Structured solutions: GPs consider equity alternatives

It is a familiar scenario: an Asian entrepreneur has spent the best part of a decade building up his business and the next level is in sight - maybe expansion into a new market, adding a product line, or shifting to a more advanced production base. But the capital has run out; banks won't lend the entrepreneur the kind of money he needs to take this next step. Enter a private equity investor willing to bankroll the company in return for a stake in it. The entrepreneur hates the ideas of sacrificing even a minority position, but does he have any choice?

Increasingly, GPs are looking at how they can offer alternative solutions to companies that fall down the cracks between senior debt and traditional private equity.

Olympus Capital is one of them. In March the firm announced plans to enter the structured credit space by launching Olympus Capital Asia Credit (OCA Credit). Based in Singapore, the business will provide loans of $20-100 million with 2-3 year maturities, focusing on Southeast Asia, India and Australia. A dedicated credit team will operate independently of Olympus' core PE operation, not seeking to add value to companies but simply providing capital for expansion.

"In the past, once we realized that a deal wasn't well suited for private equity, we would throw those fish back in the sea, so to speak, but now we can refer companies who just require transition capital to OCA Credit," says Daniel Mintz, founding managing director of Olympus.

Others have already seen the potential for a more holistic approach to capital provision in India and Southeast Asia. KKR established a non-banking finance company (NBFC) to provide local currency structure credit solutions to Indian promoters, while Indonesia-focused Quvat Management has run a credit pocket alongside its corporate PE funds for several years.

Although credit funds are well established in other markets, few GPs have followed up thought with action in Asia and made the move down the capital structure, offering alternatives to companies they might otherwise have passed over. But is structured credit about to go main stream in private equity and, if it finds its feet, are traditional GPs best placed to take advantage of the opportunity?

Mintz is eager to make the distinction between what OCA Credit is doing and the kind of structured deals that already exist in the special situations and distress space. "We do not view this as a distressed debt opportunity," he says. "We believe this opportunity is about offering companies and owners an attractive trade-off between equity and debt." 

As such, OCA Credit has positioned itself just below mezzanine on the capital scale, providing debt and taking collateral, but not exposed to as much risk. Continuity Capital, the Australian private markets asset manager, is looking at a similar niche. It recently announced plans to expand its Asia credit business from its new office in Hong Kong, with a particular focus on small- and medium-sized enterprises (SMEs).

"I think that private credit, lending to small to medium sized enterprises, is absolutely in the growth stages right now," says Scott Hancock, a partner with Continuity. "It is a very attractive space with terrific risk-adjusted returns and good downside protection."

The factors driving demand for structured credit solutions across Asia is seen both as cyclical and structural. In the short term, at least, regulatory pressure on banks to strengthen their balance sheets has starved the region of a once fulsome source of capital. The Volcker Rule and the Basel III standards have effectively double-teamed banks, the former restricting engagement in proprietary trading and alternative investments, and the latter imposing increased capital adequacy requirements.

Other potential lenders - ranging from hedge funds to family offices - have also withdrawn from the space in the wake of the global financial crisis.
At the same time, the significant expansion of in the number of medium-sized businesses in Asia has not been accompanied by similar growth in lending from traditional sources. "This is a long-term structural imbalance between demand and supply and we don't think that is going away in the near term," adds Hancock.

Regulatory conundrums

The scale of the opportunity appears to be greatest in China where demand for capital among SMEs is high. According to Adamas Asset Management, Chinese SMEs on rely on banks for just 4% of their financing needs - a world away from 80% in Europe and 30% in the US.

"This is massive driver for why SMEs in China are in need of credit," says Barry Lau, managing partner with Adamas in Hong Kong. "We believe there are around 50 million SMEs in China which contribute more than 65% of the country's GDP and are responsible for more than 80% of employment."

Yet few players in the private credit space are considering China because investing brings with it a host of regulatory hurdles. Though active in China through its private equity funds, Olympus, for example, hasn't made the country an area of focus for OCA Credit.

Typically, those with China credit exposure have to construct deals though a network of holding companies and offshore entities to ensure they are in compliance with the law. One approach is to acquire a local lending license - of which there are several different types - so that assets can be collateralized for a loan with a piece of real estate or mortgage acting as security. Even then, it is extremely difficult for offshore money to secure collateral in China.

"We and other foreign dollar-denominated funds are not able to easily obtain security interests on hard assets," explains Joseph Ferrigno, managing partner at Asia Mezzanine Capital Group (AMCG). "You need to be a licensed lender or you need to work with a licensed lender.

AMCG and other cash flow lenders usually depend on the ability of the company to send dividends outside of China.

An offshore investor lends money to a Cayman Islands-incorporated company, which then invests the capital into a joint venture or a wholly foreign-owned enterprise (WFOE). This onshore entity must register with the State Administration of Foreign Exchange (SAFE) in order to send the proceeds of the investment all the way back along the chain in the form of dividends. In this way interest on the offshore loan can be serviced and the principal returned to the lender.

When investing in structured credit the level of risk involved should compare favorably with that of private equity, but success ultimately relies on a GP's ability to carry out effective due diligence.

"The big issue is what happens when things don't go well," says Hugh Dyus, head of Asia private equity at Macquarie. "Do the creditor rights put you in a position where you can seize collateral, liquidate the loan, or otherwise get your money back?" Dyus notes that most LPs are still observing these China strategies and will only back them once they are stress-tested, with a proven ability to recover value from difficult situations.

For investors looking to make structured credit play in Asian emerging economies - not only China, with its particular challenges in enforcing creditor rights onshore - the reality is that there are still dangers in dealing with potential target companies. Ferrigno speaks of AMCG discovering fraud in incidences when the Big Four accounting firms could not. "I would say it is very challenging to sift out the trustworthy management and companies," he remarks.

One of the advantages of the NBFC approach employed by KKR and others in India is that cross-border currency issues are not a concern - everything is done onshore. NBFCs differ from conventional lenders in that they are excluded from retail banking and foreign exchange, and are not subject to the same restrictions as conventional lenders. And as registered entities under the Reserve Bank of India (RBI), foreign-backed NBFCs are able to provide structured debt and mezzanine financing in locally currency.

KKR launched KKR India Financial Services in 2009 with a two-prong strategy. First, it wanted to facilitate the development of the country's still nascent debt markets, recognizing that corporate bonds and structured credit would become a significant asset class over time. Second, much like Olympus, there was a desire to desire to maintain a relationship with those quality companies who may not be an appropriate target for private equity investment.

"We have spent a lot of time getting to know their companies, getting to know the family members and these are groups we want to be partners with over time, but private equity was not what they needed or wanted at that point," explains Joe Bae, head of Asia for KKR.

As to how the debt solutions are structured, there is an emphasis on the bespoke approach, offering tenures that may be short, medium or long term, depending on what the business needs. "This is not plain vanilla corporate bonds or bank loans, these are highly structured pieces of credit that are tailored to what to the family needs or the collateral package they may have available," Bae adds.

Philosophical mismatch

While some GPs appear to be developing a taste for structured credit in Asia, they won't be able to realize these ambitions without support from LPs. It begs the question as to whether investors will be willing to back private equity firms that expand beyond their traditional competencies to provide such solutions. Is the risk/return profile on offer sufficiently attractive? Currently, those LPs with exposure to growth mezzanine and private credit space represent but a fraction of the whole private equity investor base. 

"There is a philosophical mismatch," says Adamas' Lau, citing a common preconception that that credit can't deliver the 2-3x cash-on-cash multiples LPs investing in Asian private equity have come to expect. "However, our view is that if each deal we invest in can generate 1.5x over a 2-3 year holding period, post recycling of the principal/committed capital, we can get to the same multiples without taking on the same level of equity risk."

Indeed, this may appeal to LPs who have been disappointed by their portfolio GPs' performance in Asia. It is estimated that a properly administered credit play can deliver net returns in the mid to low teens, which in the current environment might be more palatable than a higher risk special situations strategy.

"We are finding this opportunity is very interesting to LPs who want a stake in Asia's growth," says Continuity's Hancock. He sees the advantage of credit over traditional private equity as twofold: first, current demand-supply characteristics mean that moving down the capital structure to a more secure, less risky position can still yield high returns; and second, because these are loan funds, LPs receive an annual cash yield, with repayment of loans in 24-36 months.

Once again, though, Macquarie's Dyus asks whether industry participants can really deliver on what they are promising. A fund needs to go through a full cycle and return capital to investors in order to prove it is viable - no one in emerging Asia has done that yet. And for some, the strategy might not be viable at all, simply because they don't possess the appropriate resources.

"It is hard to do this without a separate pool of capital or a separate team of credit specialists who know how to structure a price," says KKR's Bae. "I think there is an opportunity there for a lot of other firms. Whether everyone's vision is along these lines, I don't know."

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• Topics
• Financials
• GPs
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• Asia
• India
• China
• Structured finance
• GPs