Attractive macro fundamentals and underserved borrowers underpin Southeast Asia’s private credit proposition. But navigating the fragmented landscape is far from straightforward

Private credit investors baulk at the notion that rising interest in Southeast Asia is merely a diversification play. They want to catch tailwinds created by strong macro fundamentals and relative geopolitical stability, and support exciting corporate transition stories that often get overlooked by traditional lenders.

Southeast Asia’s basic appeal is rooted in its scale – a population of 690m, nominal GDP of USD 3.6trn in 2022 – and growth prospects tied to young, upwardly mobile consumers and regional trade flows. It is a notable beneficiary of supply chain diversification intended to ease reliance on China, with more companies investing in production facilities in the region.

Private credit allocations to Southeast Asia by global GPs stood at USD 65.4bn in June 2022, up from USD 43.1bn in 2020, according to Preqin. This represents a tiny portion of worldwide activity, but some investors still see a compelling opportunity.

Andrew Tan, head of Asia Pacific private debt at Muzinich & Co, identifies two principal drivers. Some investors have included Southeast Asia’s emerging markets in their mandates because of the potential macro upside. Others are looking for alternatives to China, and Southeast Asia is “an easy story to tell” given its young population and rising middle class.

However, for an asset class heavily reliant on local execution capabilities, it is unwise to consider the region as a single market. Southeast Asia is highly fragmented – with Singapore at one of the spectrum and the likes of Cambodia and Laos at the other – so investors must assess each geography on its own merit when sourcing lending opportunities.

“You have one developed market and the rest are developing at various stages, so keeping that in mind, you have very different dynamics at play, including different bank regulations and different levels of adoption of Basel III standards,” Tan said, emphasising the importance of scrutinising the policy environments and political stability of individual jurisdictions.

Different strokes

Private credit began to take shape in the aftermath of the Asian financial crisis when investors supported bailouts of distressed companies and fulfilled the lender-of-last-resort role in place of banks unwilling to take on excessive risk. The subsequent evolution has been significant.

Domestic capital markets have become more stable and sophisticated, while local bank lending has flourished. The opportunity set has moved from special situations to providing financing support to performing credits that need bespoke structures and solutions.

“How we think about private credit is to be a flexible provider of capital solutions that complements bank lending. Banks are good at providing working capital or lending against fixed assets, but anything outside of standardised policies is often not a fit for banks,” said S.J. Lim, KKR’s head of Southeast Asia and India credit.

“If companies need to stretch leverage, if they need support for business transition, or an entrepreneur needs partnership capital to scale and grow the business, that’s where private credit players are relevant.”

Local nuance strongly influences engagement. In Vietnam, banks face “limitations around the types of businesses they can fund,” especially small-scale operators, said Muzinich’s Tan. In these situations, private credit can step up – provided they are familiar with the local legal system and the challenges around enforcement.

He added that the scope for private credit in Indonesia might be curtailed by the country’s reliance on commodities. Some of the biggest borrowers operate in this space, and following a spurt in debt issuance in recent years, they are less inclined to lever up further through relatively expensive private credit products.

Opportunities in Malaysia could be constrained by liquid local bank markets and tight capital controls, while Thailand is a small-scale private credit play where investors back businesses that are unable to turn to banks, Tan explained.

Sabita Prakash, a managing director and chair of the investment advisory committee at ADM Capital, observed that opportunities in different markets change year to year. Thailand is core to the firm’s USD 2bn private credit programme, but it has also enjoyed strong years in the Philippines, and recently it has tracked growth in Indonesia, Malaysia, and Vietnam.

“There are some projects we have recently invested in and others we are considering in Malaysia and Vietnam, both with a cross-border element,” said Prakash.

ADM Capital describes its sweet spot as underwriting loans of USD 20m to USD 100m, a pocket usually avoided by traditional bank lenders. It is positive on Indonesia and Vietnam, citing growth driven by post-election stability in the former and a tourism resurgence in the latter.

Education, healthcare, consumer and retail, and warehousing and logistics feature among the areas favoured by private credit investors in Southeast Asia. ADM Capital is particularly interested in supporting the development of smart cities, or urban centres where robust infrastructure, technology, and sustainability go hand in hand.

“When we talk about smart cities, we refer to anything that makes cities smarter spanning sustainable infrastructure, education, financial inclusion, healthcare, entertainment, and food and beverage or deals with circularity,” said Prakash.

Structural innovation

While some industry participants insist that having boots on the ground is essential to identifying opportunities and conducting due diligence, others believe that strong partnerships with domestic advisors suffice. The outsourced approach reduces pressure to generate deal flow in unproven markets, but it requires geographic agility from centrally located teams.

In addition to private credit opportunities around M&A, KKR’s Lim highlighted situations where companies want to stay private for longer and draw on third-party value creation capabilities – as well as third-party capital – to support growth. Investors can also play a role in rebalancing shareholding structures for the family-controlled enterprises that dominate Southeast Asia.

Muzinich’s Tan added: “You must have a solutioning mindset and unravel things from a deal standpoint. As a private credit practitioner in Southeast Asia, that’s where you get your alpha or premium – not from being a run-of-the-mill direct lender but picking situations that require more structuring or are more complex.”

Depending on risk appetite and deal structure, private credit investors expect returns of 12%-18% in Southeast Asia. However, aggressive deal making shouldn’t come at the expense of strong covenants and downside protection that help address the region’s hit-and-miss legal frameworks and less sophisticated bankruptcy regimes.

“You need to try and find the right alignment with the counterparty, build in appropriate monitoring and intervention mechanisms – whether it’s on covenants or shareholder agreements – and keep a close eye and local pulse on jurisdictional risk,” said KKR’s Lim.

“Downside protections vary by deal, but you must always think about the capital preservation theses and how you can avoid value destruction in your deal structuring.”

According to a Singapore-based lawyer who focuses on private credit, most deals in Asia feature tight structures, including covenants and security that are a bit more lender-friendly. With Asian corporates being less levered than their counterparts in Europe and the US, it amounts to a risk-return proposition palatable to many investors.

“LPs need to be aware that idiosyncratic risks here are quite high, unlike investing in Europe or the US, both of which are relatively homogenous markets,” added ADM Capital’s Prakash.

“Building relationships also matters a lot more in Asia. Even though markets are becoming more professional, and the bankruptcy processes are improving, those strong on the ground relationships yield mutual understanding and help in getting your money back.”