Why LBOs are set to grow in Asia

Morgan Stanley shares its views on why the leveraged finance market in Asia is poised for future growth.
Jon Kindred is a veteran at Morgan Stanley with almost 25 years experience across products and locations. Among his other responsibilities, he currently heads Morgan StanleyÆs fixed income division in Asia and is president of Morgan StanleyÆs Japan business, based in Tokyo. Peter Szekely is part of the global capital markets group in Hong Kong, responsible for the lending business in the Asia region including Japan.

How is the loan market shaping up relative to more developed markets?
Jon Kindred: Market development is in line with where we expected it to be. It looks like the European market did 5-6 years ago with a similar demand-supply profile. On the demand side, bank investors continue to dominate the first lien loan market in Asia but we are seeing the entrance of hedge funds and other institutional investors.

Peter Szekely: An important influence on Asian loan markets has been sponsor driven business. Sponsor clients are introducing best practices from the US and Europe to Asia which has sped up the development of the market. This is true of the investor base too û large institutional investors active in Europe and the US are appearing in Asia in greater numbers and bringing their investment experience in more complex products to the market here.

What has driven growth in the Asia-Pacific region over the course of 2006?
PS: On the demand side we would cite the $90+ billion of CLO (collateralised loan obligations) money raised in the US last year which is driving global demand, including in Asia. Coupled with over $21 billion of Asia-Pacific dedicated private equity money, taking the total to more then $100 billion, the market seems poised to see activity increase.

JK: In terms of markets, Australia was the most active market in 2006 with approximately $10 billion in financings for leveraged buyouts (LBOs). This represents a 10-fold increase versus previous years. Not only has the volume of deals increased but also the size, complexity, and ability of institutions to deliver higher leverage.

What is your view on specific countries?
JK: Australia will continue at its active pace. In the short term we expect Taiwan and Japan to witness increased activity. Japan has historically been a bilateral or club lending market but this will change as Japanese banks focus increasingly on managing their assets. TaiwanÆs markets have benefited from a strong domestic banking industry which will help support continued deal flow.

PS: Both financial sponsors and banks continue to look at China opportunities but we would observe that China remains in investment mode. India is a market where there have started to appear some very exciting, large acquisition financing opportunities. We expect this to continue although volumes will increase over the longer term and not immediately.

What have been significant recent changes?
JK: The bank and institutional investor base is expanding globally with more money looking at Asian deals. This supports larger financings as liquidity increases. Borrowers also have increasing access to more sophisticated instruments and can better develop deal capital structures. In Australia for example financing has been across not only local banks but also institutional investors in the US and Europe and we have seen the development of 2nd lien, and mezzanine products in that market.

More players in the market translates into increased liquidity which means investors are able to better manage their exposure. This is important with the introduction of Basel II as banks must more effectively manage their loan portfolios.

Do you think there are investment opportunities for so much private equity money?
JK: The key is patience. Over time private equity brings not only money but managerial expertise and operating know-how. So the sector adds value in various ways. As financial sponsors grow more comfortable with the risk-reward profile of operating in Asia, we are confident this money will find a home.

What kind of Ebitda multiples do you raise money at?
PS: In the Asia-Pacific region, like the global markets, we have seen leverage multiples creep up as high as 7-8 times but the average probably still remains in the 5-6 range. It is tough to generalise because it is ultimately sector and company specific. In 2006 LBOs were financed at an average leverage of 5.5 times globally, though we saw this trending upwards through the calendar year. What has made investors comfortable with higher leverage are the points we have been discussing: growing liquidity, increased investor sophistication and more diverse product availability.

How is the secondary market developing?
JK: I would say it is currently on the cusp. As primary markets grow, secondary market growth will necessarily follow. We are relocating a senior resource from Europe to aid us in our development of a secondary market and other firms are doing the same. We expect institutional investors û for example in the US 60% of demand is driven by CLOs û to start picking up their activity as they take comfort from the growing liquidity. It will also become easier to diversify investments.

What kind of spreads are you seeing?
PS: Spreads have tightened globally through 2006 to around Libor+190 levels for BB issuers and Libor+270 levels for single B issuers. Both are all times lows.

Are these sustainable?
PS: There is a lot of talk that valuations are stretched. Lagging default rates currently stand at 0.79%. We will not argue that these can continue to go down further but we do not think they will spike either.

What kind of innovation are you seeing?
PS: Covenant-lite loan structures are emerging which have incurrence rather then maintenance covenants (similar to bond covenant packages). Ratios like DSCRs (debt service coverage ratio) which have been typical in Asia are now no longer in every transaction. This allows issuers with a natural volatility in their businesses to manage cash flows without triggering covenants or defaults in short term normal course downturns.

JK: Investors are becoming more sophisticated and hence are willing to look at more innovative products as long as it is priced appropriately.

What are the risks specific to operating in the region?
JK: Currency and withholding taxes are the more obvious ones that come to mind. Regulatory risks exist but I believe the regulatory environment is evolving favourably. Regulators have an important job to do and every country has its own specific issues.
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