Ares Commercial Real Estate : Private Credit Opportunities in Asia Pacific

Private Credit Opportunities

in Asia Pacific

Private Credit in Asia: Filling the Void October 2023

Table of Contents

1	Executive Summary
2	A Case for Private Credit
Investing in Asia Pacific
3	Key Challenges for Asian Private
Credit Managers
4	Asian Private Credit - Defining
the Opportunity
5	Relative Value for Private Credit
in Asia Pacific
6	Conclusion

in Commitment

2

Executive Summary

• In Asia Pacific (APAC), there is a sizeable funding gap arising from rapid demand growth and structural inefficiency in credit supply, which is dominated by banks (77%). Many banks are increasingly unable to meet the funding needs underpinning the region's economic growth due to (i) a large share of bank lending being prioritized for certain policy-favoredindustrial sectors, (ii) loan books of many banks and non-banksbeing hampered by unresolved non-performingexposures, and (iii) in some cases, banks needing equity injections from governments. Similar to the U.S. and Europe, we believe that the selective retrenchment of banks is further underpinned by renewed banking sector anxiety, tightening credit conditions, and increasing regulatory constraints, creating sizeable funding gaps in APAC. We believe this market dynamic will present attractive growth opportunities for alternative private capital providers.
• At the same time, demand for credit financing will increase driven by continued rapid economic growth in APAC. APAC's GDP growth over the coming years is estimated to contribute 52% of global GDP in 2030, up from 45% as of September 2022.1
• The funding needs and liquidity pressures faced by many corporates and sponsors across APAC have been exacerbated by recent developments causing volatility and increased conservatism by some funding providers - recent shocks, including COVID-19,a sharply rising interest rate environment, the China real estate crisis, and most recently a confidence crisis in the global banking sector caused by U.S. and European bank failures, have impacted funding available for corporates and sponsors. As a consequence, capital markets for equity and debt have remained largely shut as a funding or exit option, leading increasing demand for alternative financings in the region and allowing investors to focus on more attractive risk-rewardopportunities, with better counterparties, and enhanced terms and covenants.
• Managers have to be able to navigate the more complex market structure in APAC, encompassing several very different jurisdictions, business communities and legal frameworks, the APAC Private Credit market has higher barriers to entry. These limit the intensity of competition in APAC, leaving experienced managers who are able to take advantage of these barriers to seek attractive risk adjusted return opportunities, comparing favorably to those in developed markets.

• Due to the continued demand for capital, coupled with selective bank retrenchment, a manager with flexible capital and scale, able to provide a one-stop financing solution, can often extract superior economics including cash and accrual interest, fees, non-callpremiums and potential equity upside. At the same time, lenders can benefit from very tight protections, including robust covenant packages, tight documentation and asset collateral (often ~50% loan-to-value).
• Private Credit providers in APAC offer capital solutions in three categories:
• • Sponsor direct lending - Provides financing to a private equity sponsor enabling them to acquire a majority or controlling equity interests in a business or to make value-enhancing changes to a portfolio company.
  • Non-Sponsorcorporate direct lending - Provides loans to corporates that do not exhibit financial strain, but need capital for general operations, business expansion or strategic acquisitions.
  • Special Situations/Distressed Debt - A more flexible mandate that invests across the entire capital structure of a potential borrower, whether by providing new primary capital or by acquiring existing instruments in the secondary market. The strategy often focuses on low entry valuations due to dislocations in the market or at the borrower level.
• We believe the APAC region offers attractive risk adjusted return opportunities for those investors who have the right team, right infrastructure, and right approach. Demand for funding solutions is increasing rapidly and the penetration of credit investors is relatively low at this stage of market development, as a result, GPs with effective local origination platforms and local know how can take advantage of market inefficiencies by sourcing opportunities with relatively limited competition.
• Finally, APAC Private Credit offers significant diversification benefit to LPs.2 Economic drivers and business cycles in the APAC region are very differentiated from those in the U.S. and EU, resulting in low correlation to the asset class in developed markets.

1. World Economics, Share of Global GDP - Global. Data as of December 2020.
2. Diversification does not assure profit or protect against market loss.

Unwinding the Market's Clock: Opportunities in Commitment
Timing	3

A Case for Private Credit Investing in

Asia Pacific

Current financing channels in APAC are dominated by bank lending, which is becoming less effective in meeting the growing demand for financing and is heavily concentrated in specific geographies and sectors. The resulting limitations represent a growing opportunity to be addressed by Private Credit, which has already displayed rapid growth over the last five years.

1. The State of the Current Financing Channels

Corporates and businesses in APAC have been accessing credit through three channels: banks, public markets and private markets. In contrast to the U.S. and Europe, banks represent the dominant funding channel in APAC, with c. 77% of all financings provided in 2020. The U.S. and Europe have gone through a sharp decline in their dependence on banks. For example, within the syndicated leverage loan market in the U.S. and Europe, on average, banks only provide balance sheet financing for 20% and 12%, respectively, of the transaction volume arranged for by banks.3

Fig. 1: Asia Pacific Financing Activity by Type, 20204

3% 2% 0.1% (Private Debt)

18%	Bank Loans

Public Debt

Public Equity

Private Equity

Private Debt

77%

One of the reasons for APAC's heavy dependence on banks is that the public capital markets in the region are much less developed than those in the U.S. and European markets. While APAC accounted for 39% of the World's GDP in 2020, the region's bond market accounted for only 10% of international bond issuances. Comparatively, the U.S. and Europe accounted for 31% and 23% of the world's GDP, respectively, with their bond markets accounting for 49% and 41% of total international bond issuances.5

2. Private Capital Underpenetrated in Asia Pacific

Similar to corporate bonds, private capital is less developed in APAC. Private Equity in APAC accounts for only 13% of the global Private Equity capital.6 Even more skewed is the situation for Private Credit in APAC, which accounts for only 11% of Private Credit capital.7

3. Heavy Concentrations in Several Financing Channels Create Opportunities

Several existing financing channels in APAC, including bank lending and high-yield bonds ("HY") are heavily concentrated in specific geographies and sectors, making these funding channels fragile and subject to pullbacks when individual geographies or sectors experience shocks. In contrast, we expect the stability of capital provided by Private Credit to drive further adoption by borrowers seeking alternatives to bank financing.8

Specifically, Asian USD HY is dominated by mainland China (46%) and India (24%). The market is also heavily concentrated in the Real Estate sector (34%), with approximately 69% of the total offshore bonds out of China being issued by real estate companies.9 Crisis' in these sub-segments, such as the current real estate crisis in China, can necessitate the development of alternative financing channels, in particular Private Credit.

1. U.S. data is represented by Milken Institute: Institutional Investor Base for Non-Investment Grade Loans. Europe data is represented by Pitchbook.
2. International bank loans data is represented by annual issuances from Dealogic. Domestic bank loans data is represented by data from various central banks, assuming rolling 4-year maturity. Public debt data is represented by ICMA analysis on data provided by Dealogic. Domestic public debt is represented by Asia Development Bank, assuming 6-year maturity. Public equity data is represented by corporate-only equity issuances from Bloomberg. Private debt data is represented by annual deal volume from Preqin. Private equity data is represented by annual capital called from Preqin. The analysis is based on Ares' assessment as of December 2020.
3. ICMA analysis using Dealogic. Data as of December 2020. International bonds refer to issues that are sold in a market outside the issuer's home jurisdiction.
4. Pitchbook and Preqin, Private Equity Deal Volume by Region. Data as of December 2021.
5. Preqin, Private Debt Deal Volume by Region. Data as of December 2021.
6. Projections and forward looking statements are not reliable indicators of future events and no guarantee or assurance is given that such activities will occur as expected or at all.
7. ICE. Asian Dollar High Yield Corporate Index. Data as of June 2022.

Unwinding the Market's Clock: Opportunities in Commitment
Timing	4

Fig. 2: Asia Pacific's Share of Global Allocation to Private Equity and Private Credit (by Deal Value), 2017 to 2021

Private Equity by Deal Value

Total: US$7.7bn

Private Debt by Deal Value

Total: US$1.1bn

13%

34%

52%

14%

11%

Asia US Europe

Fig. 3: Asia USD High Yield Bond Market, June 2022

Others

7%

Hongkong

5%

Indonesia

7%Real

Estate

69%

Macau	China
46%
11%

76%

Asia US Europe

Financials

16%

Basic

Industry

5%

Others

3%

Consumer

Goods

7%

India

24%

Unwinding the Market's Clock: Opportunities in Commitment
Timing	5