OP-ED: Asia Investment Megatrends May Show True Opportunities
Art by Woshibai
The credit market in Asia may be characterized as nascent, dominated by large pools of unsophisticated capital. Most credit funds disappeared because of the lack of buyside talent, making it hard to scale and producing a mixed track record.
Credit opps may be defined as opportunistic private lending, as well as high yield and special situations. Credit opps basically sit between private equity and commercial banks. Tightly owned and controlled companies are unwilling to dilute equity or cede control and prefer to borrow against cash flow and assets. Unlike private equity, there is no change of control or negative covenants, giving the property or corporate owners much more flexibility to match the cash flow to the needs of the situation.
Though there are many international players with regional credit funds (including Apollo, Bain, Edelweiss, Lone Star, OCP, and Varde), few operate across real estate and corporate with a flexible structure (warrant, TLB, PIK, converts, holdco) whose instrument are nonconventional and avoided by typical commercial bank lenders.
For the most part, international banks have retrenched in light of the Basel rules and the need to shed risk weighted assets. Global banks are shifting from warehouses of capital to become distributors of capital. Regional banks, on the other hand, are unable to provide cross-border lending and are much less nimble.
Examples of direct investments in both primary and secondary markets include leveraged loans, high-yield bonds, mezzanine, and pre-IPO convertibles. Deep focus on downside protection is key to producing risk-adjusted returns. A big vacuum exists in performing non-investment-grade credit. And achieving 12% to 15% gross returns is realistic. Simply put, senior lending, while producing equity returns. For credit that incorporates equity-linked upside via mezzanine, share-backed financing private bonds and convertible bonds, the gross returns top 15% to 20%.
China Unicorn: Upround or Downround?
In 2018, China fostered 186 unicorns valued at $736 billion despite the economic slowdown. Startups are proliferating in industries ranging from ecommerce and fintech to transport and artificial intelligence. Ant Financial, valued at $150 billion, is the largest unicorn, followed by news aggregator ByteDance and Didi Chuxing, operator of China’s largest ride-sharing platform.
Though 24 Chinese unicorns went public in 2018, over 70% are trading above their pre-IPO valuation. Trading of Xiaomi and Meituan-Dianping, on the other hand, are both below their IPO offering price.
Tighter financing is curtailing the ability of startups to raise subsequent rounds of financing. Burning cash to subsidize services and grab market share is no longer sustainable. Mobike, a bike-sharing platform, shut down and was later acquired by Meituan.
This frenzy feels like the meltdown that occurred during the tech bust in 2001. The contagion is already spreading from China’s stock market correction in Q4 2018. A number of unicorns have felt the pain of a downround valuation, with the most acute write-downs occurring from investors in the D, E, F, or G rounds.
The next tech meltdown will likely occur in 2020 or 2021 to be precipitated by massive write-downs and no potential for exit. Once the correction occurs, earnings will be the new driver of valuation and not ideas, eyeballs, or options. As these unicorns run out of cash, they need to keep the companies afloat in order to meet the liquidity needs of negative cash flow. True mark to market valuation could decline as much as 40% to 80% or more depending on the break-even level, burn rate, industry peer multiples, capital market conditions, and extent of dilution.
The burgeoning opportunity is to recapitalize the company, reprice to the proper discounted true value, and inject preferred equity with an accrual coupon feature. Through this structured recapitalization method, later-state investors will have a “pull up” clause allowing them to recoup part or whole of their principal through a waterfall structure that repays the white knight investor first.
How Much to Invest?
Australia: Senior Corporate and Mortgage Lending
A comparative analysis of the private loan market in the United States vs. Europe provides a good perspective to the burgeoning Australia private loan market.
Private credit is now the backbone of corporate and real estate lending in the United States, comprised of 200 funds totaling $900 billion in lending capacity. Compare this to Europe, where there are 80 credit funds amassing $120 billion. Spreads differ as well; European financings can earn about 500 bps compared to 200 bps in the US. That said, the base rate in the US is 2.5%, while in Europe, the base rate is hovering around 0%. Loans in the sub-€250 million range are mostly bank financed.
Regulatory changes are curtailing or shutting off lending in Australia amongst the banks. Much like in the US 30 years ago, 90% of lending is bank-led and 10% comes from institutions.
Private lenders providing real estate mezzanine loans for land development projects have filled the vacuum created by commercial banks. With accrual features, debt funds earn about 15% debt yield with fees.
With regard to corporate lending to small to medium enterprises, private lenders can earn up to 9%, including fees and spread. That compares favorably to 7% earned in the United States for senior secured loans.
Australia is a relatively small market, which makes it hard to scale. Spreads will likely compress in the medium term. This drought in lending has spilled over to the real estate market as values are in a freefall. The opportunity to capture the extra yield is attractive so long as the banks are sidelined.
China Corporate Bond Defaults: Crisis or Opportunity
Debt was the fuel that kept China’s economy growing. China’s bond market is ranked the 3rd largest globally, amounting to $12.7 trillion, $4 trillion of which is made up of the corporate loan bond market. Corporate debt surged to 160% in 2017 compared to 101% in 2007. Ownership of these bonds remain in the hands of the nation’s state-run banks, insurance companies, and brokerage houses, while foreign holdings are less than 2%. Yields for bonds rated AA- hit a 3.5-year high of 7.48%, which is equivalent to junk status. Credit spreads on China high-yield widened to 300 bps in Q3 2018 from as narrow as 50 bps in Q1 2018.
Amid the trade war with the US, coupled with the looming overhang of corporate and real estate debt, corporate bond defaults spiked to 119 in 2018 totaling $17 billion, nearly triple the 35 cases in 2017. Private companies accounted for 85% of defaulting issuers. Another drag on the economy stems from the zombie state-owned enterprises. Beijing wants all zombie companies to close by 2020.
China Minsheng Investment Group, for example, triggered a wave of $800 million in cross defaults when it failed to make debt payments. Cross defaults clauses are especially common in industries with overcapacity issues, such as coal and steel. This high-profile corporate default in China could signal a domino effect as growing debt-laden companies send tremors through the industrial and property sectors. Some industry professionals say this signal is the tip of the iceberg.
Another example of private enterprise default is illustrated by high-tech material firm Kang Dexin, which supplies optical film to Apple and carbon fiber material to Mercedes-Benz. Again, the cross default on bond payments triggered about $300 million.
The crackdown of shadow banking is also blamed for the record-high default rate amongst private companies as enterprises have less cash flow to meet their debt burdens. For lower creditworthy companies, shadow banking was the final lifeline to credit.
Default contagion is starting to spread from manufacturing to smaller property developers and local government financing platforms. China’s $3 trillion bond market could bring more stress as some $29 billion of sub-investment grade and unrated bonds will mature in the offshore market in 2019 followed by another $40 billion in 2020.
That said, the deleveraging process is leading to defaults, restructuring, and potential recapitalization opportunities. Unlike the United States, corporate restructuring and reorganization in China are less amputative, fairly opaque, and much more consensus-driven. In default situations, the issuers (i.e., commercial banks, securities firms, and trust banks) often form onshore credit committees. It is rare for a company to enter into liquidation. What’s common is to convert debt into equity in a structure that allows the company to meet its current and future debt obligations.
For the offshore bond market, the opportunity for western investors is varied. Buying the new issuance bonds issued to Hengda, a large property developer, at 14% is the most transparent. Providing bridge transitional super senior debt with collateral offshore with a high coupon plus potential equity linked upside. For institutional investors with onshore RMB income, opportunities abound as investors can snap up discounted bonds or acquire strategic non-core assets from performing and defaulting private companies.
Asia Outbound Investments: Cheaper Capital – Longer Hold
The magnitude of capital outflow is still in its embryonic stages in terms of non-traditional illiquid investments. Except for sovereign funds domiciled in developed markets like Singapore and Australia, the developing and emerging markets are facing major challenges to generate real returns in the face of massive inflow of pensioner premiums. Funding these deficits via a special line item within the Asia’s government budget is no longer sustainable. National debt to GDP are hovering at such high levels where governments have no other alternative but to diversify and produce real returns above inflation via outbound investments.
A historical perspective show that Asia growth was fueled by western direct investments and domestic and foreign bank lending. Simply put, the west financed the east, now the east is buying and financing the west.
Rising currency hedging costs are the major roadblocks curtailing the flow of Japan and Korean capital into the United States. Korean investors need to add at least 200 bps in annual return to compensate for the currency costs. Japanese, on the other hand, need to absorb close to 300 bps. That means real rate of returns are negative.
Korea’s foray in outbound investment began before the global financial crisis. Having suffered much financial losses after the Lehman collapse, Korean institutions laid dormant until 2012 until such time when the likes of KKR, Apollo, CD&R, Aries and Blackstone became the major recipient of commingled fund investments. With higher hedging costs and compressing returns, Korean investors need to generate higher returns and are venturing into direct mortgage and mezzanine lending, specialty finance funds, aircraft leasing and CLO equity.
Public pension funds have historically weighted towards Japanese government bonds and domestic equities market. In Japan a greater shift to alternative assets and illiquid assets are occurring. In search for alpha, Japanese pension funds have shrunk their government bond exposure and ramping up alternative assets allocation. Japanese corporate pension fund now has 17% to alternative investments compared to 11% in 2013.
The top 10 life insurance companies plan to increase their overseas commitment to infrastructure, private credit and private equity.
In Japan, the outbound investment trend is led by GPIF and Japan Post and other large insurance companies. Leasing companies, corporate pension fund, asset management companies, trading firms, regional banks and city banks are following the momentum. Though Japanese institutions have strong appetites for overseas investment, the lack of mid level and senior level investment professionals have thwarted the pace of the expansion efforts.
Asian insurers in China, Taiwan, Singapore, Korea, Indonesia and Malaysia experienced a four fold increase in alternative allocation in the past five years from 12.4% in 2013 to 25.2% in 2018. Private debt, infrastructure and real estate are deemed long term assets which bodes well with the long dated matching liabilities. Regulatory changes and new capital adequacy rules now impose high capital reserves.
China’s investment management market is set to reach $17 trillion by 2030 — up from $2.8 trillion in 2017. Limited to owning 49% in CHinese fund management businesses, foreign managers can now take majority ownership of Chinese fund management entities. Measured in AUM, China should overtake the United States in terms of assets managed. Flows of global products represent some 6% of industry AUM.
Taiwan’s investment outflow of capital are tightly regulated. There are some eight financial holdings companies whose subsidiaries include commercial banks, leasing companies, insurance firms, brokerage entities and financing arms. For offshore private market investments, life and P&C insurance companies are actively seeking foreign funds, as well as separate managed accounts. In select circumstances, Taiwan funds are permitted to acquire cash flow commercial buildings so long as they are situated in major markets like New York, London or Tokyo.
In summary, Western institutional investors are severely under-allocated to the Asia/Pacific region when compared to multinational corporations. In the next 10 years, growth will occur, for the most part, in China, India, and the ASEAN region. The GDP growth in the next three years in China will equal to the combined GDP of Germany and the UK. The sheer size of wealth and capital value creation are unmatched in the history of mankind.
John F. Tsui, is Managing Principal of New York based Peninsula Hose, LLC which is a single family office investment firm. He co-invests with institutional and private investors in fund and direct transactions.