2023 is the Year of the Rabbit, an animal known for its adaptability, peace and prosperity in Chinese culture.
In the last few years, public markets have been roiled by volatility and uncertainty relating to Covid-19, the Russia-Ukraine conflict, a China property crisis and rising interest rates. In the face of such macro volatility, private credit in Asia is certainly proving adaptable, given the ability to be selective in credit identification and flexible in the pursuit of downside protection, benefiting both lenders and borrowers.
Prospects for Investment Performance
In January 2022, we highlighted investment risks arising from travel restrictions and other Covid-19 related issues, further exaggerated by politics and rising interest rates. Through the year, ADM Capital’s flexible underwriting approach, combined with a regional capability across developed and emerging markets, ensured our portfolios were well diversified across both sector and geography, delivering attractive return on risk.
We continue to finance medium-sized borrowers (“SMEs”) that remain underserved and misunderstood by local banks, sustainably supporting the unprecedented urbanisation across Asia and the development of smart cities. Over the last twelve months, our funds invested in sectors such as education-technology (Ed-tech) in India, climate-smart infrastructure such as data centres in China, agricultural/ carbon capture projects in Australia and affordable modular housing units manufactured in Vietnam to supply the New Zealand market. Borrowers used proceeds for a variety of purposes, including project completion, general growth purposes, acquisition funding and refinancing.
As such, our funds benefited from the variety added by these loans across sectors, countries, collateral profile and use of funds, limiting correlation risks within portfolios and with other major asset classes.
We believe that our lending can foster better outcomes for our portfolios and borrowers via comprehensive yet materiality focused ESG due diligence, risk identification and the introduction of ESG action plans. A unifying theme across all investments last year was the attempt to add incremental ESG value – reducing negative impact, aligning with UN Sustainable Development Goals, or actively investing in climate smart solutions.
We were able to deploy ~USD618m across 14 loans (including USD85m in LP co-investments), and, amidst a challenging operating environment for many portfolio companies, realise value by fully exiting USD300m of our commitments across 8 loans at a weighted average gross IRR of 15.9% and weighted average holding period of 36 months.
During 2022, ADM Capital also exit the ADM Asia Secured Lending Facility (ASLF I) fund, a 2012 vintage that disbursed USD247m across 27 loans in seven countries, eleven sectors and five ‘lending strategies’, delivering a net return of 10.4% to investors.
The year saw fixed income assets struggle with the ICE-BAML Asia IG index generating a return of -11% and the ICE-BAML Asia Dollar HY index delivering a return of -22%, the worst performing year since 1997. In difficult market conditions, HY Asia issuance was USD13bn in 2022, down 87% from heights of USD102bn in 2019. Indexes are heavily concentrated toward China and the real estate sector, with performance influenced by domestic macro policies and broader market forces. In contract, ADM Capital’s private credit funds continued to grow and provide access to a diversified, highly selective pool of borrowers with success attributed to micro factors.
Looking ahead to 2023, steadiness and predictability will be valued in the face of continued macro uncertainty and related volatility. ADM Capital’s secured financings are structured to provide income, limit downside and, where possible, achieve equity upside. We will continue to pursue higher quality credit and downside protection in these challenging times, and are excited by the following pipeline themes:
- Positive Macro Story: In the context of the positive economic growth in emerging and frontier markets, Asia needs to bolster services and infrastructure to serve its growing population. Asia currently accounts for 35% of world GDP and is expected to grow to 50% by 2030, with Asian SMEs accounting for 30-40% of this output. For a market like this with assured growth, debt financing is more efficient than equity. For an economy that is fueled by SMEs, private markets are a lower cost, lower execution risk, higher flexibility and quicker access route to capital, especially for smaller companies that have not yet scaled operations and find it difficult to access traditional funding channels. We believe that private capital can be an effective bridging solution to companies before they go public and over 60% of the deals we financed in 2022 were to support such companies in their growth aspirations.
- Intra-Asia Connectivity: Asia is a diverse region consisting of developed, emerging and frontier markets with varying banking sector sophistication and capital market maturity. As powerful Asia-for-Asia trade and investment networks form, the region becomes more resilient in the face of any global volatility. In recent years, Asia’s developed markets have provided capital, technology and personnel to neighbours as the region becomes increasingly connected. For example, the Indian stock market performance has been buoyed by investments from Singapore and Japan, which have been two of the top five FDI contributors in India between FY2000 – FY2022. As this trend accelerates, liquidity and funding diversity in the region has expanded, contributing to an improvement in the credit quality of borrowers. Similarly, companies in Asia are investing outside their home countries but within the region, adding ballast to our cross-border strategies and the demand for alternative credit. For example, we financed a Vietnamese modular housing construction company to set up affordable housing in New Zealand, a Malaysian engineering services business to expand services across Asia, and a global utilities consulting company to finance green projects in India.
- Robust Downside Protection Irrespective of Competition: Given the strength and depth of ADM Capital’s proprietary sourcing networks and the extensive filtering of pipeline opportunities, underwriting standards for the middle market segment have remained strict and conservative irrespective of the cycle, ensuring sufficient over-collateralisation and alignment of interest. Governance remains strong. Of the deals financed in 2022, ~80% had board seats and personal guarantees. All deals were structured with multiple exit options and highly restrictive covenants, augmented in some cases by the inclusion of amortising/variable interest rate features that we began considering last year as interest rates began to rise.
- Short Durations Facilitate a More Vibrant Portfolio: In a rising interest rate environment, our investments are exposed to limited duration risk that typically inhibits longer dated bond strategies. Last year, maturities on our exited deals averaged 34 months in tenor. Shorter tenors or prepayments keep our portfolios fresh and allow us to capitalise on opportunities of the moment, where we believe there is optimal risk-adjusted return. For instance, using our liquidity to invest in what we believe are trends for the future, from funding agricultural efficiency and carbon capture projects to provision of quality services including education and healthcare. The introduction of default interest, extension fees and enhanced collateral helps to compensate for unforeseen duration increase.
- Importance of the Micro: Credit discrimination, fundamental research and individual borrower selection are critical as a receding tide exposes weaker companies. ADM Capital works with promoters and companies to understand their unique, idiosyncratic situation, proposing highly structured credit solutions that solve their financing need. We layer top-down sector targeting with forensic bottom-up research and target inspired, driven and experienced management teams that have clear strategies and authentic ideas. For example, in September 2022, ADM Capital invested in a promoter who sought to introduce more scientific and regenerative agricultural practices to Western Australia, repositioning a farm asset into a carbon sequestration project under the Human Induced Regeneration (HIR) methodology, while continuing to operate the cattle business to generate synergies. As an essential capital provider, ADM Capital maintains a high-touch relationship with borrowers and enjoys board visibility/ representation. This allows us to work with companies to offer growth guidance or remediate any deviation in performance before it is too late, effectively preserving capital and maximising value. This approach proved effective throughout Covid-19 when we actively worked with management teams to manage costs and develop conservative business plans.
- ESG Integrated Strategies: In a world where land, economies and communities are increasingly vulnerable to climate change, Asia Pacific needs to urgently accelerate decarbonization, equitably enabling its projected economic growth. Private credit strategies allow investors to effect change in companies through the introduction of relevant ESG practices. We view Environmental, Social and Governance (“ESG”) integration as part of our fiduciary duty and believe integration can mitigate potential environmental and social risks that would otherwise reduce an investee company’s financial viability and bankability.
In addition to targeting investments in socially and environmentally impactful sectors, we work with third-party providers to build an action plan for each transaction that identifies key E&S risk factors and guides sustainability mitigation or enhancement based on IFC Performance Standards. The plan is broken down into identifiable and measurable timebound and budgeted actions and included in our loan documents. Our investee companies agree to implement various projects to deliver incremental ESG value such as including the setup of better-defined E&S Management Systems, hiring senior resources to coordinate ESG action, building real estate to LEED building standards, carbon sequestration projects and social improvements, to name but a few.
Ultimately, we capitalised on the opportunity presented by the markets to arrange more flexible and quicker access to capital solutions to smaller companies who were eager to capitalise on immediate opportunities.
The current pipeline reinforces the above structural trends and is ~USD2bn, confidently exceeding pre-covid levels. The geographic blend includes opportunities across core markets of Australia, China, India, and Southeast Asia, together with the more opportunistic frontier markets of South Asia and developed markets of North Asia. Sector wise, we expect to see demand across climate smart infrastructure, service companies, digitally disruptive businesses, and those bouncing back from Covid-19 related slowdowns, hospitality and travel/tourism.
Our intentional focus on this private credit niche we believe enables a more consistent return with less volatility and hopefully, given continuing uncertainty in the current macro environment, prosperity in the Year of the Rabbit.