Distress fundraising: In credit?

If further convinving were required that Asian distress funds have become a major draw for LPs, perhaps May saw the last doubts laid to rest. Within days of each another, two GPs - one focused on India distress opportunities, the other a pan-regional special situations fund - revealed they had raised $1.73 billion between them, both far exceeding their original targets.

The first was Aion Capital Partners, a joint venture formed by Apollo Global Management and ICICI Ventures. It received commitments of $825 million for its maiden special situations fund, having set out to raise a more modest $500 million just over a year ago. The fund will pursue opportunities such as financial restructurings, recapitalizations and promoter financings.

Then second was SSG Capital Partners, which closed its third Asia special situations fund at the hard cap of $915 million after only five months in the market. The fund - backed by mixture of large family offices, pension funds and insurance companies, among others, from Europe and the US - targets numerous proprietary transactions but specializes in restructuring.

The two GPs' strategies differ but both speak of a broader trend of growing acceptance in the investor community. Already part of the furniture in developed markets, distress and private debt are now more widely recognized as an asset class in Asia and LPs are looking to increase allocations. Strategies and track records are being scrutinized, but will these niche managers receive enough backing to enter the mainstream?

"I think, from an Asian perspective, it is a factor of the maturation of the Asian private equity market, where investors have built significant exposure to the region during the mid-to-late 2000s and now they are seeking further diversification and yield," says Jonathan English, managing director with Portfolio Advisors.

According to Preqin, three Asia-focused distress funds have raised $1.9 billion so far this year compared to $1.7 billion, across 11 funds, in 2013. This is less than the 2012 tally of $6.5 billion, but it could be argued that Mount Kellett Capital Management, which raised $4 billion for a global fund with a substantial Asia allocation, should be discounted. Meanwhile, there are around seven Asia-focused funds currently in the market looking to raise a collective $5.8 billion.

Given the Asian market still lacks depth, the numbers offer only a partial insight. On a global basis, while distress fundraising has been slow so far in 2014 - with $13 billion committed to 16 funds - managers have proliferated in recent years. In 2013, $35 billion raised by 45 funds compared to $26 billion by 39 funds in 2010. An estimated 63 managers are currently seeking to raise $33 billion.

Growing appetites

There are number of factors driving increased LP interest in debt-related assets, particularly in Asia. First and foremost, many investors say returns coming out of the region have been disappointing. This leads LPs to look for alternatives and private debt is an option.

Barry Lau, managing partner as Adamas Assest Management, observes that LPs had historically overlooked private debt in favor of seeking 2-3x returns by investing traditional growth capital and buyouts. But as the reality is changing, so is investor appetite. "LPs are sort of having this awakening and realizing that actually it is not bad to generate a quick cash return and therefore private debt has become more of an interesting topic," he says.
Rob Petty, managing partner and co-founder of Clearwater Capital Partners, contends that the absolute yield for Asian credit relative to the US and

Europe is simply more compelling. "If you compare growth capital or buyout return history and cash distribution timetables versus the credit and special situations track record, the opportunity set looks increasingly interesting," he says.

To better understand where LPs are looking for with regards to distressed debt one must examine the areas that have seen the most activity to date.
Across the region, slower growth and increasing corporate debt are putting more pressure on company balance sheets. Add to this the number of Asian companies that have run into trouble due to overexpansion or mismanagement and there are a number of opportunities for distress investors. In many cases, these companies might be good businesses with bad balance sheets that - as a result of unwise strategic moves - are unable to service their debt under current operations.

"The broader trend is that banks are not lending for their own reasons and there is a gap in funding in Asia," says Sharon Hartline, a fund formation lawyer and partner with White & Case in Hong Kong. "In particular, Asian debt-related strategies are popular among US pension plans and college endowments where they are looking for steady returns instead of home-runs."

Within Asia, three jurisdictions have typically been the focus of distress investors: India, China and Australia. The first two account for the bulk of opportunities in the region.

While the election of a new government has been a cause for optimism in India recently, over the past year economic growth has deteriorated to its slowest pace in a decade, leaving companies struggling to raise capital. Aion is just one of a number of GPs looking at the country.

Data from the Reserve Bank of India indicate that stressed assets, including bad debts and restructured loans, rose to 10.2% of total debt held by Indian banks last year, the highest in a decade. In this context, the government has also sought to encourage private-equity funds and asset reconstruction companies to play an active role in stressed assets markets.

"Two years ago when we sat on the conference panels and said India was interesting, people rolled their eyes," says Petty. "Today, if you look at realized returns, India has performed very nicely over the past 18 months."

Specifically, more GPs are looking to target debt opportunities in the country. KKR has been providing local currency debt products via its own non-banking finance company for several years. In January, the firm reached a final close of $2 billion on a global special situations fund. A month later, during a visit to India, KKR co-founder Henry Kravis said the firm was keen to capitalize on corporate indebtedness by investing in companies with distressed balance sheets that have difficulty raising capital through conventional channels.

China's economic expansion has yet to slow to Indian pace, but for companies with business models predicated on the hyper-growth rates of recent of years the financial pressure is very real. According to the China Banking Regulatory Commission, non-performing loans (NPLs) rose by RMB28.5 billion ($4.7 billion) in the last quarter of 2013 to reach RMB592.1 billion, the highest level seen since September 2008.

These debts represent a complex patchwork of state and private interests, making it difficult to quantify the size of the opportunity, but Shoreline Capital is the forefront of those looking to take advantage of it. The China-focused GP, which raised $303 million for its second fund and is said to be targeting $500 million for Fund III, buys NPLs and looks for ways to force payment or extract value from related assets.

Adamas' strategy is to provide credit alternatives to companies that can't access financing through conventional channels - certainly not the capital markets and increasingly not the banking system either. Lau explains that with bank balance sheets shrinking so often, his firm is often one of few options remaining, which translates into creditor-friendly terms. "We are looking at an emerging market risk but we are getting paid for taking that risk," he adds. "For example, we are getting returns of 25% and you can't get that from anywhere else in Asia."

However, not all of Asian distress opportunities are limited to the region's emerging economies. Until recently, Australia tended to be seen in the context of highly-leveraged companies struggling to unwind positions that became untenable in the wake of the global financial crisis. Now most of this low-hanging fruit has been picked, investors are looking at smaller mid-market deals.

The challenge is generating attractive returns in a market that is far more mature than China and India and doesn't offer the same risk-return profile. Allegro Private Equity is an example of an investor with a strategy closer to traditional private equity. It focuses on control positions in distressed business where operational improvements are used to drive returns.

"The large restructurings have been done so I don't think that space is as rich in targets," says Adrian Loader, managing director at Allegro. "But businesses below $150 million dollars are in need of solutions that involve more than just money because we you have to fix the board and solve operational issues."

The combination of strong a rule of law supported by predictable creditor laws and strict director laws means Australia is can be attractive to more risk-averse LPs. But Loader cautions that making the system work requires a local presence and a highly specific skill set. "I honestly believe that the whole game is about providing capital and solutions, and a lot of the solutions involve being on the ground," he says.

Region vs. country

The diversity of the distress opportunity in Asia begs the question as to whether LPs are best served backing managers in individual markets rather as opposed to pan-regional players. It should come as no surprise where the different GPs stand on this. Much like Loader, Lau of Adamas - which focuses exclusively on China - emphasizes the advantages of a country specific approach and an on-the-ground presence.

"Private debt is a localized business because credit protection is different from country to country and it is difficult to be experts in almost every single geography and jurisdiction," he says. "You need a local team for everything you do and our vision was that we would focus on China because from a risk-return standpoint, it makes perfect sense."

On the other hand, Petty of Asia-focused Clearwater argues that debating the respective merits of a regional versus a country-specific strategy somewhat miss the point.

"It is not just about geography, but people always chart Asia by geography. We emphasize again and again that it is about sectors," he says. "For example, if you look at the commodities and natural resources space, whether it is in India, Indonesia, Australia or China - coal is getting crushed. Shipping is also creating opportunities across a number of jurisdictions."

Indeed, the market has seen a number of deals in these areas. Clearwater previously bought and sold both Griffin Coal Mining and Carpenter Mine Management to Lanco Resources Australia. Meanwhile, GPs like Denham Capital and Helmsman Capital are targeted distressed mining opportunities.

However, regardless of strategy, convincing some LPs of the Asian distress opportunity is still a challenge. "For the nascent LPs in this space, there always tends to be an issue with return multiples, as the multiples are typically going to be lower than with a pure PE play," says Portfolio Advisors' English. "That is an issue for some LPs - getting comfortable with the return profile and where it fits into their broader portfolio construction."

He is not alone in this view. While an increasing number of LPs are focused on private debt and building out their absolute returns coverage, education remains an issue. Speaking to AVCJ after announcing the final close of Fund III, Edwin Wong, managing partner of SSG, observed that receptiveness to credit strategies had improved since the firm's previous fundraising cycle, but defining the opportunity set can be challenging.

Needless to say, explaining a portfolio of 25 credit or special situations investments relating to companies with varying levels of financial health is more complicated than 10-12 buyout or growth capital deals that may follow coherent sector patterns. "It is just more complex, especially when you layer in structures, cash- flow characteristics, and multiple scenario analysis of different exit routes," notes Clearwater's Petty.

The other difficulty facing GPs is the lack of track records in Asian distress. One LP observes that pan-regional funds have served investors well these past few years, providing liquidity even when markets are tough. But at the same time, few data points are available for a fully-realized, liquidated portfolio in Asia.

"In some cases, the returns are locked-in from a current yield perspective," the LP explains. "You can try to goose the IRR with an equity kicker, and the upside can drive the multiple, but there are very few data points from a fully realized track record that demonstrate that outcome."

Chicken and egg

Despite the recent fundraising success stories, question marks over strategy and track record still present obstacles for distress-focused GPs as they make the transition from niche to mainstream. It is arguably the same for many managers in Asia, but particularly the more specialist players, as they deal with investor inquiries. Certainly, the phenomenon of capital being concentrated in fewer hands is common to all.

"We have had people coming in to talk to us for the last years two years on these strategies, but in the past six months we have noticed more people in the market are having trouble raising even their third or fourth fund," says White & Case's Hartline. She adds that LPs remain cautious about stepping in too soon, especially in China where some expect the economy to deteriorate.

If distress is to sustain the broader interest it has been receiving, a larger manager universe is essential. But are there sufficient people with experience and expertise in executing transactions across the capital structure? Clearwater's Petty says no.

"It is a pretty small group of GPs that run institutional capital of $1 billion plus and have a team across multiple geographies that can do deals of $25-100 million," he explains. "There are perhaps 10 of us - that is not many for a $30 trillion market. Because of the complexity of the deals, it takes larger teams, generally more systems and analytical firepower to play across the capital structure."

The more managers, the easier it becomes to fill the gaps in investor education. The caveat is LPs have to be comfortable enough to support new GPs as they emerge. Adamas' Lau understands the need to tread carefully when an industry is in its nascent stages, but stresses that early movers might have the most to gain.

"So long as investors are willing to consider the space and willing to take a leap of faith in this emerging sector I think they will be handsomely rewarded," he says.

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• Topics
• Mezzanine
• Credit/Special Situations
• Asia
• White & Case
• Mezzanine
• Clearwater Capital Partners
• Distress
• Adamas Asset Management
• Allegro Funds