Market Views: Where distress may arise in Asia
Distressed debt opportunities are expected to emerge in Asia and beyond as Covid-19 lockdowns push companies into financial difficulty, sparking potential opportunities for asset managers with financing and restructuring expertise.
Oaktree Capital Management, for example, is reportedly looking to raise $15 billion for what would the world's biggest ever distressed fund.
Moreover, a growing number of asset managers – such as Canyon Partners, Cerberus Capital, KKR and MBK Partners – have been setting up or expanding teams in Asia in recent years with a focus on such strategies. Is now the time for such players to make their mark?
Major Asian economies like China and South Korea may be emerging from the pandemic earlier than their counterparts in the West, but the economic impact is still expected to be deep and lingering given their reliance on Europe and the US as export markets.
Six investment professionals shared their thoughts on the outlook for distressed investing and what opportunities may arise in Asia.
The following extracts have been edited for brevity and clarity.
Chris Botsford, co-founder
An increase in distressed situations is certain, and we see a clear and compelling opportunity to capture this within the private lending space. Small and medium-sized enterprises will be disproportionately affected by the crisis, and our strategy is to target performing or stressed companies, typically working alongside borrowers if they remain engaged and willing to facilitate repayment.
Insolvency processes in parts of Asia are less clear than in the US or European markets, and investors should consider the efforts required to pursue workouts in emerging markets.
The financial impact of the Covid-19 situation remains unclear with highly varied government responses across the Asia Pacific region. The wide economic disparity of Asia’s economies and societies will likely drive different outcomes, producing a varied opportunity set once the crisis abates. As well as compelling distress, there will be opportunities for growth as market leaders seek industry consolidation.
Given the importance of mid-market corporates to the region’s economies and an increasing awareness of private credit financing among borrowers, we expect the alternative lending industry will continue to grow in size and sophistication in the coming years.
Jamie Tadelis, head of Americas
Allocations to stressed distressed assets will increase over the next year or so as the next phases of poor corporate earnings, credit rating downgrades, defaults, restructurings and bankruptcy filings pick up the pace.
Asia has proven to be more resilient than the US and Europe during the March pandemic selloff across fixed income, as developed economies get thrust into recessions or even a depression, but Asia economies and corporates will suffer as well.
Although April has seen a strong recovery that pared much of March’s losses, corporate earnings will be poor and perhaps worse than expectations. This will likely trigger further rating downgrades, forced selling and, ultimately, restructurings and bankruptcy filings. Such developments will provide the opportunity to seek out fallen angels across the stressed and distressed Asian corporate landscape.
The biggest challenge will be filtering opportunities to determine which provide the best upside potential – i.e. the fallen angels – and which truly deserve to be where they are. The balance of your review needs to include knowing local enforcement rights and procedures, knowing the equity holders/sponsors well, and how they have dealt with creditors in the past, and understanding whether the company has a “need to exist”, either politically or economically, in its home region.
Rahul Kotwal, founder and managing partner
Credit investors have been waiting for a catalyst for the next distressed cycle. While no one anticipated a global health emergency like the Covid-19 pandemic to set it off, the opportunity set it is creating bears similarities to previous cycles. In Asia, a host of opportunities are coming to the fore.
The secondary market is more accessible in the current climate, as travel restrictions make it more challenging to conduct due diligence for primary deals. As social distancing measures start to ease, however, we expect the situation to evolve, with a large need for distressed and special situation financings in the region.
Asset owners continue to increase allocations to distressed and special situation strategies in this environment, especially in Asia, as they seek non-correlated, higher-yielding investments.
Asian corporates are relatively under-leveraged and tend to have collateral to back their debt. In addition, the financing structures in the region tend to be tighter than those in the US, with shorter tenors. This provides investors with better diversification and risk-adjusted returns compared to similar private debt strategies in developed markets.
The US cycle is being distorted by monetary easing, and the trajectory out of the Covid-19 shutdown remains uncertain. This is likely to extend the distressed investment period. Recovery rates on existing debt will likely be lower than in previous cycles, given the higher corporate leverage levels and weaker deal structures going into the pandemic. Investors will need to price that risk accordingly.
Sheldon Chan, associate portfolio manager, Asian credit bond strategy
T. Rowe Price
The sell-off in Asia US dollar credit markets has led to massive dispersion in credit spreads. Roughly half of the Asia high yield sector is trading at stressed or distressed levels. While some issuers will default on their debt, we believe most will be able survive the recession, meaning current valuations offer attractive opportunities.
In particular, while the US high yield default cycle will be heavily influenced by energy and commodity defaults, the Asia high yield market has limited weight in energy issuers.
Combining active management strategies with strong bottom-up fundamental research is key to identifying the credits with the best chance of survival and picking bonds that are mispriced.
Having said that, there are still some pitfalls for investors getting into default and recovery situations, especially as bankruptcy regimes remain less developed compared to those in the US. Historical recoveries in emerging and Asia markets have a wide range of outcomes and often tend to be long drawn-out processes.
Shawn Khazzam, head of Asia alternative solutions group
JP Morgan Asset Management
Investors have been looking for shorter-duration assets in high-quality companies that are trading at significant discounts due to the Covid-19-induced sudden economic stops, or deeply discounted credits with strong asset or cash flow characteristics that have been overlooked by the markets.
In respect of the strategies that form a diversified alternatives portfolio over the long term, distressed credit generally plays the role of enhancing portfolio return.
The significant Covid-19-induced dislocation has put even more focus on these investment opportunities, and we have strong near-term conviction in core private credit, convertible lending and distressed investing. We are seeing many asset owners and allocators either already sharing our view or starting to follow this segment closely.
Elisabeth Colleran, emerging market debt portfolio manager
I am marginally more positive on Asia relative to developed markets. In general, companies in Asia and in broader emerging markets borrow for more productive reasons. In the US, a lot of financial engineering determines capital structure. So the starting point is different, and that is important for recovery.
On the other hand, we tend to see more opaque inter-company transactions in Asia, which can make traditional recovery analysis difficult. The key is what kind of certainty can you put around a situation. A distressed investor needs to realistically assess: what do I know about this industry, the company, its management and willingness to pay?
Institutional investors looking at this space need to have boots on the ground. It is so important to have a close view of the key relationships impacting a credit, including the owner, customers, suppliers, regulators and – critical to distressed names – the relationship banks.
I believe we will see increasing interest in the distressed space in Asia as we start to see more clarity on the reopening from the lockdown. Some sectors and firms have been unreasonably punished by this market, and investors with a longer-term view will be attracted by potential high returns.