In today’s market marked by persistent inflation and rising interest rates, it is increasingly tough for investors to generate satisfactory yields on their long-term investments.
In the past year and a half, the US Federal Reserve Board lifted interest rates 11 times to combat inflation, taking the federal funds rate to a target range of 5.25%–5.5%, its highest since early 2001.
In such an environment, floating rate funding, particularly those in the realm of private credit, has grown to be highly appealing. A 2022 survey by the UBS Global Family Office states that in 2017, a mere 8% of investors took on private debt. Last year, the number grew to 27%.
The reasons for this growing popularity are multifold but can be most simply explained with the key advantage of private credit-generated returns scaling alongside interest rates — a quality that more mainstream returns such as bank deposits are unable to match, according to a private sector class report by Altheia Capital released April 10.
Other motivations include the higher yields offered by private credit funds, typically exceeding the two-year US treasury bond rate by 3% to 4%, as well as the benefits of diversification via an alternative asset class.
Correspondingly, private credit has witnessed remarkable growth in Asia. According to a 2023 Preqin survey, this asset class has experienced a nearly 30-fold increase from US$3.2 billion ($4.3 billion) in 2000 to over US$ 90 billion as at June 2022.
However, the growth of this asset class is not evenly distributed. Western markets continue to have a greater prevalence amongst private credit investors, as opposed to Asian markets which have continued to prove more elusive.
Li Yifei, managing director of private markets investment platform operator Alta, attributes the contrast to the different levels of maturity between both markets. “One key difference is Western markets such as the US and Europe are very mature private credit markets. They are more standardised with clearer regulations. Everything is set in one currency, either the US dollar or euro,” says Li, in an interview with The Edge Singapore.
On the other hand, Asia, as a whole, is a much more diverse investment universe, with markets and economies at varying stages of development, where multiple currencies are used and which react differently. The fragmented nature means it has become more difficult for investment teams to conduct effective due diligence as well as select the right targets to put money into, reasons Li.
Level of comfort
Although the lack of homogeneity and maturity in Asian markets can be quickly dismissed as unsuitable for private credit, the converse might actually be true, especially for investors looking to generate regular cashflow, says Li.
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In general, the risk-return profile of private credit is greater than that of peer asset classes and senior debt, but lower than that of equity and equity-linked investments. This middle-ground could prove beneficial to many investment profiles in Asia, due to its lower level of risk involved.
Furthermore, private credit encompasses various classes because they can be packaged differently to serve distinct financing needs and risk profiles. Senior secured loans, positioned at the lower end of the risk and return scale among private credit strategies, offer a relatively stable yield of 5%–10% and have to be paid off before other forms of debt financing in bankruptcy. In contrast, mezzanine strategies are subordinated debt, with most funds having a 10-year lock-up period. This class of financing ventures further up the risk and return scale, delivering higher yields of around 15% to compensate for heightened credit risk.
Meanwhile, speciality and alternative credit opportunities are investment opportunities that involve corporate events such as mergers, liquidations, litigation and demergers. They span the spectrum greatly, providing a yield from between 5% and 10% to 20% while distressed and opportunistic strategies focusing on firms facing substantial challenges feature amongst the greatest yields as compensation for the added risk.
Aside from the attractive variance in risk-return between different categories and the interest-resistant qualities of private credit, the asset class has also arrived at a time when traditional sources of funding have slipped into decline in recent years, Li adds.
Before the global financial crisis in 2008, major sources of funding were from public debt markets or banks. However, tighter regulations to bolster and safeguard the financial system after the crisis have raised the minimum issuance sizes for public debt markets, rendering the market beyond reach for many corporations.
According to data compiled by the World Bank, Asian small and medium enterprises, which represent 96% of all business enterprises in the region, face an estimated funding gap of US$5.2 trillion every year.
This gap in funding has allowed private credit to capitalise on the opportunity. According to a 2022 McKinsey global private markets review, this is an increasingly popular asset class. In 2013, the ratio of investment between bank lenders and non-bank lenders stood at 58% to 42% respectively, but had shifted to 11% and 89% by 2021.
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The step forward
Despite the significant growth already achieved, Li, for obvious reasons, is optimistic that the asset class will continue to grow in popularity in Asia due to current inflationary market conditions.
To help grow this market, Alta works with multiple private credit fund managers such as Lighthouse Canton and Hamilton Lane to allow investors pan-regional market access to a variety of different asset classes. Lighthouse Canton’s portfolio includes technology-based startups across Southeast Asia and India, while Hamilton Lane’s firm has completed five digital technology partnerships, three of which have been with firms in Southeast Asia since 2022.
Li expects the funding gap to provide more exciting opportunities and existing room to grow private credit as an asset class as well as a financing tool across the Asian region.
“There is clearly a need to increase your investment allocation to private markets. The traditional 60:40 fixed income to equity exposure does not work in current market conditions anymore. In fact, there are some large private banks out there encouraging clients to dedicate 40% of their portfolio into the private market,” she adds.
Besides the chance of squeezing out more returns, another advantage of this asset class is its ability to meet the different profiles of investors, says Li. “It’s in your power to negotiate your downside protection. If your risk appetite is already there, where maybe you have done some private equity or venture capital investment, then a higher risk investment can be quite an attractive journey. But if you want to put a baby step into private markets, why not start with a more conservative senior secured credit opportunity?”
