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Update Magazine II/2020 |
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A major funding shortfall for Asian companies
Asia offers a lot of opportunities, particularly for institutional investors. One of these lies in the rather new asset class of Asian private loans, a segment with huge growth potential and a wide variety of investment options. Access to these markets is relatively complex. Anyone investing in the region needs extensive expertise and local specialists who can look into regional and company-specific peculiarities. For that reason, many major global lenders have practically stopped serving this market – i.e. demand for credit from middle market companies in Asia excluding China. International banks largely withdrew in the aftermath of the global financial crisis, and this trend is expected to intensify as a result of COVID-19. Chinese banks now also lack the capital for aggressive lending outside their own country.
That means that barely any credit is available to middle market companies in Asia, while at the same time demand for funding sources is rising sharply (see Chart A/). The reasons for this are obvious: economic growth in the region is sound, while Asia’s emerging middle class and strong productivity trends are ensuring robust structural growth in demand. Companies in these regions therefore urgently need capital in order to expand and create more supply. The impact of COVID-19 will not lead to any change in this stable and longterm economic growth trend. On the contrary, we can expect Asian manufacturers outside China to benefit from the fact that many global companies are planning to diversify their supply chains more widely, and to purchase goods from other regions in Asia. Middle market companies have the best chance of profiting from this.
Asian private loans: a market with huge growth potential and a wide variety of investment options.
A/ Since 2017, demand for corporate credit has accelerated...
DEMAND FOR CORPORATE LOANS IN EM ASIA
Source: IIF (as of Nov 2019), IMF World Economic Outlook (as of October 2019). Forecasts are inherently limited and should not be relied upon as an indicator of future results.
... and is likely to remain strong due to positive economic growth momentum.
GDP PER CAPITA FORECAST CAGR2 (2019–2024)
Source: IIF (as of Nov 2019), IMF World Economic Outlook (as of October 2019). Forecasts are inherently limited and should not be relied upon as an
indicator of future results.
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The US and Europe as a blueprint for future potential
We can also see how much potential the market for Asian loans offers by comparing it with established markets in the US and Europe (see Chart B/). While assets under management in private debt – i.e. financing for middle market companies from non-banks – have multiplied in western regions, growth in Asia has been comparatively modest; the market was worth USD 55 billion at the end of 2018, far behind the US (USD 455 billion) and European markets (USD 287 billion).9 If we look solely at the development of “dry powder” – i.e. funds that have not yet been invested – for the Asian market, a striking difference becomes apparent between private equity (USD 300 billion) and private debt (USD 13 billion). Based purely on the available private equity capital and the assumption that only a quarter of these transactions are served by private credit markets, demand in this segment doubles very quickly. These considerations alone show how undercapitalised the market for private credit in Asia is, and how high the chances of significant growth are.
B/ CATCH-UP POTENTIAL FOR PRIVATE DEBT IN ASIA: CLEARLY UNDERREPRESENTED COMPARED TO PRIVATE EQUITY
Source: Preqin, September 2019.
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Investing in a market full of peculiarities
The approach of a sustainable investment strategy must therefore be to fill the gap between credit supply and demand. The philosophy that Allianz Global Investors uses as the basis for this has been tried and tested in many other strategies. It aims to offer middle market companies in Asia holistic financing solutions that can be tailored to their individual needs, right across the entire capital structure. Important criteria when selecting companies include their growth potential, as well as steady cash flow, a leading market position, a well diversified product portfolio, strong management and good governance. The focus is on providing capital for more growth, acquisitions and refinancing. The geographical emphasis is on the Asia- Pacific region excluding China, particularly South-East Asia, South Asia and Oceania – all regions that are full of countryspecific peculiarities. Allianz Global Investors has an experienced team for this, currently comprising seven specialists who have been active in the region for over a decade. It invests in a broad range of sectors, focusing on key themes such as clean energy, education, healthcare, core infrastructure and data centers. The “sweet spot” for transactions is around USD 40 to 50 million per deal.
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Two strategies for investing in Asian private loans
Allianz Global Investors offers two product concepts with a different risk/return profile for investment in Asian loans for middle market companies: the Senior Secured Strategy and the Direct Lending Strategy. The two-tiered system provides extensive flexibility for investment across the entire capital structure, enabling investors to make optimum use of market opportunities, and generate attractive returns in the respective risk segment. Another advantage that the strategies offer investors is that, along with the opportunity for additional returns compared with other fixed-income alternatives, they have low market correlation and low volatility.
The investment approach is the same for both strategies, offering financing solutions that are geared towards the strategic goals of the company concerned. It is important that the investment teams at Allianz Global Investors are closely involved in the borrowers’ business decision-making processes, and can support them with made-to-measure credit solutions. The majority of lending is proprietary, with loans being granted to companies that the investment teams deal with intensively and on a longterm basis. The differences between the two strategies lie mainly in collateralisation, leverage and the risk-adjusted returns (see Chart C/).
C/ TWO-TIERED PRODUCT CONCEPT FOR INVESTMENTS IN PRIVATE CREDIT
Source: Allianz Global Investors, 2020. This is for illustrative purposes of two Asian Private Credit strategies. There is no guarantee that these investment characteristics will be attained.
Allianz Asian Senior Secured Strategy
This is a senior secured strategy. The market in which this product invests is estimated to be worth around USD 110 billion. The aim is to generate a gross return of 9 percent in USD, mainly from proxy cash, coupons and repayments. Average corporate debt is currently around 3.5 x. The company invests in loans with an average term of less than four years. Borrowers must meet a number of minimum requirements, particularly with regard to their equity base. There are clearly defined exclusion criteria, most notably restrictions on additional debt, guarantees or takeovers. Comprehensive guidelines also apply as to which information the borrower must provide and how often.
Allianz Asian Direct Lending Strategy
This is a direct lending product that is secured with secondline or sustainable debt securities. The investable market volume is approximately USD 60 billion. This product has more leeway when it comes to the structuring of collateral. Personal collateral provided by shareholders comes into play here, for example, a very valuable form of security in Asia. The more complex strategies for providing collateral allow more potential to be exploited in order to generate additional income. The aim is to achieve a gross return of around 15 percent in USD. Average corporate debt is 4.5 x and the average loan term is 4.5 years. In principle, the same information requirements apply as for the Senior Secured Strategy, combined with issues such as budget approval procedures or a mandate to monitor the management board. That means there is even closer discussion with the borrower, and more stringent monitoring of the strategy.
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Opportunities and risks in the light of COVID-19
The question of how the global economy will change as a result of COVID-19 and all the associated restrictions, and of how this will affect different sectors and individual companies, is fundamental to every investment decision. This applies to Asian credit markets in the same way. One advantage here is that the basic drivers of further growth have not changed, and are expected to continue to prevail. This includes demand from private households, which is driven by very firmly established consumer habits on one hand and by an emerging middle class on the other.
At present, however, the focus is shifting to those sectors with ongoing investment needs, which are less dependent on current consumer demand. These include telecommunications infrastructure (masts), data centres and pharma, to name just a few examples. There is also a focus on sectors that will recover very quickly when the general economic situation stabilises, such as healthcare, education, business-critical software, etc. Allianz Global Investors has drawn up a heatmap for Asia showing the impact that COVID-19 will have on different sectors (see Chart D/).
D/ ASIA HEATMAP COVID-19:
SECTORS AFFECTED TO VARYING DEGREES
Source: Moody’s graphic modified based on AllianzGI’s view.
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Conclusion
In a world without interest, the search for adequate returns represents a huge challenge for institutional investors. Asian credit markets offer significant potential for higher yields. The investment idea is based on rock-solid assumptions: middle-market companies will benefit from a healthy and sustained increase in consumer demand in these regions, and from the relocation of global supply chains from China to other Asian countries. Middle market companies’ demand for capital is high, and will continue to grow strongly. However, very little credit is available from banks. The market for private credit is still very small; if access for institutional investors improved, it would probably grow rapidly. Anyone wishing to invest in this market segment needs an experienced partner with comprehensive country-specific expertise. Allianz Global Investors is in a very good position with its regional investment team, and can thus offer bespoke solutions that will meet companies’ financing requirements.
Investments are pooled in two product strategies that serve the different requirements of institutional investors in terms of exploiting opportunities and hedging against risk.
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Summary
The opening of the China A-share market to foreign investors is poised to be, in our view, one of the most transformative events in the financial markets over the next decade.
- The opening of the China A-share market could be a transformative event, giving investors a unique opportunity to optimise global equity portfolios.
- Stock Connect programs have lowered the cost of accessing domestic Chinese stocks and, as MCSI adds China A-shares into emerging-market indices, China’s growing importance will increasingly be reflected in global equity indices.
- China A-shares add meaningful portfolio diversification, given their low historic correlation with major equity markets globally, and can help investors access a broader investment universe reflecting the fastergrowing sectors of China’s “new economy.”
- China’s importance is not reflected in the MSCI EM Index, which has a China A-share weighting of just 4.1%4 and a mega/largecap bias. “Buying the index” is not ideal for investors to gain appropriate exposure to China.
- The asset class has risks relative to developed markets, but we expect such risks to normalise as the market matures.
- On balance, we believe investors should consider a dedicated allocation to China Ashares. Our analysis suggests that a 10% to 30% direct allocation, coming from existing emerging-market portfolios, could improve returns and may diminish risk.