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Key trends driving private credit emerging markets: a look-ahead to 2025

At SuperReturn Emerging Markets 2019, our expert panel discussed the future of private credit in emerging markets, which is predicted to be 5-10 times bigger by 2025. Gabriella Kindert, Expert in Alternative Lending and Board Member at Mizuho Europe, outlines the key drivers of these positive expectations and developments in the asset class.

In 2018, approximately USD 10bn capital has been raised with the focus on Emerging Market (EM) strategies of over 50 funds, up from 14 a decade ago (The Economist, 2019; EMPEA, 2019).

Though the volume more than tripled from 2011, this combined EM LP commitment is still less than 10% of the commitment to developed markets. In developed markets, the search for yield continues and it is increasingly difficult for managers to find lending opportunities that are yielding the promised high return. Credit supply is running ahead of demand in buy-out funds, with over USD 300B raised by funds to be invested.

1) Favorable deal supply and infrastructure support in EM

In EMs, access to financing remains challenging. Approximately 70% of SMEs lack access to credit and have identified this lack of access to finance as a major constraint to their growth (The World Bank, 2019). After the financial crisis, many Western banks left and concentrated their activities in restricted clientele, products, and regions. This presents many opportunities and favorable market dynamics to development finance institutions (DFIs) and Alternative providers:

  • There is increasing transparency on performance of GPs already active in the region.
  • Often, structures have lower leverage and superior covenant package. According to a recent EMPEA survey, the total leverage measured by Debt/EBITDA of the investee companies is 2X-4X Ems versu 6X in developed markets (EMPEA, 2019).
  • Further covenant packages are more extensive, with significant focus on flexibility in pricing to reflect the underlying risks.
  • Though there are still many challenges as it pertains to managing currency risks, volatility, economic stability, corruption, EMs showed a strong improvement in creditors’ right and execution of certain clauses such as put option, which is favorable to the development of private credit markets.

From the perspective of borrowers, owners often prefer to finance their growth via credit instead of equity because they don’t want their equity exposure diluted.

2) Private credit has become a mainstream asset class as search for yield continues

Private credit globally became mainstream in the asset allocation of institutional investors. The low interest rate environment nudging institutional investors to search for yield.

Key investor considerations are:

  • Favorable yield coupon and regular interest distribution
  • Downside protection
  • Low volatility and less correlation with public markets
  • Portfolio diversification
  • Often floating rate, thereby natural inflation hedge

Similar rationale exists for investing in private credit in EMs, though the approach and risk mitigation techniques should take into account the underlying complexity and additional risks (currency, legal system) and opportunities (possibilities for impact creation and respecting SDG). Regions have different dynamics.

As the asset class becomes increasingly established in developed economies, it will be very natural to apply the product in other geographical contexts. Convergence to trends in developed markets will be further prevailing.

3) Credit is the best product for addressing the uncertainties

In EMs, there are several risks that can be better mitigated by a debt product rather than equity.

Key risks   How private credit is addressing / could address
Lack of ability to predict and commit long term
  • Focus on cash interest (coupon)
  • Focus on amortizing loans instead of bullet
  • Shorter duration (WAL)
Country risk
  • Shorter duration than Private Equity
Credit risk
  • Full-fledged covenants
  • Ability to take control and ensure protection
  • Protactive structuring features (Experienced credit teams are able to create structures that minimise credit risk i.e. setting up offshore SPVs to collect interest payments or hold share pledges, or making sure the loans are done under English law)
Exit uncertainty
  • Amortizing loan
  • Refinancing via bank market or alternative liquidity at lower leverage level than at deal closing (self-liquidating over tenor)
  • Potential focus on short-term credit solutions (factoring, WC)
Alignment of interest
  • Exposure to companies with strong alignment with local shareholders who prefer not to give up their equity (yet)

If something iniquitous happens with the underlying borrower, managers have the ability to ensure sufficient downside protection. They can exercise more control via a put option linked to milestones,  for example, Debt/EBITDA, min EBITDA, min Sales trigger, and obtain/increase equity participation in the business, assuming that the debt is appropriately structured.

4) Exposure to companies with sustainable development goals (SDGs), impact investment agenda

Impact investments and ESG considerations are becoming increasingly required in the asset allocation of LPs. It is not easy to gain diversified exposure in public markets. Though the green bond market has become mainstream and is booming, other non-green offerings are limited both in size and variety. Private markets offer a broad investment universe to companies wanting to fulfill SDGs.

FIs and Independent GPs are increasingly using frameworks to measure the consistent impact in the context of SDG goals (job creation, contribution to sustainable economic development).

With regard to Alternative Lending providers, there are several developments I see emerging with different risk-adjusted return parameters:

  • Independent GP/manager with different deal sourcing strategies (own sourcing strategy or in syndication with DFIs), e.g., Cordiant Capital, Bain Capital Credit, Vantage Capital.
  • Partnership between DFI and LP (investor) often with downside protection via Preferred creditor status of DFIs, e.g., FMO with several institutions and IFC with AGI.
  • Partnership with Big Tech/Fintech companies and other stakeholders for solutions via digital lending platform, e.g., Victory Park Capital.

These offer various focuses related to purpose, downside risk protection, and tenor of financing ranging from short to longer terms.

In terms of  launching a successful EM Private Debt GP strategy, here are my suggestion:

Diversification
  • Ensure sufficient diversification in the fund (country risk, value chain and industry exposure) to ensure negative impact of defaults. Ideally, I would suggest a fund of at least 50 investments in 5 -10 different countries.
Simplicity /Quality
  • Reduce complexity in the structure. Focus on hard currency lending. Ensure clear governance with strong alignment of interest.
  • Reduce complexity in fund management structure. Reduce risk of captive set-up and duplication of roles in investment process.
  • Ensure all suppliers (valuation, trustee, admin) are best-in-class.
Risk Protection with Return Assurance
  • Shorten tenor and focus on amortizing loans.  Ensure all possible downside risk protection (covenants, security) but,
  • Also facilitate the ability to take some equity, especially if things go wrong via warrants. Ensure audit trace of investment process.
  • Pre-agree on stress testing measures and framework of the portfolio.
Alignment
  • Seek alignment of interest in all stages with partners. Not only with the owners via equity buffer or profit share, but also with lenders and potentially with other stakeholders (government and other fiscal policy-makers).
  • Limit risk of correction (oversight, reputation check of stakeholders in value chain).
Commercial Feasibility
  • Ensure you launch a scalable strategy with sustainable long-term setup of the GP/Investment management team.
  • Ensure alignment of interest between GP and LP and clear, transparent risk metrics and reporting requirements.
Transparent Impact Measures
  • Measure and report on consistent practices in line with best practices developed by leading institutions.
  • Monitoring of companies should include ESG tools. Ensure active engagement with portfolio companies to improve SDG impact while respecting means.

To conclude, the demand for return-seeking strategies aligned with SDG goals is increasing. If we want to address this and the other challenging global issues we face, then exposure to private markets solutions in Emerging Markets seems inevitable. In this context, private credit offers excellent downside protection measures to protect investors with reduced exit risk and credit risk.

When looking onward and upward to 2025, which is more meaningful: to contribute to SDG goals and still obtain high return in Emerging Markets OR to push excess liquidity to buy-out firms that often put 6-7 times leverage on Western companies to obtain the desired return?

Though answer may be obvious, there are seem to be many other LP considerations and debates will continue.

Sources:

Private Credit Solutions: A closer look at the opportunity in emerging markets. 2019. https://www.empea.org/app/uploads/2019/05/EMPEA-PrivateCreditReport_2019_WEB.pdf

Buy-out forms are the new banks in emerging markets. Loan away from home. The Economist. 27 June 2019.