The Asian Banker Friday, 8 November 2024

Private credit in Asia Pacific will continue to expand, driven by niche demand and growth

5 min read

Private credit markets in Asia Pacific have grown rapidly in the past decade. Banks' continued dominance in lending in the region means private credit markets are still small.

However, the private credit sector in Asia Pacific will continue to expand, led by large economies in the region, as robust economic growth boosts overall credit demand and financing needs in niche areas create opportunities for private credit investors. In addition, Asia Pacific investors are also interested in the global private credit market and will continue to allocate their
investments into US and Europe.

Despite rapid growth, private credit markets remain small in Asia Pacific due to banks' dominance. Private credit assets under management (AUM) earmarked for lending to Asia Pacific companies in aggregate roughly doubled to about $120 billion at the end of 2023 from four years earlier. Still, credit markets in Asia Pacific as a whole have accounted for just 6%-7% of total transactions globally in the past decade as banks remain dominant in the provision of credit, a situation that is not likely to materially change.

Private credit in Asia Pacific will still continue to expand, helped by economic growth and niche demand. While strong economic growth will drive up overall credit demand in the region, private credit has advantages over traditional bank lending in riskier niche areas, with funding from investors seeking higher returns as their allocation to private credit remains low. For one, private credit will continue to draw demand from middle-market companies as it can help fill their funding gaps. In addition, private credit can be a boon to companies seeking financing for projects such as infrastructure development or leveraged buyouts (LBOs). This is because the main investors in private credit in Asia Pacific are long-term institutional investors and with higher degrees of risk appetite than banks, so they have more leeway to participate in financing for such relatively riskier deals. They will also allocate their investments in US and Europe.

Large economies will drive private credit growth in Asia Pacific. Large developed economies, such as Australia, Japan and Korea have more sophisticated financial and legal systems, and larger investor pools. In some large developing economies including China and India, demand for private credit will be mainly driven by economic growth and improvements in regulatory and legal systems.

Despite rapid growth, private credit markets remain small in AsiaPacific due to banks' dominance

Private credit markets in Asia Pacific have grown rapidly in the past decade. Yet their growth is from a low base, and they remain small by global standards as banks continue to be dominant lenders in the region. Private credit AUM earmarked for lending to Asia Pacific companies in aggregate roughly doubled to about $120 billion at the end of 2023 from four years earlier, with $36 billion of the total yet to be deployed, according to Preqin. Still, private credit markets in Asia Pacific as a whole accounted for just 6%-7% of total transactions globally in the past decade.

While private credit funds can target special areas of lending, in many Asia Pacific economies, especially emerging ones, banks remain dominant in the provision of credit, a situation that is not likely to materially change. Banks accounted for more than 80% of total credit in Asia Pacific at the end of 2023, a significantly larger proportion than in Europe or the US.

Because banks in Asia Pacific generally have large capital buffers and less complex loans which have lower risk weighting, they are under less pressure to preserve capital than those in the US and Europe. This enables Asia Pacific banks have more capacity to lend and remain dominant in credit markets in the region.

While banks in Asia Pacific have started implementing final Basel III capital rules or plan to do so in the coming years, we do not expect their risk-weighted assets (RWAs) to increase materially under the new requirements, unlike in the US and Europe. This is because the use of internal models for the calculation of capital, which often results in smaller RWAs than prescribed levels, is less prevalent in Asia Pacific, and regulatory capital requirements in the region are already stringent.

At their current sizes, private credit markets in Asia Pacific do not pose material risks to financial systems in the region. However, as private credit funds tend to target riskier borrowers that are vulnerable to economic stress, and most of their investors are financial institutions including insurers, regulators in the region are also paying close attention to the development of this space. If the market becomes big enough to trigger any material risks to financial systems and affect financial stability, the regulators in Asia Pacific will likely increase oversight of them and could curb their growth.

Chinese authorities' efforts to increase oversight of shadow banking, which is similar to private credit in nature and has once flourished in the country, can be a good example. In the past decade, they have tightened regulations for shadow banking to curb risks it poses to the country's financial system. Also, in July 2024, the Australian Securities and Investments Commission said that enhancing transparency and investor protection in the country's private credit market will be a key priority in the next 12 months.

Private credit in Asia Pacific will still continue to expand, helped by economic growth and niche demand

Even though banks will remain primary lenders in Asia Pacific, private credit markets in the region will continue to expand as strong economic growth drives up overall credit demand. Particularly, private credit has advantages over traditional bank lending in riskier niche areas, with funding from investors seeking higher returns.

For one, private credit will continue to draw demand from middle market companies, including small and medium-sized enterprises (SMEs), especially in developing countries, as it can help fill their funding gaps. Such companies typically cannot access public markets for funding as easily as larger organisations. They can also be in growth phases that require significant funding but lack the revenue or assets to obtain traditional loans from banks.

Small businesses are a significant part of developing economies in Asia Pacific, so their potential credit demand is significant. Micro, small, and medium-sized enterprises (MSMEs) accounted for 28% of aggregate GDP in Asia Pacific in 2022, with the proportion exceeding 40% for some emerging markets in Southeast Asia and Central and West Asia, according to Asian Development Bank.

In addition, private credit can be a boon to companies seeking financing for projects such as infrastructure development or LBOs, because long-term institutional investors such as insurance companies, sovereign wealth funds, government agencies and superannuation schemes are the main private credit investors in Asia Pacific and their allocation to private credit remains low. They have higher degrees of risk appetite than banks, so they have more leeway to participate in financing for such higher-risk deals.

On the other hand, these Asia Pacific investors are also interested in the global private credit market. According to Preqin's data, the total private credit fund AUM of these investors which have geographic preference in US and Europe were around $50 billion at the end of August 2024. We expect they will continue to allocate their investments outside of the Asia Pacific region given the higher supply of investment opportunities in these markets and the broader variety of structures for diversification purposes. That said, any material credit issues in the US or other market will create contagion risk to these Asia Pacific investors.

Increasing interest among global investors and asset managers in private credit opportunities in Asia Pacific to diversify their portfolios will also drive the sector's growth in the region. Total AUM for private credit funds deployed from outside Asia Pacific nearly tripled to about $35 billion at the end of 2023 from $12 billion four years earlier, with their share in total AUM growing to 30% from 20%.

As private credit in Asia Pacific continues to grow, we expect its size relative to private equity to also increase and slowly inch toward the global average, which is much higher. Private equity managers are likely to accommodate growing investor demand for private credit, given that they often also run private credit funds.

Moody's Ratings Report Re-disseminated by The Asian Banker

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