Private debt: Enforcement issues

Fundraising across all segments in private debt - which covers direct lending, distressed debt and mezzanine financing - has increased significantly since the global financial crisis. The number of funds raised globally more than doubled between 2009 and 2013. In 2013, there were 137 successful closes. Capital inflows have also soared from $23 billion in 2009 to over $77 billion in 2013, according to Preqin.

Although North America and Europe have been the primary targets, LPs and GPs recognize the role private debt can play as an alternative to pure equity strategies in Asia. Most importantly, it can help address the imbalance created when the expansion in small and medium-sized enterprises was not accompanied by similar growth in lending from traditional sources.

KKR has been providing local currency structured financing in India for several years. In August, it rolled out a similar strategy in Southeast Asia with the appointment of Jaka Prasetya to lead regional credit and special situations initiatives. Meanwhile, Intermediate Capital Group (ICG) has entered the Japanese mezzanine space and Olympus Capital Asia has launched a dedicated credit arm (OCA Credit).

"The key components for LPs are downside protection and enforceability," Josh Stern, senior investment officer at the US-based Robert Wood Johnson Foundation, told the AVCJ Forum in Hong Kong. "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."

The enforcement issue is complicated by Asia's varied legal systems. How can debt specialists construct deals, across different geographies and credit strategies, while simultaneously creating solid downside protection for investors?

For OCA Credit, downside protection means being able to secure collateral and enforce creditor rights onshore. With the preservation of capital a priority, the firm looks more at developed markets, such as New Zealand and Australia, while emerging markets like Southeast Asia remain a challenge.

"The question is what happens if you've got a Singapore holding company with assets in an emerging market," said Gary Stead, managing director at OCA Credit. "We don't want cash trap. We don't want to rely just on how the sponsor would behave in a default situation. We want certainty, and for this we want things stitched up in multiple ways. We don't need to do this in Australia and New Zealand."

Much like OCA Credit, ICG has a preference for Asia's developed markets, with Australia and New Zealand accounting for about 40% of its exposure to the region. Chris Heine, managing director at ICG, noted that while mezzanine funds are relatively rare in developing Asian countries, about 70 deals are completed each year in Japan. ICG's recently-formed mezzanine fund with Nomura is looking to exploit an expected rise in demand from domestic corporates.

The company relies on debt instruments for downside protection. These usually come with an annual coupon and an equity kicker, either warrants or co-investment. Heine sees more upside in holding investments for longer periods and working alongside other stakeholders. As a result, ICG has been investing in the Asia Pacific region since 2002 but has yet to enforce security.

Not just collateral

While collateralizing assets is an important consideration for ICG and OCA Credit, KKR's Prasetya sees it as just one part of the credit business - there are other ways to ensure downside protection in Southeast Asia, and Indonesia in particular. While the country's bankruptcy system is still unproven, Prasetya said, the system of enforcing creditor rights is among the most advanced in the region.

"In China, you're not allowed to use local assets to secure International debt. It's the same in India," he added. "But in Indonesia, you can write your loan agreement into international law, which could be in Singapore or the UK."

Those with China credit exposure tend to construct deals through a network of offshore entities to ensure they are in compliance with the law. Offshore GPs would also partner with licensed onshore lenders so that assets can be collateralized. But the process can be challenging.

In Indonesia, creditors and target companies can set up a security arrangement. If the borrower breaches of obligation under the Singapore law, for example, the lender could assume ownership of the assets. "One, there is a value for the asset; two, it's not as bad as expected in Indonesia when you think about security arrangement," added Prasetya.

KKR isn't alone in seeking to tap Southeast Asia's private debt market. A few months ago, Singapore-based United Overseas Bank (UOB) and Japan's Orix Corp. launched a mezzanine fund to provide expansion capital to mid-sized companies in the region.

The companies that UOB and KKR invest in aren't necessarily distressed; they just don't see equity as the best solution for their capital needs. Prasetya therefore stressed the importance of having the flexibility. Once the relationship with the entrepreneur is established, opportunities for traditional PE funding may emerge later on.

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• Topics
• Financing
• Southeast Asia
• Greater China
• Australasia
• Structured finance
• Asia
• Southeast Asia
• Australia
• KKR
• Intermediate Capital Asia Pacific
• Olympus Capital Holdings Asia