singapore: SGD2m / Hong Kong: HKD 8m). Private credit funds in Asia are largely closed ended funds, ensuring that redemption pressures and resulting market disruptions are avoided.
For the discerning investor, this presents a very useful allocation in an investment portfolio. Investment in Private credit funds are a buy-and-hold investment products and thus less exposed to vagaries of valuations and market movements. A steady yet attractive return ensures increasing allocation and interest from the Asian institutional investor base of sovereign wealth funds, insurance companies and family offices. In an indirect manner, having an alternate avenue to earn attractive returns will also regulate the inflows of investment capital into public equities and real estate, which hitherto were the only avenues for return enhancement pursued by investors. For the overall investment landscape in Asia, this should be a welcome addition.
Can Asia be the new bright spot in Private Credit?
To conclude, as global markets deal with the excesses of capital raise, leverage and heightened competition in markets outside, sophisticated pension funds and institutional capital are already looking eastwards to Asia for moderate yet attractive long-term returns. A responsible and calibrated approach to growth and regulation attracting stable and new pools of capital through the private credit market could be the biggest opportunity ahead of us as we move towards Asia being the engine of global growth. While Asia’s heterogeneity means a regional regulatory standard would be hard to implement, we see Singapore as a gateway to ASEAN / North Asia with its transparent and well-regulated financial markets, stringent AML regulations and independent regulatory bodies, investors have one less worry when investing in an increasingly complex world.
[1]‘Solution premium’; structuring flexibility of Private Credit instruments allow the issuers to tap into additional liquidity pools to finance business and growth opportunities which would otherwise be out of reach, accelerating their business plans and providing increased shareholder value.
[2] Source: EMPEA Emerging Market Private Credit Survey, March 2019. BPEA Estimates
January 25, 2024
