Greater China-focused private debt funds are outperforming their developed market peers, and fund managers say demand for the strategy is rising
Greater China-focused private debt funds are outperforming their developed market peers, and fund managers say demand for the strategy is rising
International money managers are increasingly warming up to the opportunity in Greater China-focused private debt, which includes direct lending, mezzanine financing, distressed, and special situations strategies. Diversification is a big driver behind the rising demand for private debt in China, but so is performance. As Fig. 1 shows, Greater China-focused private debt funds of vintages 2012-2017 have produced a net IRR of 11.0%, beating their peers in North America (8.2%) and Europe (7.8%). Private debt funds focused on Asia as a whole generated a net IRR of 10.0%.
We spoke with Francis Ho, Managing Director of CDH Investments and Founding Partner of CDH Mezzanine & Credit, and Selina Zheng, President of distressed assets specialist DCL Investments, about the dynamic private debt landscape in China.
What notable developments have you seen in the Greater China private debt/special situations market in recent years?
Francis Ho: First, investment strategies have expanded from being primarily real estate centric, and now include mezzanine financing, direct lending, non-performing loans (NPLs), and venture debt, etc. Accordingly, there is a wider variety of private debt funds available now than before. Second, an increasing number of first-tier GPs have entered the private debt market, CDH, CPE, and Hillhouse, to name a few. Some were much earlier than the others – the CDH Mezzanine & Credit Team launched its first China-focused private credit fund back in 2011, and as of today, we’ve closed six mezzanine funds with total asset under management (AUM) of $1.8bn, including one that invests specifically in data centers.
Selina Zheng: More sellers are seeking to dispose of distressed credit assets as a result of the COVID-19 pandemic, so the types of distressed assets and products have gradually become diversified. We believe that the next few years will continue to be a good window for non-performing asset investments. First, the NPL ratio of commercial banks has continued to reach new highs over the past 10 years, and banks face regulatory pressure to step up efforts to write off NPLs. Second, the number and size of projects financed by China’s trust industry that are deemed to carry a degree of risk has hit a new high in recent years. Trust funds are more actively seeking external partners for the restructuring or direct transfer of risky projects, many of which involve high-quality assets. Finally, the slowdown in economic growth has led to a deterioration in the overall credit environment, and a large number of private enterprises are unable to repay their own debts due to liquidity issues. In 2020, in response to the pandemic, a series of short-term hedging policies were introduced at the supervisory level, and default risks were delayed. We believe that the supply of distressed assets will continue to show up and increase in the next few quarters.
Where do you see the best opportunities for private debt in China right now?
Francis Ho: We believe the best opportunities for private debt in China lie in those defensive industries with strong growth, hard assets, and good cash flow. Real estate, which is characterized by large-scale, stable returns and measurable risk, is generally an area that attracts the most interest from institutional investors. NPL investments are also a good sub-strategy to defend against the broader economic downturn, and NPL investing is favored by many investors. In terms of sectors, we believe that industrial data center assets could be a good opportunity for at least 3-5 years under China’s promotion of new infrastructure construction. Senior care could be another long-term investment opportunity, considering China’s aging population.
Selina Zheng: From a deal-sourcing perspective, brokerage firms, trust companies, and other non-bank financial institutions have become more and more important sources of distressed asset opportunities in recent years, alongside traditional banks and asset management companies. From a geographical point of view, the Yangtze River Delta, the Pearl River Delta, and Beijing are areas that we particularly like, because of high asset quality, efficient and transparent law enforcement, and sufficient liquidity for transactions.
How would you describe the current fundraising environment for Greater China-focused private debt?
Francis Ho: In term of LPs, insurance companies are still the major investors in private debt funds in China. For CDH credit funds, insurance companies account for around 65% of the institutional investor base. Besides the big ones, we have started to see an increasing number of small and medium-sized insurers entering the market. Other types of LPs include endowments, funds of funds (FOFs), and corporates. LP types are very similar to those in the US and Europe.
Selina Zheng: We have seen more and more institutional investors participate in special situations investments as LPs. DCL closed the Special Situation RMB Fund III in October 2020, with a total fund size of $450mn. The fund's LPs include banks, insurers, investment arms of brokerage firms, state-owned enterprises, FOFs, endowments, and others. DCL Special Situation RMB Fund IV is expected to complete its first close in April this year, and we are seeing growing interest from all kinds of LPs. Although 2020 was a tough year for most GPs in the RMB market to raise significant money from LPs, GPs with competitive advantages and specialized expertise fared better in terms of fundraising. Moreover, top-tier GPs in each asset class are still attracting most of the capital, and we believe this trend will continue for a while.
There are now more channels and opportunities for foreign credit funds to make investments in China. Do you see international GPs increasing their activity in the Chinese private debt market now?
Francis Ho: We have seen some foreign credit funds raised in USD make investments in the Greater China area, with a major focus on commercial buildings, logistic parks, and NPLs. International GPs have definitely increased their activity in the Chinese private debt market, especially since there are now more channels. The Qualified Foreign Limited Partners (QFLP) scheme enables USD-denominated funds to make onshore debt investments. However, we haven’t seen these foreign credit funds raising large-scale RMB funds, owing to a lack of local knowledge and experience. We believe that private debt investments have to be accompanied by strong risk control measures in China, thus localized GPs with both USD and RMB funds will excel in the market going forward.
Selina Zheng: At present, competition for distressed assets in China is still dominated by local investment institutions. Due to the impact of COVID-19, among other reasons, foreign institutions are currently less active in China. Going forward, we strongly believe that local players have a significant advantage in both deal sourcing and exits. In fact, local presence is one of the key attributes of successful distressed asset investors across the globe.
What is your expected target return, and how do you hope to achieve this?
Francis Ho: Our expected target return is in the middle to high teens, which is normally achieved by a combination of fixed coupon notes and back-end upside from minority shares, options, convertible or exchangeable bonds, and profit sharing. We also balance our portfolios by maintaining a majority allocation to real estate, with some exposure to NPLs and corporate lending.
Selina Zheng: For NPLs and single-loan assets, on a deal level, we expect a 18-20% gross IRR, mainly through debt transfers, litigation recovery, borrower settlement, etc. – among which we expect a higher return for single-loan deals. For distressed asset-based special situations deals, we generally expect a gross IRR above 20%, and the exit strategies we pursue are mainly loan-to-own, bankruptcy reorganization, repayment of debts, and exit after restructuring.