An allocation to private credit investment presents opportunity for investors.
Private credit continues to surge worldwide as traditional lenders take their focus away from smaller enterprises. This article from GSFM’s examines this trend in Australia and Asia and explores how this presents investment opportunities to your clients.
The Australian private credit or private debt market (the terms are used interchangeably) pertains to the industry in which non-bank lenders extend credit facilities to businesses and individuals. It operates independently from the traditional banking system and serves as an alternative source of financing.
Private credit is surging in Australia as a confluence of factors have seen traditional lenders shift their focus toward servicing larger corporates. This has left a large number of smaller borrowers looking elsewhere to meet their funding needs. Consequently, there’s been a large number of private credit providers enter the market to fill this gap, and an increase in the number of private credit funds available to investors.
Borrowers seek private credit for various reasons, including:
- an inability to access public credit markets or traditional bank financing
- bank financing is too restrictive for the borrower’s needs
- does not wish to be diluted by issuing new equity
- requires funds quickly.
Private credit as an asset class has enjoyed explosive growth in recent years with total global assets under management (AUM) reaching over US$1.4 trillion in 2022[1]. Private credit AUM in Asia also doubled between 2018 and 2022 to US$95 billion.
However, Asia remains a small segment, comprising just seven percent of the total global private credit market. This under allocation is more pronounced when considered against the backdrop of the region’s significant contribution to the world economy, accounting for ~40 percent of global output.
This is changing as investors begin to turn their focus on the superior economic growth and favourable demographics in Asia. Fundraising in Asia has overtaken that of Europe in the first half of 2022, and several global private credit managers have announced plans to expand in Asia in recent months. Although Asian Private Credit markets are nascent in their development, they will almost certainly follow the growth path experienced in the US and Europe.
The Asian private credit market
The Asian private credit market is a significant and dynamic component of the global financial landscape. With Asia being geographically and culturally diverse, comprising over 40 countries, it presents unique challenges and opportunities for investors and operators. Each country in Asia is at a different stage of economic development and navigating this diversity becomes a high barrier to entry for new players. However, for specialised and experienced private credit managers, this diversity can be a competitive advantage.
One approach that some private credit managers adopt is to focus on developed Asian jurisdictions, such as Hong Kong, Singapore, Korea, Japan and Taiwan. These countries offer several key advantages that make them attractive investment destinations for private credit opportunities.
- Robust corporate governance: developed Asian jurisdictions are known for their robust corporate governance practices. They have well-established regulatory frameworks, transparent reporting standards and investor-friendly corporate governance structures. These elements foster investor confidence and provide a strong foundation for sustainable growth.
- Proven enforcement regimes and rule of law: the presence of effective enforcement regimes and a strong rule of law in these markets enhance creditor protection and reduce investment risks. Investors can have more confidence that contracts will be honoured and disputes will be resolved fairly, which adds stability to the private credit market.
- Strong sovereign ratings: the selected markets, with sovereign ratings ranging from A+ to AAA, demonstrate fiscal discipline and economic stability. These ratings indicate that these countries have a low risk of defaulting on their debts and can maintain financial stability even during challenging economic conditions.
- Highly developed credit infrastructure: Hong Kong, Singapore, Korea, Japan, and Taiwan boast highly developed credit infrastructures, including efficient credit bureaus and advanced financial systems. These infrastructures facilitate credit assessment and risk management, allowing investors to make informed decisions and deploy capital efficiently.
- Exposure to regional economic growth and dynamism: while focusing on developed jurisdictions, investors can still benefit from the region’s overall economic growth and dynamism. These countries have strong ties and supply chain integration with other Asian economies, contributing to regional economic growth. Additionally, their emphasis on technological collaboration and economic partnerships ensures they remain integral to the region’s economic progress.
What’s driving growth in Asian private credit?
There are several factors driving growth for private credit in Asia, notably:
High economic growth and strong demographics: Asia is the fastest growing economic region in the world, contributing over two third of total global growth. This strong growth outlook is supported by favourable demographics – large, young growing populations who are increasingly skilled – and increasing intra-regional trade further integrating economies within the region. There is a corresponding need for significant capital in order to continue to finance the businesses that are driving this growth.
Increasing burden on banks due to regulatory change: Asian banks face higher compliance requirements and increased funding costs in order to adhere to Basel III/IV requirements, making it difficult for many businesses to access bank funding. Private credit lenders can step in to fill this gap, providing capital to those businesses that are struggling to access traditional sources of financing.
Large funding gap for Asian middle-market companies: Asian middle-market (small and mid-sized corporates) lending space has been particularly hard hit by its over reliance on the bank market. While the middle-market companies comprise more than 96 percent of all Asian businesses, banks have generally turned focus away from this segment as they look to optimise use of scarce regulatory capital and extract efficiencies, pivoting towards larger relationships. This creates opportunities for private credit lenders to provide the much needed capital for Asian middle-market companies and enable them to continue to meet their strategic objectives and growth targets.
Borrower demand for creative financing solutions: there is growing appetite for private credit financing from Asian borrowers as it provides several advantages over other traditional sources of financing. Private credit offers more flexible terms and conditions; for example, principal repayment upon maturity versus the strict amortisation schedule favoured by banks, as well as certainty and speed of execution versus a traditional bank loan. Borrowers can also reduce equity/control dilution from a private credit solution versus an equity financing.
Why is Asian private credit attractive to investors?
Investing in Asian private credit can be an attractive option for investors looking to diversify their portfolios and seek stable returns with unique benefits. Here are some key reasons why people should consider investing in Asian private credit:
- Significant and growing market opportunity: the Asian private credit market presents a significant and growing opportunity for investors. Private credit is relatively under-penetrated in the region compared to more developed markets. As Asian economies grow and mature, the demand for credit from private companies will likely increase, providing investors with ample opportunities to deploy capital.
- Stable, regular cash income product: Asian private credit offers a stable and regular cash income stream for investors. Private credit investments often involve lending to established businesses with solid revenue streams and strong cash flow generation. This can provide a predictable income stream, making it an appealing option for income-oriented investors seeking alternatives to traditional fixed income products.
- Lower volatility compared to traditional fixed income investments: private credit investments tend to exhibit lower volatility compared to publicly traded fixed income products. This is because private credit investments are less susceptible to market fluctuations and the day-to-day price swings often seen in public markets. The illiquidity premium associated with private credit can also contribute to reduced volatility.
- Floating rate structure hedge: private credit instruments typically have a floating interest rate structure, meaning that the interest payments adjust with prevailing market interest rates. This feature provides a natural hedge against inflation and high interest rate environments, as the income generated from the investments can rise along with interest rates.
- Attractive risk adjusted returns: Asian private credit investments can offer attractive risk adjusted returns. The illiquidity premium and the additional due diligence involved in private credit can compensate investors for the increased risk.
- Geographic diversification and exposure to Asian growth: investing in Asian private credit provides geographic diversification for investors’ portfolios. This diversification allows investors to reduce concentration risk and take advantage of Asia’s dynamic growth and demographic tailwinds, which can further enhance the potential for attractive returns over the long term.
As well as the factors particular to Asian private credit markets, the opportunity to invest in this asset class more broadly also presents benefits to investor portfolios. These include:
- Potential for attractive returns: private credit funds can potentially offer higher returns than traditional fixed-income investments because private credit funds invest in non-publicly traded debt instruments, such as private loans or structured credit, which can offer higher yields.
- Diversification: private credit funds can provide diversification benefits to an investor’s portfolio. By investing in private credit funds, investors can gain exposure to a range of different debt instruments and borrowers, which can help to spread their risk and potentially improve the overall performance of your clients’ portfolios.
- Lower volatility: private credit funds can offer lower volatility amid geopolitical uncertainties, inflationary pressures and historically high asset valuations compared to more traditional, public, investment products.
- Access to institutional-quality investments: historically, private credit funds are typically only available to institutional investors or high net worth individuals. By investing in a private credit fund, individual investors can gain access to institutional-quality investments that may not be available to them otherwise.
- Potential for downside protection: Private credit funds often have tighter covenants in place that provide downside protection that reduce the risk of capital loss and help to ensure that appropriate returns are maintained relative to any changes in credit risk.
Risk and private credit
There is a perception that the higher returns offered by private credit (compared to traditional bank lending) means that it is a high risk investment that should be avoided as either the borrowers are low-quality, or the deals carry too much risk.
This perception is exacerbated by the cashflow lending nature of corporate private credit, and limited hard asset security compared to some traditional bank loans. However, there are a number of tools and structures deployed by private credit managers to mitigate and manage the risks associated with private credit financing, which when combined with the returns available, can deliver an appealing risk/return proposition for investors. It’s important that advisers ensure any private credit manager they consider have robust risk management processes that include rigorous due diligence and lender protections.
Rigorous due diligence
Detailed due diligence on prospective borrowers should include a review of third party financial, legal and commercial due diligence reports, as well as detailed financial modelling to assess a range of downside scenarios. This enables the manager to better understand the credit profile of the businesses they are looking to finance. It also allows the manager to ascertain the ability of the cashflows of the business to service the debt.
Lender protections
There are several downside protection features available for private credit investors. These include:
- Senior ranking security: a manager that primarily invests into senior secured loans will have first rights to the cashflows and assets of borrowers. Further, investments that have meaningful equity capital that sits underneath the debt in the capital structure is ideal; the equity bears the volatility and risk of earnings or deterioration in valuation. In such cases, significant value would need to be eroded before the capital is at risk.
- Maintenance financial covenants: these are typically tested quarterly and provide an early warning signal if there is deterioration in the credit quality of the borrower. This enables the private credit manager to take action as required to protect their capital.
- Documentation protections: loan documentation will typically impose a range of restrictions on the borrower that protect the private credit manager’s position as a lender, including cashflow sweeps to repay debt should the business underperform, restrictions on ability to make acquisitions and disposals (without debt repayment), and not allowing distributions to shareholders until leverage has reduced.
The outlook for Australian and Asian private credit continues to be promising. As financial markets remain volatile globally, the asset class offers a range of benefits to investors, not least an attractive risk return profile and important diversification benefits. It is imperative for advisers to entrust their clients’ capital to experienced managers with a proven track record across credit cycles, effectively managing risks and uncertainties in the year ahead while capitalising on private credit’s downside protection features. Private credit, with its attractive diversification potential and defensive investment strategy, offers investors a compelling opportunity to navigate the uncertain landscape of 2023.
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