Mason: Banks have a monopoly on extending credit

Eric Mason joined the Carlyle Group in June 2007 to head the firm's leveraged finance team in Asia, based in Hong Kong. He explains why he remains optimistic about the opportunities in Asia despite the prevailing US subprime situation and liquidity down-cycle.

How is the subprime mortgage situation going to impact your business in Asia?
The asset prices, valuations and terms and conditions for our target asset bases have improved, at the same time we would argue that based on current data, the credit environment is no worse and arguably improved. There have been upgrades in sovereigns, growth rates in economies are robust and corporate earnings are still strong. Therefore, the relative risk return profile for investments in Asian leveraged finance is much more attractive. I believe the opportunity has actually improved over the last few months.

At the same time, I believe the debt market in Asia faces critical deficiencies in the make-up of its investor base. As one of the leading institutional debt investors in the US and Europe, the establishment of Carlyle Asia Leveraged Finance can be an important bridge to addressing this issue.

Overall the subprime mortgage situation has a very limited impact directly on our plans. There is better pricing for our target assets and in an accommodative credit market this provides the basis of a fundamentally sound business plan.

There are challenges of course. The financing cost for any kind of effort like this is likely to be higher in the near term. And we are fully cognisant that the economic environment outside Asia could slow down and this could have some impact.

Although it is difficult to quantify if or how a downturn in the US would impact Asia, we are developing an investment strategy that certainly takes this into account in our credit scoring.

Most observers agree that thus far the subprime mortgage situation has lead to a liquidity crisis but it has not, at least yet, led to a major credit event. Because there is a perception, right or wrong, that the subprime asset class is subject to greater default risk, there has been greater scrutiny on almost all asset classes. In turn, the risk premium on a wide variety of assets in this category has increased and evolved into a serious liquidity crisis in the US and Europe.

What is your comment on development of the leveraged finance market in Asia?
In the early days of leveraged finance we used to seriously look at a handful of deals and hopefully close a couple each year! Now the market is not so ad hoc but consistently provides opportunities across the region to where it has become a more much pan-Asian market.

Sophistication is also emerging in the capital structure û stratification with better differentiation in pricing of senior and non-senior debt. Currently, there is less supply of available capital in the sub debt or mezzanine portions of the capital structure. As sponsors continue to compete tenaciously for new deals, the need for more specialised capital structures to enhance their returns has become a competitive and strategic imperative.

Bankers in the region are also getting more specialised. Certain local banks in each of the key markets have come a long way and are now offering sophisticated debt structures for LBOs. Among the international players there has also been a wave of new hires and transfers from the US and Europe who also have experience with a wider variety of debt structures.

What hasnÆt developed is diversity of the investors in the debt product. Some say the current situation in the US and Europe is, in part, exacerbated by the concentration of non-bank investors as the contagion effect has been spread through the interrelationship of institutional investors. I would argue that in Asia we are too concentrated among banks as providers of debt. The establishment of CALF and other investors will help create greater diversity in the market. In turn, this will help provide underwriters and sponsors greater transparency and more alternatives in assessing liquidity. Eventually, investors like us will help to create greater secondary liquidity, ratings and innovation.

What needs to happen in Asia for the leveraged finance market to deepen?
First and foremost the industry needs more deals. This is happening but it may appear a bit slower than some expected. For the debt markets to deepen we need more liquidity in Asia especially in the secondary markets. This would be very helpful to provide more transparency in the mark to market valuation on assets. The development of a loan ratings system may also help because it facilitates more liquidity by providing an objective reference point on credits. Obviously, this is not going to really take off until local banks become more willing to trade and sell some of their assets.

Has covenant-lite come and gone in Asia?
Even in Europe covenant-lite was just starting to take root. With regard to Asia something can not really ôcome and goö if it never really came in the first place, in other words the covenant-lite concept was not really tested in Asia. What is clear is that such borrower friendly structures are probably off the table for most new deals in all markets for the time being.

Generally speaking, because of the pre-dominance of banks providing capital in this market, it is less likely to be acceptable than in a more liquid capital market such as the US.

Commercial banks follow a pattern of structuring loans and covenants are a strong part of that criteria. As an illustration, banks have traditionally been very reticent about moving down the capital structure into mezzanine or other sub-debt. In Asia, where the debt comes primarily from banks, senior debt covenants are still important so it may be some time before they take the leap into covenant-lite deals.

Will larger deals be impacted by the credit situation prevailing?
Asia can still provide significant levels of credit for buyouts. Deals which, either because of size or structure, had to rely on debt markets outside Asia may be affected. But thereÆs a lot of liquidity among local banks to provide funding. It also depends on which market. For example, in Japan or Australia a large deal can still get done with a combination of local banks, regional banks and eventually with a dedicated fund such as CALF.

The key issue is whether the big money centre banks and bulge bracket investment banks will be impacted in Asia by their outstanding inventory of underwriting exposure in the US and Europe. I believe that most teams can make the argument back at their headquarters that they are still open for business in Asia. But the question is whether this backlog in terms of underwriting prevents them adding more Asia exposure.

Is it a real or perceived threat that the cycle could turn before the LBO market in Asia takes off?
The market size for LBOs in Asia may be modest compared to the US and Europe but it is on a growth trajectory. In some respects it has already taken off from the early days but I believe that even if this current correction slows the pace down it will not change the direction of the market.

We need to differentiate between credit and liquidity cycles. As mentioned, there seems to be a global liquidity crisis taking place but it is not clear if this is yet going to result in a credit downturn. The LBO markets can exist through credit cycles and in many cases flourish as asset prices usually fall. Some deals structured in more robust economic cycles may not have the capital structure to withstand a downturn - underwriters and sponsors have to be cautious when structuring these deals and we as investors are always factoring in the resulting risk and return.

The structural issues around why these things slowed down in the US do not currently exist in Asia. Investors have to ensure they have a balanced portfolio which is defensive enough to withstand downturns.

We may not be in a credit down cycle now but we are certainly in a liquidity down-cycle so capital is more scarce.

Another risk is the slowdown in primary deals due to the backlog of underwritten deals that have not been or cannot be syndicated. It is like selling down inventory and how does it get sold down û it may have to be discounted and this could create problems.

The good news for Asia is it is somewhat independently capitalised. Sponsors here have independent funds. Banks are awash with liquidity. Investors like us are open for business.