Against the backdrop of increased volatility in markets, uncertainties in macro fundamentals relating to potential trade wars and higher rates, we take the opportunity to discuss the risk management of our portfolios and articulate our views.

Based on our risk factor and scenario analysis, we expect that our portfolios will be shielded from these risks over the medium term, particularly given the strong growth dynamic in Asia, the increasing domestic consumption focus and improved sovereign credit quality in the region. Admittedly, the portfolio is not totally immune to a prolonged period of sluggishness in markets which may impede investment exits, but we believe this extension risk is tempered by our underwriting approach that looks for multiple exit options. We conclude that our Asian secured loan portfolios have little beta to these various headwinds, but nonetheless remain vigilant about possible market changes.

RISK FACTORS

As all our loans are backed by collateral, our risk analysis separately reviews the standalone credit quality of our borrowers and the collateral package. Currently, the key macro risk factors to our portfolio include currency and market volatility, interest rate rises, a fall in property prices, and reduced competitiveness of Asian goods arising from trade wars.

LOW BETA TO INTEREST RATE MOVEMENTS: Our deals are special situations that are priced in relation to the specific risks pertaining to individual businesses, while coupons are fixed rate and often we are the only lender involved. As such, the credit quality of our deals has limited correlation with public markets. Admittedly, the risks of a broad economic slow-down in the face of rapid rate hikes always exists; however, the market consensus terminal rate in this cycle does not cause undue concern. Furthermore, US Treasury 2Y-10Y spreads are quite flat, at ~50bps currently vs. 250bps in 2013), suggesting no market expectations of rapid rate rises in the near term. While rate rises do represent an opportunity cost to our portfolio given the fixed coupons in most of our deals, the realised tenors of our loans are generally only two years and often shorter, enabling us to take advantage of rate increases as they happen.

MODERATE EXPOSURE TO PROPERTY PRICES: Recent property price volatility peaked in emerging markets at approximately 24% in 2016 when there was concern of a global slowdown. During the global financial crisis, Hong Kong real estate prices fell by 25%. Other regional real estate prices are managed, and are not as volatile, given more limited hot money flows. In our view, a fall in real estate prices is unlikely to impact the standalone credit quality of our investments, as most involve property management backed by real cashflows rather than sale (eg. hotels). A permanent or long-lasting drop in property prices will ultimately impact only those portfolio companies that will need to sell off their non-core assets/properties to repay our debt – not very many in the current portfolio. Similarly, our collateral cover of typically over two times may be affected by a decline in property prices but is offset to some extent by the diversity in the collateral package, which includes shares and cash, besides property.

LIMITED INFLUENCE OF TRADE WARS IN THE NEAR TERM: The ongoing trade wars, and potential for these to spiral out of control, create an overall uncertainty in the region and in the sectors being targeted. We have limited exposure to the sectors under immediate threat, namely metals and tech products. In fact, our portfolio is substantially invested in sectors reliant on intra-Asian demand, or in services sectors, which is uncorrelated to the protectionist policies of the US, but worth watching closely for any future developments. Ultimately, the diversity of revenues both in terms of sectors and countries is a mitigating factor against this risk – for instance, our biggest country exposure across active portfolios is around 33% of AUM, while largest sector exposure is under 17%.

ABILITY TO WITHSTAND NEAR TERM CURRENCY AND MARKET VOLATILITY: In the past five years, Asia Emerging Market currency one-year volatility has been a maximum of 6% (except IDR around 14-16% in 2014). Most of our deals are denominated in USD, and the underlying companies have natural hedges via exports or cross border, revenue generating operations. Given these supportive factors, our calculations suggest that the portfolio can accommodate the level of FX volatility we have observed in prior years.

EQUITY MARKET CONDITIONS MAY NOT IMMEDIATELY INFLUENCE CREDIT QUALITY OF OUR PORTFOLIO: on the other hand, a drawn-out slump in the markets is admittedly negative for investment exits via Initial Public Offerings (IPOs).  Collateral packages have equity holdings and may also be affected by equity market sentiment. In that regard, diversity of options relating to investment exit, as well as the access to various types of collateral also helps greatly.

CONCLUSION
We prefer to be the sole/lead lender to our borrowing companies. Our self-sourcing, bottom-up investing strategy reduces correlation between individual investments in the portfolio to a certain extent. Our focus on downside protection via strong borrower relationships, cash flow monitoring and board seat positions, enable us to monitor positions at every step, help insulate portfolios from day to day macro risks and volatility, and take remedial actions on a timely basis. Ultimately, even if standalone credit quality is at some risk, we have strong and diversified collateral packages to fall back on. Indeed, even under a worst-case scenario, with currencies down 10-15%, equity markets down by 40%, and real estate prices down by ~30%, we have confidence that the dual protection enjoyed by our investments, in terms of their standalone credit quality as well as collateral cover, will protect the portfolio to a large extent.

Should you have any questions or require additional information, please contact admir@admcap.com