The relationship between debt providers and financial sponsors is a delicate one, especially in Asia, where the scarcity of leveraged buy-outs means each and every deal is the subject of intense scrutiny. While private equity sponsors have been responsible for so large a part of the institutional debt market in Europe and the US, the dynamic in Asia is very different. Rampant bank liquidity in the region has allowed most of the LBOs completed to date to be financed predominantly through senior loans, though market participants on both sides have high hopes that institutional investors will play an increasing role in financing future buy-outs across Asia. EuroWeek invited a cross-section of leading private equity sponsors, fund managers and leveraged finance bankers to share their views on the potential of the Asian LBO market, asking what the influx of fresh money means for debt providers.
|Jiffriy Chandra is executive director and chief investment officer at Income Partners Asset Management (HK) Ltd and is responsible for overseeing the daily investment and operational aspects of the firm's investment team and portfolios.||Tim Donahue is a managing director and co-head of syndicated leveraged finance for Asia at JP Morgan. He is also head of high yield and mezzanine capital markets for Asia and is based in Hong Kong.||Eric Mason is a managing director and co-head of leveraged finance for Asia Pacific at JP Morgan in Hong Kong.|
|Roy Kuan is a partner at private equity firm CVC Asia Pacific Ltd. He is responsible for the firm's activities in the Asia ex-Japan region.||Ricky Lau is a managing director at TPG Newbridge, the Asian arm of Texas Pacific Group, the US private equity firm, and is based in Hong Kong.||Sandeep Gupta is a director in special situations, Asia group at Citadel Investment Group, based in Hong Kong. He is responsible for looking at high yield and private financing opportunities across Asia.|
EuroWeek: While private equity firms such as CVC and Newbridge have a long history of investing in Asia, the number of financial sponsors targeting the region has risen sharply in the last couple of years. This has yet to really translate into a booming LBO market, but what do you think of the recent increase in competition and what do you see as the biggest obstacle to the development of the LBO market in Asia?
Lau: What has been driving the increased activity, in our minds, are the healthy returns that have been generated by private equity investments in Asia. We have seen a number of exits realised that have been very profitable, and this is attracting new players to look at investments in the region.
The primary obstacle, speaking perhaps with a bias towards China, is the shallow pool of management talent. It is difficult to find local talent, and this means we have to rely on international talent while grooming local talent at the same time. It's a key issue in many countries in Asia and especially in China.
When you're working on a major transaction it's often a question of finding a whole new team to manage a business, and this can complicate deals. At the end of the day the management team would have to execute to deliver the returns.
Kuan: We believe the increase in the number of private equity firms looking for business in Asia is inevitable, and our reaction to this increased competition is to work harder and to try to identify situations that are less competitive.
The biggest obstacle to the further development of the market is that many companies in Asia — excluding Australia — are still reluctant to divest subsidiaries or divisions of their businesses.
Given this recent increase in private equity activity in Asia, are debt investors concerned that downgrades of high grade debt issuers are likely to become increasingly commonplace as investors increase leverage on their targets.
Gupta: It is possible there will be some impact on credit, but I'm not convinced this will be as prevalent in Asia as it has been in the US or even in Australia. Many of the companies in Asia that could be considered potential targets for the buy-out firms are often government owned or family owned in Asia, and this will limit the number of downgrades.
There are some exceptions to this, but the sporadic level of activity in the LBO market means the impact will be less severe.
Chandra: I don't think the impact on credit will be as pronounced as in the US, for example. The debt markets here are driven more by corporates than by the financial sponsors, and the mergers of equals that often result in downgrades are far less common.
Lau: I think this market is still at an early stage, and there's really not enough data available to draw a full conclusion. Private equity firms need to work closely with debt providers to develop a full range of capital structures, but it will be a couple of years before we can make a call on whether credit ratings have changed.
EuroWeek: Which markets across Asia do you think are particularly suited to LBO opportunities? Where are the barriers to entry just too high?
Kuan: I would not say there are any barriers to entry in any of the Asian markets. Japan and Australia are particularly suited to buy-out opportunities, while several other markets are more challenging, such as China and South Korea.
Lau: I don't think there are barriers that make any market impossible, but some countries have been very receptive to private equity, such as Taiwan and Australia. We continue to hold high hopes for the growth of the business in Japan, India, China and much of South East Asia.
China, and to some extent India, are more difficult markets in the sense that most transactions do not involve a controlling stake. Very few owners are willing to part with a business given the potential for growth in those countries. We think Japan will be a big market, but equally it takes time to develop business there. So far perhaps the local groups have been more successful but we are very optimistic that the Japanese market will develop and we are very focused on building a business there.
In China the amount of leverage available has been limited because few transactions involve taking full control of a business. The structures that are available are harder for banks to get comfortable with, so the use of debt financing has been less than in other markets.
EuroWeek: Is the availability of debt financing one of the factors that is holding the LBO market back? If you could change any single aspect of the LBO financing market here, what would it be?
Kuan: The amount of debt financing available is fine. If I could change one thing it would be that the banks stop marketing to private equity firms on the basis of their debt capabilities, and instead show or create more deals and origination ideas. If there are no LBO deals, then there will be no leveraged finance opportunities — it's obvious, but almost no one seems to recognise this.
EuroWeek: So far, deal sizes in Asia remain far below those in Europe and the US. How important is it for the market to prove that multi-billion dollar deals are possible in Asia (and not just in Australia and Japan)?
Lau: It's important, but size is never the most important consideration. We wouldn't shy away from a deal just based on the size of the business and I think our bank investments across Asia are a good case in point. It's not only about size and leverage, although our access to the capital markets is very important. We are very focused on building operational value in the deals that we do. Sometimes, in a turnaround situation for instance, it's clear to see the value we can bring, but increasingly there is an emphasis on helping the companies that we work with at an operational level, and that is much more important to potential sellers.
Kuan: I do not think it is important to have multi-billion dollar deals in the market. It is much more important for the industry to do mid-size deals first and to do them well.
That is the way the business developed in Europe and the industry there has been very healthy because private equity firms have moved more steadily up the scale in terms of deal sizes. There is way too much infatuation in Asia on doing big deals rather than good ones.
EuroWeek: We're beginning to see the first signs of institutional investors playing a role in financing Asian LBOs, after a number of deals that have relied entirely on senior bank loans. To what extent do you expect the Asian LBO market to generate opportunities for institutional investors, as it has done in Europe and the US?
Chandra: It's definitely a growing area. The private equity firms that are coming to Asia have raised a lot of money and have a mandate that clearly includes the privatisation of public companies. To the extent that they would like to enhance their returns, there will be a strong demand for leverage loans.
Donahue: In general we expect the Asian market to follow more along the lines of the development of the European market as opposed to the US market particularly on the subordinated debt part of the capital structure.
Europe has only recently developed an institutional term loan 'B' market and has a very robust mezzanine market alongside its high yield market. Many sponsors are opting for mezzanine tranches as opposed to high yield in their buy-out capital structures in Europe. Even though the yield may be higher, when you factor in the weaker call protection, it is much cheaper on an all-in basis if the debt needs to be redeemed or refinanced in two to three years. Given how quickly companies are being sold or taken public after acquisition, the more flexible call structures that mezzanine debt provide are becoming more preferable.
On the senior side we are expecting an institutional loan market to develop in Asia over the next few years as CLOs begin to ramp up in the region. The biggest roadblock to date has been the extremely liquid local bank market in Asia and senior secured leverage levels from a senior debt multiple perspective that look high.
However, this is changing quickly. Institutional investors in the term loan 'B' style loans are beginning to show interest in this market with such deals as the Venetian Macau and the acquisition of Columbian Chemicals by DC Chemical from Korea.
Gupta: Institutional investors have played a part in supporting LBOs in Japan, Australia and to some extent Korea, but I don't think we'll see a great deal of activity in this space in other parts of Asia. This is predominantly down to a lack of LBO opportunities, but also the sponsors have tended to go to the senior bank market.
There may be some opportunities for funds such as ourselves that are able to play in the senior loan space but not everyone is able to do so. It also has to make sense on a risk and reward basis, and this has limited the appeal of some of the buy-out financings that have been completed in Asia.
EuroWeek: Do you agree that there are similarities between the European and Asian markets? Given the relative lack of dealflow in Asia, is competition in this market more intense?
Kuan: No, not really. I think competition for business in Asia is about equal with that in Europe.
Lau: Comparatively speaking, Asia is a much more complex environment. Each country has its own cultural and political characteristics, and they are at very different stages of development. Generally speaking you need to have a specialised team on the ground wherever you are doing business — in China you need to be able to do business in Chinese; southeast Asia has its own idiosyncrasies even though most deals are done in English; a lot of European and US experience can be migrated to Australia but you still need a team on the ground.
EuroWeek: The financing structures used on certain recent deals seem to suggest that debt structures here are coming more in line with the traditional European and US LBO financing models — CVC's recent investments in Plantation Timber Products in China and PBL Media in Australia might be good examples of this. Without giving away any deal specifics, do you think the use of more traditional LBO structures is a growing trend on Asian deals, and what are the advantages of this for a financial sponsor?
Lau: We believe European and US structures can be used in Asia and we are pressing very hard to develop this aspect of the market. We have helped to bring global norms to the Taiwanese market, for instance, in the deals that we have worked on. There are clearly local terms and conditions that we have to work with, but the market is moving in the right direction. We will definitely see more opportunities for institutional investors going forward.
Kuan: Debt financing has certainly become much more abundant in Asia, and the structures available have become much more creative. One development has been in the tenor of financing available, which is getting longer — before we were limited to a maximum of five years. Banks are also prepared to underwrite deals now, whereas a few years ago they insisted on syndicating the risk before the deal closed!
The use of several tiers of debt beyond straight senior loans has become much more prevalent in Asia, and this has helped tremendously. This includes amortising senior loans, bullet senior loans, subordinated or mezzanine debt as well as high yield. The ability to raise financing at a holding company level has also helped in certain markets, such as China.
EuroWeek: How important is the development of a subordinated/mezzanine debt market in Asia? What do you think has been holding this back outside of Japan and Australia?
Donahue: From an investor perspective, post-crisis, many of the key players were loath to take subordinated risk in Asian leveraged capital structures. Today, given the glut of global liquidity and the improving economic prospects across almost all of Asia, investors have recently been willing to buy securities further down the capital structure.
It began with distressed investors, then hedge funds and now most institutional investors in the region are looking to take more risk in search of seemingly elusive yield. The continued development of the Asian subordinated debt market is inevitable.
Globally there are more and more funds searching for high yield returns and, with the continued contraction of spreads in the US and Europe, many are naturally turning to Asia.
Gupta: In part this has been held back by a very liquid senior bank market, which has allowed sponsors to get funding for acquisitions at an attractive price. The lack of LBO opportunities is also a factor, as there have been very few situations where a subordinated tranche would make sense, and Asia's corporate high yield market is also only really a couple of years old.
There are also structural considerations that may be holding the market back — when you're talking about taking a subordinated position you need to be confident that there is a robust legal system in place that will allow you to enforce the rights and security you negotiate, and this could become a challenge in several jurisdictions in Asia.
I would not disagree that the market will grow. I think the use of subordinated structures will grow as the LBO market expands here, and this is a very healthy trend for overall liquidity in Asia, but it won't develop at the same pace we've seen in the US or Europe. Where I think opportunities might arise for such issuance is in the private financing area where we have seen a potential to develop much more tailored and unique structures that are beneficial for both issuers and the investors.
Chandra: I don't think there is any one factor that is preventing the development of a subordinated debt market, but it takes time. This is a relatively young market in Asia, although we're starting to see some activity on the investor side with an increasing number of funds — including ourselves — turning their attention to Asia.
The US and Europe tend to run ahead, but subordinated structures have been seen in Asia, starting with Japan but also in China and Indonesia. Deals here tend to have a long lead time compared to in the US, and there are some structural issues on cross-border deals, but it is an emerging trend that will continue to grow.
Mason: From the private equity perspective subordinated debt or mezzanine debt is perceived to be increasingly important for sponsors to achieve their return objectives, and a slug of high yield or mezzanine debt is needed to plug that gap in Asia.
Outside of Japan and Australia there have been a lot of deals and bids that have benefited from mezzanine structures of one sort or another. Many of these are private deals that don't attract a lot of attention.
Outside the sponsor world, mezzanine is a very important source of 'growth capital' especially in situations where there is no liquid bank market. As long as values remain high, the total leverage multiples needed to make some investments work will contribute to the continued importance of subordinated and mezzanine debt.
Lau: We are working very hard to develop a subordinated debt market, as are the other private equity firms that are active in Asia. It's an important piece in the capital structure, but there is a lot of liquidity in the region and it hasn't been the key priority so far. Right now our main aim is to gain operational insights into businesses that will give us a competitive edge in an acquisition process, but over time debt structures will become more important. We always want an optimal capital structure as this allows us to determine a competitive price for a business.
Mason: Frankly, when viewed broadly, we are not sure that this market is necessarily being held back outside of Japan and Australia. Indonesia, China, Malaysia, Taiwan and Singapore have all had some experience with mezzanine debt. But if there is one constraint it is probably that there are not yet many of the sizable deals seen in other markets.
EuroWeek: Banks compete for leveraged finance mandates not just on pricing but also on structure. How important is the structure of a leveraged deal? Given the intense competition in this space, have you noticed any loosening in deal structures in Asia?
Chandra: It's certainly true that we have seen a number of credits coming to the market in recent months that would struggle in a weaker market. And pricing may be reaching a point where investors are not fully compensated for the risk, but I don't think structures have been loosened necessarily. Some of the deals that are getting done now in fact come with better security packages than we typically see in emerging markets deals.
Mason: In an LBO in Asia, structuring a deal has a much higher degree of importance than in more mature markets such as the US. For one, we are often dealing with cross-broader transactions that include multiple levels of debt in the capital structure. Each country has its own unique characteristics that may affect, to name a few, financial assistance, security, tax and intercreditor agreements.
These issues are complicated in mature markets but when we are co-ordinating in a market like China or Indonesia that has never seen something like this it underscores the need to get the structure right. Only after getting the structure right can you effectively price the transaction.
Donahue: From an investor perspective, both bank and bond, everyone would like to see a tight structure and good pricing. As an underwriter, the art is striking the best balance between a structure that provides our clients with the necessary operational flexibility and one that is acceptable to senior and subordinated debt providers at a fair return.
Obviously, the client depends on us to know how to strike that balance of knowing what the right risk/return is acceptable to all parties. We think that providing a fully underwritten commitment is a great motivator of discipline in banks — there is only so far a bank can go to win a deal by cutting the structure — ultimately if you go too low you will end up owning the deal.
EuroWeek: What do you look for from a bookrunner on a leveraged deal? And should the lead managers bear some responsibility for a high yield deal that subsequently fails?
Gupta: We look to work with a bank that has the ability to structure the right deal, both in terms of pricing and covenant packages. A bookrunner should be able to demonstrate that there are adequate investor protection rights on a given deal, and we can see a clear difference between banks in this regard. We also look for a bank that we are confident will support a deal in the secondary market. It seems a simple task in a strong market, but the banks that stand out are prepared to commit to a trade even in weaker market conditions.
I don't think anyone can blame the bookrunner for a deal that fails. We all go into business with our eyes wide open and are well aware of the risks involved.
Chandra: Generally speaking we take comfort from a situation where our interests are aligned with those of a bookrunner. Particularly when you're looking at the private market, we like to work with a bank that is going to be in the same boat as us as an investor.
There have been few defaults in recent years, but everyone has to be careful, and in some cases the security that you can negotiate in a private deal can mitigate the impact of a default. The public bond market is mostly unsecured and covenants are looser, so in some ways a private deal is easier.
EuroWeek: What about the private equity firms? Competition between banks for leveraged finance mandates has probably never been more intense, especially given the enormous number of firms that are expanding their teams in Asia. What do you consider to be the most important criteria when you are selecting a bank?
Lau: Obviously we want a bank to be a long term partner. We want to build a relationship with someone who is going to be there when the good times turn to bad.
We also feel a local execution team is key. The banking and private equity markets are becoming more localised, and we would look to work with someone who can combine that local know-how with international experience.
We are fortunate, in that regard, that we work with a number of international institutions around the world, so we leverage off our international relationships at the same time as building local ones. Clearly a bank also needs to be competitive in pricing, but it's not the only element.
Kuan: Now that underwritten deals are possible, the reliability of the underwrite is very important. That, and the ability to tailor the debt to the cashflows of a business are the most important criteria for us.
EuroWeek: It is often said that the Asian high yield debt market relies on a small group of cornerstone investors. Given the number of non-investment grade issues in the market in recent months, is there a danger of oversupply?
Gupta: So far the supply has been getting absorbed pretty well. That may be a function of certain anchor investors demanding adequate covenants and adequate pricing to do a deal, but the market has been more than capable of soaking up the supply as it comes.
That said, we do have some concerns over the overall level of liquidity in the high yield sector. The secondary market is not deep enough, and we saw ample evidence of this in the sell-off in high yield assets in June. The investor base is growing but needs to be broader. So far the Asian high yield market has had to rely on private banks, hedge funds and some traditional funds, but there are very few dedicated high yield investors of the kind that play in the US and European markets.
There may be more hedge funds looking at Asian high yield today than there were this time last year, but there are still very few long-only funds and we still have concerns over liquidity should the market hit another rough patch. It means we have to be very selective in choosing our investments.
Chandra: On the contrary, there is a growing investor base for such deals. There are anchor investors whose role may have grown proportionally larger, and some of the large players are taking 10%, sometimes 20% of a deal. But the domestic players have also become more aware and the number of funds looking at Asia continues to grow.
Donahue: I would agree that the Asian market has historically relied on a handful of key investors that were needed to get any deal off the ground, with the rest of the market following their lead once they hear a deal is successful or done.
More recently, we have witnessed a marked increase in demand for our deals from the US and Europe, with an investor base comprised of mostly 'real money' accounts. For example, our recent deal for Greentown [a Chinese property developer that issued $400m of 9% bonds due 2011 in November], generated over $2.2bn in orders with over $70m in demand coming from each of the US and Europe.
This has clearly added stability to the market. Two years ago, any one of the Ocean Grand default, the Thai coup, the Amaranth failure or the North Korean missile test would have shut the market down.
We now have enough liquidity in the market where a hic-cup in not met with mass selling and the broker dealers being the only liquidity providers 30 points back. Now we see value investors pouncing on securities once they show a hint of irrational weakness.
Given the glut of liquidity on the buy-side, I think the continued development of the Asian high yield market is a healthy thing. More benchmarks will lead to more reasoned pricing and greater underwriter accountability.
EuroWeek: Recent leveraged loans, particularly from markets such as Indonesia, have been placed with institutional investors, and we understand some CDO funds have been building their exposure in this area of the market. How attractive are these private-style deals for you, and how does this compare to the more public bond markets?
Gupta: You give up liquidity to do a private deal, there is no doubt about that, and many of these deals are already done at the riskier end of the credit spectrum. But in general we find that we have a greater ability to structure a credit in a manner that gives better protection to investors, and on balance the risk and reward profile is often better.
Donahue: As a leader in the underwriting of leveraged loans and bonds we are thrilled with the increasing interest in Asia among many of the top institutional investors. Deals in Macau, Singapore, Korea and even Indonesia are starting to benefit from the participation of the non-bank investor in senior loans.
EuroWeek: We are enjoying something of a bull run in the Asian debt markets at the moment, with nuclear tests, military coups and ratings downgrades having little effect. How confident are you that this environment will continue? Is there any danger of another Asian crisis?
Gupta: I do not think we're heading for another Asian crisis, but spreads are certainly starting to look very tight. Macro indicators and economic trends across Asia have been very supportive, and the positive ratings trend for countries such as Indonesia and the Philippines has been supportive for credit spreads. But a lot of Asian issues are now trading at the tight end of their historic range, and we are slightly concerned that spreads may be unsustainable at their current levels. Overall, we see only limited pockets of value in the public credit markets, though structured private financings continue to provide a better risk-reward profile in our view.
A correction could be triggered by a range of external factors, and a negative surprise in the US economy would certainly have an impact. The liquidity situation in Asia is pretty benign, and I don't think default risk is likely to increase significantly over the next 12-18 months in Asia. Rates movements, oil prices and other external factors are much more likely to be the cause of a correction.
Lau: I would say we are cautiously optimistic. Things feel good now, and we don't see anything of a magnitude that could trigger another Asian crisis. But we are constantly monitoring the situation — any time you become complacent, you risk missing something that is right in front of you.
Kuan: We don't want to get too caught up in thinking about strong or weak markets. I think the key is to invest at a steady pace over time, selecting good deals on an individual basis and for their own merits.
Chandra: We do monitor the situation very carefully but at this stage our outlook is relatively healthy. Asia has gone through a decade of de-leveraging, while sovereign and macro indicators are very healthy. Indonesia and the Philippines, for instance, have reduced their costs of funding and the region's governments have improved as credits.
Corporate borrowers, now that this period of restructuring and consolidation is over, are in the process of expanding and raising money for additional capital expenditure. This increase in leverage is at a very early stage, and we don't think we're at a point in the cycle where a crisis is on the horizon.
There will always be external risks, and the US economy still has a big impact on Asian credit. We are in a period of high liquidity that is often followed by a credit event that will bring about a correction in the financial markets, so we're focused on selecting the right credits that will continue to generate good returns over a 12 or 24 month timespan. It's about using your experience to manage the risks.
Mason: We think most of the Asian economies are fundamentally stronger today than they were in the late 90s when the balance of payments situation in many countries was not strong enough to absorb the massive exchange rate volatility.
Donahue: We remain confident that the debt markets in Asia will continue to grow and deepen with more alternative forms of investment.
The key drivers remain a strong M&A market of which the financial sponsors should make up a growing percentage in key markets in Asia as well as the need for growth capital in markets like India, Indonesia and China.
Clearly, interest rate markets and macroeconomic trends may experience volatility enroute, but we still believe that over the medium to long terms debt markets — syndicated loans, high yield bonds and mezzanine — will likely continue the expansion exhibited over the last several years.