Private Equity Wire exculsive: Australia and China important markets for distressed debt investors, says ADM Capital’s Robert Appleby
Right now there are clear dislocations in capital markets, particularly in the eurozone as banks continue their mission to deleverage and scale back the volume of debt sitting on their balance sheets in response to Basel 3. The European Banking Authority has determined that banks needs to raise EUR115billion in new capital – the volume of European sponsored loans set to mature between now and 2014 stands at EUR264billion: hence the urgency.
But one person’s misfortune is another’s gain. Hedge funders who specialise in distressed debt and special situations are rubbing their hands in glee as they eye up cheap CDO valuations. They are, undoubtedly, becoming an important alternative financing solution to small and mid-sized companies as banks move to choke off their funding channels.
Although not directly affected by the eurozone debt crisis, there is a degree of contagion affecting the Asia markets as European banks scale back their operations in the region. One of the region’s leading distressed debt hedge funds, Asia Debt Management (ADM) Capital, co-founded by Robert Appleby (pictured) in 1998, is keen to capitalise on the situation.
Speaking with Hedgeweek from the firm’s headquarters in Hong Kong, Appleby, the firm’s CIO, points out two major drivers in distressed debt that differ from this time last year. One, as already mentioned, is the European demise. “We’ve lurched from what was originally a sovereign debt crisis to a fully blown bank solvency issue which is only likely to be delayed for three years by the LTRO (Long-Term Refinancing Operation) and we’re seeing both direct and indirect consequences of that here in Asia.
“Secondly, traditional avenues of funding are getting restrictive in Asia generally. For corporates in need of oxygen it’s not obvious where you can go, particularly if you’re a small firm, and this has led to a wealth of opportunities for people like us who live in the grey world of shadow banking system and whose job it is is to lend money to corporations,” says Appleby.
As a result he thinks Asia is beginning to fatten out and look quite attractive given everything else going on in the world and the risk premia that are available.
The firm’s flagship fund - the Galleus fund - follows a pan-Asian mandate stretching as far west as Turkey. ADM Capital also runs two other hedge funds, nine private equity funds and a series of managed accounts. “Each of these funds has approximately 20 to 30 investments in the portfolio,” confirms Appleby. “We’re running just shy of USD2billion today.”
Some of the distressed debt themes Appleby is seeing in countries like Ukraine, Kazakhstan, and more traditional emerging Asian economies like Thailand, could, he suspects, be mirrored in core Europe in time to come. “Watch this space,” says Appleby, with a wry smile.
Within the Asia-Pacific region Appleby says he’s seeing some interesting investment opportunities coming out of Australia, a market not historically known for distressed investing. “That’s because Australia is home to the only leveraged loan business in greater Asia and like its European cousins it too is collapsing under the large amounts of debt it took on.”
Australia has felt the effects of the eurozone crisis to a far greater extent than other Asia-Pacific countries where the presence of European banks is less pronounced. “The four pillar banks were warehousing secondary loans at prices that were pretty close to par. When the European banks started to capitulate these loans were sold at substantial discounts from par,” says Appleby, no doubt making a substantial dent in their bottom line.
Appleby is also seeing indirect effects of the eurozone crisis as well. Shipping loans are being sold at discounts because the freight rates have collapsed significantly. Last year a modest fall in rates was enough to send one shipping operator, Korea Lines, into insolvency. As for new ship builds, today’s global macro environment means the viability for banks to provide loans just isn’t there.
“That’s going to be a substantial opportunity provided the timing is right: particularly in shipping markets such as China, South Korea, Taiwan, Japan,” comments Appleby.
Things like shipping loans, aircraft leases and mortgage servicing businesses are the most likely sectors in which to find distressed opportunities in Appleby’s view because the LTRO has effectively consigned the sale of corporate loans to the ‘to do’ category. He thinks it’ll be a while for this cycle to play out before the corporate loans of Asian corporates are sold by European banks, adding: “I suspect we’ve got quite a lot to come over the next two to three years.”
Whilst Australia clearly represents market opportunities for the Galleus fund right now, the rest of Asia continues to captivate, particularly Greater China, which Appleby believes probably holds sway over the rest of the region at present with regards to risk/reward.
Accounting irregularities of Chinese companies were well documented last year, with Muddy Waters shining a light, rightly or wrongly, on Sino Forest Corporation, a Toronto-listed forestry company that was aggressively shorted and which led to its share price plunging 80 per cent last year. Other overseas Chinese companies have also suffered and seen their P/E multiples collapse amid allegations of improper accounting practices. The net result is that companies are starting to de-list from foreign exchanges and re-list on the mainland where some of the multiples are higher and liquidity is better.
Amidst all the short selling and corporate allegations, it raises the obvious question of just how viable some of these companies are. Although Appleby says he wouldn’t jump into China with both feet, ADM are actively looking at opportunities there. “Last year we did due diligence on 159 companies in China and we made four investments. There was enough grit in the wheels for us to walk away from a vast majority of situations we looked at,” confirms Appleby.
One interesting development for distressed debt investors is that real estate developers have been using trust financing as an alternative to bank lending, which tightened last year in a bid to cool real estate prices. These trust loans are typically short-term and although there’s nothing inherently wrong with them, the China Banking Regulatory Commission recently started to evaluate their use among developers. Developers need to be financially secure to repay these loans and avoid rollovers and as Appleby points out: “Finding trust financing facilities that bail you out are becoming few and far between. That’s a big area of focus for us.”
The key to being a good distressed debt investor in Appleby’s view is simple: due diligence, due diligence, due diligence; and not being ignorant of the macro conditions. “An economy that suffers some financial stress gives rise to a lot of distressed debt opportunities but a distressed investor will always make more money if an economy improves and establishes a more fluid financing system.
“Take Japan for example. It has spent two decades coming out of recession. Distressed investing in Japan is very difficult because while there’s lots to buy, the exit point remains very unclear so understanding the macro conditions is crucial.”
South-east Asia also has some compelling investment opportunities in Appleby’s view, such as Thailand and Indonesia, a country which benefits from a stable fiscal/economic framework. Going back to the point about understanding the macro conditions, Appleby says: “Indonesia needs careful handling because when hot money enters these markets pricing tends to go out of the window. You have to be very careful about entry points in economies that are hot. It’s on our radar though.”
ADM Capital’s team, which totals 51 worldwide, typically spends about six months conducting due diligence on companies although it can be as short as three months or as long as two years depending on the company. One such deal recently got pulled when the terms were changed by one of the participating banks at the last minute. That’s one of the unfortunate hazards of distressed investing.
The Galleus fund will sometimes buy up secondary loans, bonds, but it also works directly with companies to provide new loans which can be used to pay off existing loans; this is where distressed debt hedge funds take on the role of shadow banker.
The benefit of creating these loans for companies in financial distress or on the brink of bankruptcy is the fact that “you feel safe in the knowledge that your own handy work has been in play since day one. Your relationships with that corporate and its management tend to be much stronger if you’ve been negotiating with them six months than if you bought debt off the shelf.”
So what keeps Appleby awake at night as a distressed debt investor? Well, it’s not the exogenous risks that other people talk about in the global economy because each investment in the Galleus is predicated entirely on the investee company’s ability to pay back the loan. Global macro conditions might create indirect second derivative effects but they tend not to be correlated to ADM’s investments.
“What keeps me awake at night is changing attitudes of governments. We’ve found ourselves in the greatest form of difficulty when we’ve been closely associated or reliant on government support for a company we’ve been involved with. Even jurisdictionally well-developed countries like Australia can be extremely debilitating to an investment strategy.”
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