Five things to know about Asian private credit

May 20, 2024

From stresses in the bank market to the growing need for infrastructure to meet net-zero targets, Andrew Tan sets out why the Asian private credit market could be poised for growth.

To date, the Asia Pacific region has been a bit-part player in the ascent of private credit over the past decade. While the market globally has increased almost threefold during that period, from US$441.2 billion to US$1.7 trillion, Asia Pacific accounts for just 7%. Even within the region, at US$124 billion, private credit is dwarfed by the more-established private equity (US$1 trillion) and venture capital (US$1.4 trillion) markets.¹

However, there is more to the Asia private credit story than meets the eye. While small, it is growing rapidly – almost doubling in size over the past five years.² In our view, that growth can continue for a number of reasons, although accessing the right opportunities will require a flexible and multidimensional approach by investors.

1.Bank stress and regulatory changes are increasing demand for alternative financing in Asia, particularly among smaller companies.

Today, we mainly see better-priced and better-quality opportunities in markets where there is some level of bank stress or pullback in risk appetite. That includes Hong Kong and Australia.

In Hong Kong, a lot of banks have sizeable real estate exposure. With the downward revision in property valuations, banks have had to take provisions and are being more conservative from a risk perspective.³ The result is that some companies are not getting the same coverage they are used to from banks. They are turning to alternative sources of finance, particularly in the lower-to-core middle market segment, which is where we tend to participate. 

In Australia, the growth in private credit is down to two factors. The first is the global trend towards the asset class. The second stems from the 2019 Financial Services Royal Commission report into misconduct in the banking, superannuation and financial services industry,⁴ which has led to more regulatory scrutiny of bank lending to smaller companies and increasing appetite among SMEs for alternatives.

Other markets we find of interest include Indonesia, Singapore and India, although there is currently a lot of liquidity chasing opportunities in India. For markets like Vietnam, Malaysia, Thailand and the Philippines, transactions tend to be more opportunistic or event-driven in nature. They depend more on the individual financing circumstances of a business, simply because of idiosyncrasies around banking systems and legal regimes in these markets.

2.Managers of private debt must be adaptable across different markets and structures, as opportunities and value can vary significantly over time.

Asia private credit is not a homogeneous market, which means asset managers have to be flexible where they spend their time. Over the past couple of decades, we have seen different markets emerge at different points in time where they offer value and opportunities. At other times, those same markets get ahead of themselves, and it is difficult to achieve the same risk-adjusted returns.

As a team, we need to be multi-dimensional in terms of our approach and capability across jurisdictions. That means being able to work across different situations and structures; whether that’s a senior-secured situation with or without a financial sponsor, or a mezzanine lending or special opportunities situation.

For middle-market companies, Asian banks have typically not followed the originate-to-distribute model favoured by European and US banks, where they originate loans and look to get them off the balance sheet. Asian banks tend to keep loans on their balance sheets, especially when it comes to larger middle-market credits. 

As a consequence, global private lenders who try to use the same playbook in Asia as they have in the US and Europe might find themselves in direct competition with banks. Our approach is different: we purposefully don’t seek to compete with banks but offer a complementary solution in the lower-to-core middle market, where for various reasons – company size, complexity, structure, leverage – banks might not be able to participate. Lenders like us can find opportunities in a less-crowded space.

3.Legal considerations are crucial in Asia, with common-law jurisdictions typically offering more robust creditor protections, while civil-law jurisdictions can present enforcement challenges.

The legal environment is a major factor in Asian private credit. You can separate the region into two buckets in terms of legal frameworks. You have Commonwealth countries (past and present), which are governed by common law and have established bankruptcy systems, creditor protections and security mechanisms. These include Australia, Singapore and Hong Kong. We have also seen reforms in the past decade in India, which have improved the legal protections for creditors.⁵

On the other side of the coin are civil-law jurisdictions like Indonesia and Vietnam, where they have rules, but enforcement is less straightforward and creditor rights are not as robust.⁶ When you are assessing opportunities in those countries, you have to think a lot harder about selecting your partners and exit strategies, away from just enforcement, if there is underperformance.

4.Despite its small size, Asian private credit looks poised for growth, driven by an increasing need for alternative funding and the investment requirements in industrialisation and infrastructure to meet net-zero targets.

As we have pointed out, Asian private credit is still relatively small compared to other regions and other private markets within the region (Figure 1). However, the Asian private credit market has grown rapidly in the last few years (Figure 2), and despite a more challenging environment in 2023 due to rising interest rates, we believe this will continue.

The need for alternative funding sources away from banks, particularly for lower-middle market companies, is clear.

The availability of equity capital has also been challenged – Q1 saw only nine private equity funds reach final close in APAC, the least active quarter for a decade.⁷ Based on what we are seeing in the market and the conversations we are having with potential borrowers, companies who might not previously have looked at debt financing are considering it now.

Another factor that should be supportive of activity is the fact Asian economies have significantly greater growth potential than the rest of the world (Figure 3).

According to the latest economic outlook from the International Monetary Fund, published in April, emerging and developing Asia economies are expected to grow by an average of 4.9% per year over the 2024-2026 period. That compares with 1.8% for advanced economies – Asian economies included in that advanced economics cohort, such as Australia, Hong Kong and Singapore, are also projected to see higher growth rates.

At a macro and sector level, there is a lot of momentum around industrialisation, manufacturing and infrastructure, all of which require a lot of investment. If you look at infrastructure to meet net-zero requirements, the Asian Development Bank estimates the Asia Pacific region needs to invest US$3.1 trillion per year between now and 2050, approximately 50% higher than the current level.⁸

We see opportunities for private lenders to be part of the solution, possibly in partnership with other investors and multilateral development banks.

5.Clarity around the direction of interest rates should support direct lending, even in a higher-for-longer scenario, but robust underwriting is key.

We saw a pullback in activity during the first three quarters of 2023 as base rates continued to rise. But in the last quarter and heading into this year, as it became more apparent rates had potentially peaked and expectations grew that the next move by central banks would be cuts, we started to see deal activity pick up again.

That isn’t surprising: lenders and borrowers need relative certainty on where are rates are going. Without that, it becomes more difficult to value businesses or assets. Even if rates remain higher for longer, there is at least clarity and borrowers know the environment they are going to be operating in and can adjust accordingly.

From a lender’s perspective, you also need to understand borrowers will face higher interest expenses, which puts a premium on picking the right target companies and getting your underwriting and structuring right.

References

1.Preqin, APAC Q1 Quarterly Update, as of April 2024
2.Preqin, ‘Private Debt Q1 2024’, as of April 2024
3.Fitch Ratings, ‘Hong Kong banks face headwinds in commercial real estate market,’ as of February 1, 2024
4.Parliament of Australia, Financial Services Royal Commission, as of 01/01/2019
5.Global Restructuring Review, ‘Overview of India’s Insolvency and Bankruptcy Code,’ as of September 09, 2022
6.Baker McKenzie, Guide to private credit in Asia,’ as of October 20, 2021
7.Preqin, ‘APAC Q1 2024: Quarterly Update’, as of April 2024

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed by Muzinich & Co. are as of May 2024, and may change without notice.

-----------------

Important Information

Muzinich & Co.”, “Muzinich” and/or the “Firm” referenced herein is defined as Muzinich & Co. Inc. and its affiliates. This material has been produced for information purposes only and as such the views contained herein are not to be taken as investment advice. Opinions are as of date of publication and are subject to change without reference or notification to you. Past performance is not a reliable indicator of current or future results and should not be the sole factor of consideration when selecting a product or strategy. The value of investments and the income from them may fall as well as rise and is not guaranteed and investors may not get back the full amount invested. Rates of exchange may cause the value of investments to rise or fall. Emerging Markets may be more risky than more developed markets for a variety of reasons, including but not limited to, increased political, social and economic instability, heightened pricing volatility and reduced market liquidity.

Any research in this document has been obtained and may have been acted on by Muzinich for its own purpose. The results of such research are being made available for information purposes and no assurances are made as to their accuracy. Opinions and statements of financial market trends that are based on market conditions constitute our judgment and this judgment may prove to be wrong. The views and opinions expressed should not be construed as an offer to buy or sell or invitation to engage in any investment activity, they are for information purposes only. Any forward-looking information or statements expressed in the above may prove to be incorrect. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation that the objectives and plans discussed herein will be achieved. Muzinich gives no undertaking that it shall update any of the information, data and opinions contained in the above.

United States: This material is for Institutional Investor use only – not for retail distribution. Muzinich & Co., Inc. is a registered investment adviser with the Securities and Exchange Commission (SEC). Muzinich & Co., Inc.’s being a Registered Investment Adviser with the SEC in no way shall imply a certain level of skill or training or any authorization or approval by the SEC.

Issued in the European Union by Muzinich & Co. (Ireland) Limited, which is authorized and regulated by the Central Bank of Ireland. Registered in Ireland, Company Registration No. 307511. Registered address: 32 Molesworth Street, Dublin 2, D02 Y512, Ireland. Issued in Switzerland by Muzinich & Co. (Switzerland) AG. Registered in Switzerland No. CHE-389.422.108. Registered address: Tödistrasse 5, 8002 Zurich, Switzerland. Issued in Singapore and Hong Kong by Muzinich & Co. (Singapore) Pte. Limited, which is licensed and regulated by the Monetary Authority of Singapore. Registered in Singapore No. 201624477K. Registered address: 6 Battery Road, #26-05, Singapore, 049909. Issued in all other jurisdictions (excluding the U.S.) by Muzinich & Co. Limited. which is authorized and regulated by the Financial Conduct Authority. Registered in England and Wales No. 3852444. Registered address: 8 Hanover Street, London W1S 1YQ, United Kingdom. 2024-05-14-13612