Private credit as an asset class has been making global headlines in recent times. The slowdown in credit from the banking sector and a pause in the broadly syndicated loan market has allowed private credit capital to step in to fill the gaps, leading to increased interest in an asset class that has already had a tremendous run in the US and enjoyed significant growth over the last 20 years. Direct lending activity had surpassed that of distressed and mezzanine in the last two decades, and now, nearly half of all private credit activity in the US can be attributed to providing capital largely to sponsor-led lower middle market (LMM) and middle market companies.
While that is now a near-commoditised asset class with normalised returns especially in the US, this brings us to the markets in Asia, which is very much in the early stages of growth. Investing in the region now is akin to investing in the US private credit markets in the early 2000s. This presents investors with a chance to get in early on an asset class that has shown resilient returns and a strong growth trajectory if the private credit market in the US is anything to go by.
So, what should investors be aware of when it comes to investing in this space in Asia? To tap into this opportunity, it is crucial to be aware of the local and regional nuances that make the Asian market different from the US and what that means for the opportunity in Asia.
Know Your Borrower
The most important aspect of this is to correctly identify and calibrate the risk associated with the target borrower segment. In the US, an LMM company is considered to have median earnings before interest and depreciation (EBITDA) of US$25 million, whereas middle market firms earn EBITDAs between US$50 to US$100 million. Over time, due to the maturity and scale of the US market, we have grown accustomed to these standards, but they should not be mistaken as global standards.
To illustrate this point, let’s zoom in on India, the second biggest market in Asia after China. In India, the total corporate output is c. US$1.5 trillion or more and going by the global definition of the mid-market sector, 35% of this output is contributed by mid-market firms. However, looking at the numbers at the sectoral level reveal an interesting finding. There are only a handful of sectors – such as utilities, telecom, oil and gas, automobile, IT services – where large companies (i.e., companies with revenue more than $1 billion) dominate and contribute the majority of the sector output and thus, make up the market leaderboard for these sectors.
But looking beyond this, most of the remaining sectors – which include high growth sectors such as auto components, transport services, logistics, healthcare, chemicals, foods, electrical and communications equipment, machinery, textiles – are mid-market dominated sectors, where more than half of the sector output is contributed by mid-market firms. Market leading companies in these sectors are not companies with revenues of US$1 billion or more, but instead, between US$200 million to US$600 million, and accordingly, EBITDAs ranging between US$20 million and US$60 million, with a median EBITDA slightly under US$50 million.
More importantly, many of these companies are very well-established with strong vintages and track records and have navigated significant changes in the Indian economy to emerge at the top of their respective sectors over the last two decades or more. Their need for incremental capital is of the order of US$25 million to US$50 million, or in other words, a turn or turn and a half of their EBITDAs. At this ticket size, there is a tremendous opportunity to provide non-dilutive flexible capital solutions to such companies and generate higher than normal illiquidity premiums. At the same time, this ticket size also allows the investor to access a far more diverse range of sectors to be accessed, compared to that presented by investments in large corporates.
Market Leaders of Tomorrow
These companies also enjoy higher relative market share. Our research shows that the top-quartile companies (TQCs) by revenues in several sectors contribute as much as 60%-70% of the sector's output. This points to very strong relative market positions and market shares versus competitors and thus, a much stronger investment profile than what is typically associated with mid-market firms. Not only are these companies well-placed to access the growth available in their sectors, but their strong relative market shares indicate a higher probability of success in capturing that growth than what is typically associated with a mid-market firm. This is important as most investors associate a certain risk profile with a mid-market firm as these are generally seen to be at the receiving end of market events with limited manoeuvring ability in more developed markets with large firms shaping the market dynamics. Whereas in Asia, these ‘mid-market’ firms are the ones shaping the market as they go about capturing the growth available in these parts of the world. The dollar-equivalent size just does not do justice to the market presence and investment profile of these companies.
Next, a lot of these companies while being privately owned, are professionally run. With several years of operations behind them, there is significant information available in the public domain that provides a strong foundation for robust underwriting and diligence processes on these companies and their operations. Compared to the US, where 60% or more of mid-market private credit goes to sponsor-led companies, the opportunity set in Asia comprises both sponsor and non-sponsor companies, which adds to the diversity available in the deal flow across sectors and in investment profiles, thereby reducing vintage risk, and concentration risk by ownership. Another key difference we see between the US and Asian markets is that there is a greater demand for customized credit solutions in the private credit markets in Asia, rather than standardized off-the-shelf structures.
Finally, the corporate sector in Asia has significantly lower leverage than it did in the past. Add to this the fact that banks tend to have strong local country bias, making it harder for cross border businesses to raise capital, while Asia is increasingly interconnected, with intra-Asian trade in 2022 rising to the highest levels in three decades. As a case study, banks in India are in good health but are increasingly focusing on the opportunities in retail and small ticket loans, or vanilla working capital loans in the mid-market space, which are more adaptable or amenable to a disciplined and templatized lending model, and further pivoting their growth strategies to capture digitalisation and fintech-related upsides. Fast-growing corporates on the other hand, especially market leading companies from the mid-market segment mentioned above, are looking for dynamic customised capital solutions to help capture the growth opportunities in their respective sectors. This shift towards private capital, which is a more organised source of capital, also ensures stronger corporate governance and information flow, and lends credibility to such businesses, ahead of an IPO or strategic dilution. The lower leverage on the corporate sector in Asia provides a more stable investment profile with healthy servicing metrics.
The private market opportunity in the mid-market segment is especially interesting with very few managers / lenders and a large untapped universe of investee companies to choose from. The dearth of financing solutions makes this a lender’s market with strong bargaining power to include attractive collateral and covenants terms in such investments. There is also tremendous upside from ability to provide additional financing through the life cycle of such fast-growing companies.
To conclude, in Asia’s dynamic and heterogenous landscape, it is important that investors reassess traditional definitions of mid-market, and calibrate investment sizes and return expectations appropriately, to capture the tremendous illiquidity premium available. A risk-adjusted lens that correctly benchmarks Asian credit in the context of regional markets, instead of a dollar-for-dollar comparison with American sector definitions, is a must.
Our belief is that the rise of private credit in Asia is set to play a complementary role alongside traditional banking capital, which is an equally important source of capital for funding the growth opportunities in the region across all sectors. This synergy between private credit and banking capital enhances the region's financial ecosystem, thereby fostering economic growth and enabling promising ventures to flourish.