[Trapped PE]② 'Double-Edged Sword' Private Debt... Concerns Over 'Shadow Banking' in Blind Spots

Editor's NotePrivate equity fund (PEF) management firms are facing difficulties without exception during the capital market downturn. Mergers and acquisitions (M&A) deals are piling up, but there are no buyers. Major PEFs have stated that they will focus on risk management rather than 'big deals' until the end of this year. This is based on the judgment that a scenario of financial market crisis may need to be prepared. Amid this gloomy atmosphere, concerns have also been raised that private lending by PEFs could become 'shadow banking' that is not captured in official statistics. While domestic PEFs have been shrinking back, the global Big Four PEFs have penetrated the market. Under the strong dollar trend, foreign funds are openly showing their ambitions for corporate hunting in Korea. Asia Economy observes upcoming changes through the movements of key players in the capital market.

[Asia Economy Reporter Park So-yeon] As interest rates soar to unprecedented levels and financial institutions tighten lending, the role of private debt funds is growing. Domestic and international PEF 'big players' are seeking to monetize through mezzanine or loans rather than high-risk M&A or equity investments in the stagnant market environment. There is also an expectation that if funds flow through private debt funds, they will ease the financial constraints of small and medium-sized enterprises (SMEs) that find it difficult to raise capital. Private debt has long been a business model utilized by global PEF management firms. However, since it is an emerging market in Korea established only since last year, there are calls for appropriate supervision by financial authorities. While it can serve as a lifeline for mid-sized and small companies desperate for funds, if private lending rapidly increases in the blind spots of regulatory oversight due to the balloon effect of tightened bank lending, it could become a 'double-edged sword' threatening corporate management rights in the future.

◇ Second Year of Domestic Market Emergence... Trillion-Won Investments Continue = Following the amendment of the Capital Markets Act last year, it has become possible for PEF management firms in Korea to establish and operate loan-type funds, leading to an increase in the formation of private debt funds (PDF) and private credit funds (PCF) domestically. In particular, as banks, securities firms, and insurance companies have recently imposed lending regulations to manage liquidity and soundness, demand for loans has expanded into the private debt sector.

Major domestic PEF management firms have established credit fund divisions since last year. Credit funds are funds that aim to generate returns by investing in mezzanine instruments with medium risk and medium returns, such as convertible bonds (CBs) and bonds with warrants (BWs), or by directly lending to companies rather than acquiring equity stakes. Representative examples of credit funds include private debt funds (PDFs), which pool investment capital to invest in corporate bonds or loans, and private credit funds (PCFs), which have a broader investment scope including structured bonds and distressed corporate assets.

Although global PEF management firms have long utilized these strategies, private lending has only recently become possible in Korea through legal amendments. IMM Private Equity (PE), considered the senior player in the domestic PEF industry, was the first to launch a subsidiary, IMM Credit Solutions (ICS). ICS has been actively investing over 1 trillion KRW in companies such as lubricant manufacturer SK Lubricants and anode material manufacturer L&F.

Following this, MBK Partners and Stick Investment opened private debt investment markets in Korea with scales of 1 trillion KRW and 600 billion KRW respectively, and other firms have since established dedicated credit teams. VIG Partners and Glenwood PE have also entered the credit market. The funds they have invested amount to several hundred billion KRW each. VIG Alternative Credit invested in the Icheon logistics center and MyRealTrip, while Glenwood Credit invested in LG S&I Construction and SK Ecoplant. Stick Investment and Apolloma Capital, which established departments this year, are also recruiting experts.

◇ Global Annual Growth of 9.2% = The global assets under management (AUM) of private debt funds have grown rapidly since the global financial crisis due to tightened bank lending regulations in the US and Europe. As capital regulations on banks tightened after the global financial crisis, small and medium-sized enterprises found it difficult to obtain bank loans, and loan-type private funds replaced banks' roles, leading to rapid growth. This situation is similar to Korea's current environment, where bank lending is restricted and the private debt market is opening up.

According to the Korea Capital Market Institute, the global private debt fund AUM recorded an average annual growth rate of 9.2% since 2010, increasing from $429.1 billion in 2010 to $1.0391 trillion in 2020. In the first half of 2021, it increased by 64.6% compared to the same period the previous year. In the US, as of 2020, over 80% of direct loans to SMEs are made through private debt funds. In Europe, private debt investment has grown by more than 20% annually since 2012.

In contrast, Asia's private debt market is relatively underdeveloped, with a high dependence on bank loans at about 75%. Recently, major global asset managers see this as an opportunity and are actively seeking investment opportunities to increase their market share in the Asian region.

Global major asset managers such as KKR, Apollo, and Carlyle expanded private debt investments last year to meet growing market demand. KKR hired experts in secured lending and inventory finance to expand its private debt platform. Carlyle announced a business plan to raise over $130 billion in private debt funds by 2024 to increase its private debt portfolio AUM by more than 40%. Apollo established a $1 billion private debt secondary platform in its credit division in April last year. JP Morgan Asset Management established the Global Performing Credit Platform last September to expand its private debt business and focus on direct lending.

◇ A Blessing in Drought... 'Double-Edged Sword' Threatening Corporate Management Rights in Financial Crisis = Private debt funds are a new growth area domestically and serve as lubricants in the capital market. However, the fact that they are in the blind spots of regulatory oversight is pointed out as a risk factor. Although the private debt system has been in operation for a year, authorities have yet to grasp even the approximate scale of domestic private debt funds. This contrasts with the strict and detailed management of loans by banks, securities firms, and insurance companies.

A chief investment officer (CIO) of a domestic pension fund warned, "Just as 'shadow banking' is a problem in China, private lending could emerge as such an issue domestically. Especially in the current situation where first-tier financial institution loans are almost impossible, private lending could grow rapidly, but since accurate statistics are difficult to obtain, it could become a hidden bomb in our market." Shadow banking refers to financial institutions that perform bank-like lending functions but are less regulated by central banks.

Another CIO from a mutual aid association said, "Unlike the US and Europe, we are still in the very early stages and the total amount is not that large, so it is not a level of great concern. However, private lending in the US and Europe expanded rapidly after the Global Financial Crisis (GFC), so it could be quite burdensome in times of crisis." Private lending is generally structured more conservatively than bank loans, often secured by equity collateral. Industry insiders worry that such contract structures could lead to situations where the management rights of many companies are threatened in the event of a financial shock.

An industry expert said, "Private equity funds can play a positive role in restructuring, but in the event of a major shock, it is not impossible that the management rights of key companies could be indiscriminately threatened. Authorities should manage private lending as a major item just as strictly as first-tier financial institution loans," emphasizing the need for regulatory oversight.