Indonesia private debt: Belt and braces

Everyone, it seems, has an Indonesia blacklist. "I've never done a Bakrie deal or a Widjaja deal," says one GP. Another is more even-handed: "We have our list, other funds have theirs. They might be fine with some of the people on our list because they have a different level of relationship, and vice versa."

Investors have long memories and mental scars remain from the Asian financial crisis when companies across Southeast Asia were brutally exposed by a mismatch between local currency-denominated assets and US dollar liabilities. As a result of their conduct circa 1997, a number of Indonesian families - the Bakries and Widjajas among them - are not welcome at certain financial institutions.

These were the origins of a reputation for poor corporate governance and shoddy treatment of foreign investors that, though partially rehabilitated, still stands. Plenty of groups recognize the opportunity in Indonesia's growing demand for structured finance, but some are reluctant to participate.

"Broadly speaking, we have found it far more difficult in Indonesia to get to the security. One can get the first lien, but can one be confident of enforcement capability, compared to other emerging markets?" says Robert Petty, managing partner and co-founder of Clearwater Capital Partners, an Asia-focused credit investor. "We are comfortable that we can get to the asset in India or China. We are not that way in Indonesia."

As a result, Clearwater's activities in the market have tilted more towards helping resolve distress situations than providing debt financing to growth companies. Others are more willing to fill what they see as a significant gap in the market, although a sensible structure and on-the-ground expertise are paramount.

This gap is occupied by companies that fall between the bases in terms of other funding options. They have particular needs that cannot be met by banks, yet they are too small to access the local equity or debt capital markets.

"Indonesia's economy has been growing consistently over the last 10-15 years; the market has expanded and there is more room for companies to grow from mid-market $500-600 million into large-cap $1 billion players. Due to the valuation gap, these companies typically don't want to sell equity too early. They would rather do slightly more expensive debt, which is still cheaper than equity," says Jaka Prasetya, managing director and head of Indonesia at KKR.

Scope of involvement

For KKR, the sweet spot for structured growth funding is $50-100 million, but there is a lot of activity in the sub-$50 million space. Prospective borrowers fall into three general categories.

Acquisition financing is a key area of demand. A company wants to acquire a rival that is one third of its size and the liability is beyond the local banks' comfort zone. Equity financing is one option but the family owners are reluctant to dilute their interest by 30-40% ahead of an IPO so they opt for debt instead, allowing the lender to enjoy a little of the equity upside.

The scenario is similar in project financing, with the company unable to obtain a bank facility large enough to complete a capital investment. A private markets solution is used to top up the capital pool and it remains in place until the project is underway, at which point a senior financing might be available. The third category is for major shareholders that want to take up a rights issue or share placement but don't have enough capital on hand. They use the shares as collateral to get the financing required.

There are various ways to play the market, and scope for a range of investors to participate. Su Ee Than, global head of OCBC's mezzanine capital unit, observes that the space has become more competitive in the last couple of years. "The line is getting more blurred between traditional private equity and mezzanine," he says. "Whether it is growth capital, special situations or mezzanine, in theory any mid-market PE firm would be able to look at a deal, depending on how they structure it and whether the return is justifiable."

Local high net worth individuals have also been known to provide financing solutions. Operating within friends and family networks, they often see deals before offshore investors and they might be more comfortable taking on the risk due to a familiarity with the business or greater flexibility in financing arrangements.

The promise of profits - IRRs can be more than 20%, comprising a guaranteed return on a debt tranche plus some equity upside - is bringing people in, but they are exposing themselves to a challenging commercial environment.

Indonesia ranked equal last with the Philippines in the Asian Corporate Governance Association's (AGCA) 2014 regional assessment. This represented a slight improvement on the previous edition in 2012 when the country occupied 11th and last place on its own. Citing Indonesia's Good Corporate Governance Roadmap for issuers and publicly listed companies, launched by the Financial Services Authority (OJK), the AGCA said there is potential for sustained reform.

"But can it succeed?" the association asked. "Much depends on political will, increasing regulatory resources and ensuring the right people are in place."

Enforcement is the area in which Indonesia and the Philippines really trail their regional peers - the AGCA scored them 24% and 18%, respectively, with ninth-placed China achieved a mark of 40%. Plenty of private markets participants would agree with this assessment.

One debt and special situations investor has been engaged in legal action with an Indonesian corporate borrower in both Singapore and Jakarta. The transaction was structured using Singapore documentation in order to provide greater comfort to the foreign party. Although the Singapore courts have found in its favor, the action now rests on enforcement within Indonesia, where the collateral is based. Given anecdotal evidence of decisions being awarded to highest bidder, it is unclear whether the case will be judged on its merits.

Some industry participants say they can't think of a case in Indonesia in which an onshore secured creditor has successfully enforced. Another take - without contesting the fact that the local enforcement and bankruptcy is uncertain - is that creditors don't have to follow this route. Security arrangements such as mortgages are often preferable because they allow the lender to take temporary ownership over the collateralized assets and sell them upon default without having to resort to the courts.

The investor involved in the recent legal actions notes that the situation has not made him less interested in Indonesia as a market. Rather, it makes it more difficult to structure transactions sufficiently tightly that LPs are comfortable there is enough protection.

As Josh Stern, senior investment officer at the US-based Robert Wood Johnson Foundation, told the AVCJ Forum in Hong Kong last November: "The key components for LPs are downside protection and enforceability. In the US, it's one jurisdiction and it's a large market. But the difference in returns expectations in Asia is the incentive that we want to go for outside of our geography."
It is possible to take steps that address both concerns, making these returns achievable with an acceptable quantum of risk.

Offshore collateral, personal guarantees from the borrower and full disclosure of their global assets are described as the three key ingredients to a copper-bottomed structure. Furthermore, the documentation would be reviewed by three different Indonesian legal counsels to ensure every aspect of local law is covered.

The availability of offshore collateral depends on the nature of the business. A small and medium-sized enterprises (SMEs) in Indonesia with land assets that may be difficult to access is clearly a different proposition to shipping companies that own tankers offshore or export-oriented manufacturers that generate US dollar-denominated revenues from international customers. In these situations investors can set up cash traps to collect the money.

"For transactions that involve oil and gas tankers, for example, the chartering contracts may be signed offshore and we would then require them to open an account with the bank and channel the charter income through the bank so we have first lien on the cash account," adds OCBC's Than.

Collateral may well come as a combination of onshore and offshore assets. As a bank with a presence in Indonesia, OCBC is able to take land as collateral when financing real estate projects and also works with domestic securities firms to take shares as collateral in a listed enterprise.

Getting personal

Personal guarantees can also be cross-border as the owners of many Indonesian companies have some kind of exposure to Singapore. However, spousal consent can be an issue - it is required for personal guarantees made domestically - and there is always a question of how much the investor feels it can ask for and how much the borrower is willing to give.

A personal guarantee is a strong statement of a borrower's seriousness in terms of building his business and honoring the financing agreement. If the investor insists on receiving guarantees from every family member and stakeholder involved, plus details of all assets held globally, several problems can arise. First, a willingness to comply could be an indication of the borrower's desperation to raise capital; the investor is legally protected but there is a lot of inherent risk in the transaction. Second, the demands could be more than a small family business, which lacks skilled back office staff, is set up to handle. Third, the borrower might just say no.

The same applies to situations of negative control. A creditor may not be able to enforce a position but it can make life very difficult for the company in question, tying up assets and blocking moves to develop the business. If the owner thinks the company is worth saving, and realizes the investor isn't going away, it might be in his best interests to reach a settlement.

"There are many ways to cause pain and force the borrower to refinance you and get you out of there, but if a company is doing well and just wants growth capital, it isn't going to like that kind of term sheet," says one GP.

This comes back to why PE investors are in the market in the first place. If the thesis is to support strong companies that require capital to achieve a particular goal but can't get access traditional bank channels, enforcement is not as much of a priority as when providing financing to groups that are seeking mezzanine solutions because they are already overleveraged.

For example, a company might have a $20-30 million from a bank and want $50-100 million for acquisitions as it bulks up ahead of an IPO. The deal is therefore structured around the public offering. The company is incentivized to achieve its goal quickly and repay the loan, but if this does not happen all is not lost provided the business remains in good health.

"If a company plans to go for an IPO two years down the road we could, for instance, structure a 4-5 year facility with warrants exercisable at the IPO," says KKR's Prasetya. "If the IPO doesn't happen within five years, the warrants can be put back to the company for a required IRR. In situations where the IPO doesn't happen for various reasons, if the company has delivered on its business plan, other options typically open up, such as a proper senior loan financing."

An equity kicker arising from a liquidity event, which takes the return from mid-teens respectability past 20%, is a standard feature of such transactions. It rests on an alignment of interest between borrower and lender, and in this sense the structure of the deal and ensuring sufficient downside protection is just the starting point. The investor is doing more than providing financing based on an assessment of underlying assets; it is about making a call on a business model and a team's ability to execute it.

"In other jurisdictions you may be able to focus on the assets and care less about the management, and then if something goes wrong you foreclose. In Indonesia it is much trickier than that - it is more holistic. Do you feel comfortable with the owner? Does he see you as a partner or as a lender?" says Edwin Wong, managing partner and CIO of SSG Capital Partners. "And then you want to structure a deal where he has a lot to gain by paying you out."

Opinion is divided as to how readily family groups are willing to treat foreign investors as true partners. Most industry participants say the companies they deal with are serious about their undertakings, recognizing that the capital required to sustain growth is unlikely to come from elsewhere. The economy has also moved on since the dark days of 1997. Laws are stronger, oversight stricter and company owners, whose wealth may have multiplied several times over, have more to lose by misbehaving.

The counterargument is that progress comes from a low base and Indonesia still has far to go. "It really depends on how badly they need the money," says another investor. "Most of these families don't wake up at night worrying about what J.P. Morgan thinks of them; they wake up thinking about Ferraris and how they are going to pay for their grandchildren's education. CFO-type people still abscond with huge amounts of money and it is viewed as a risk of doing business. This is a very tough contact sport."

Boots on the ground

Much rests on the segment of the market investors target and their ability to assess a potential borrower's creditworthiness. The historical blacklist comes into play here as well as more contemporary information networks.

For the bank mezzanine units, once they have seen a company's financial statements and business plan, the next step is to carry out name checks internally. If the borrower in question hails from Surabaya, calls will be made to the local branches - OCBC has around 400 outposts nationwide through its 85% stake in OCBC NISP, while UOB claims to have over 220 wholly-owned branches. If the company is not already a commercial bank customer they can talk to rivals, suppliers and customers who are.

"We can figure out how many other businesses a guy has and how they are performing, which family he is from and whether his grandfather would bail him out if he ran into trouble or he's the black sheep of the family no one really cares about," says Wee Yap Yeo, head of UOB's mezzanine capital unit. "We can sift out partners who have bad reputations or could be problematic investees."

In a country that remains opaque to outsiders and where the established family groups are quite closely intertwined, having a local presence is vital. Even for the very large deals that are run as processes by investment banks, due diligence may come up short without professionals who are familiar with the local language and legal systems. The SME space is less penetrated but building a scale business - along the lines of a merchant banking operation - requires manpower, and by extension confidence in the market.

Clearwater, for example, has faith in the enforcement environment in China and India and has invested heavily there. The GP has backed two finance companies in China, which employ more than 80 people, and another in India with a staff of 30. So far it has yet to replicate this approach in Indonesia.

There is every chance the finance company model will work. Several sources cite the success of Indonesian motorcycle leasing players as evidence of this. These businesses are very granular: they rely on people on the ground to collect weekly payments and recall motorcycles if payments are no longer forthcoming. Repossession is relatively straightforward and legal recourse is rare.

The question is are investors comfortable enough enter similar arrangements involving different assets and larger check sizes. "It is all about execution and that includes enforcement," says one GP. "Will someone get it right in Jakarta? Yes. Will someone blow up in Jakarta? Yes."

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• Topics
• Financing
• Expansion
• Southeast Asia
• Structured finance
• Southeast Asia
• Indonesia
• Growth capital
• KKR
• Clearwater Capital Partners
• SSG Capital Partners
• OCBC