Subprime Fallout May Hit Asia Buyouts As Credit Cost Rises

While the U.S. subprime fallout is expected to have limited impact on Asian hedge funds, which mostly focus on equities, the region is vulnerable in other ways.

Banks and insurance companies, particularly in Japan, have significant holdings of collaterized debt obligations, or CDOs, which are now getting hit by subprime woes amid a liquidity crunch for structured credit. Meanwhile, the rising cost of debt could put a dent in leveraged buyouts by private equity. The subprime woes are "drying up investments into debt...which in turn could continue to affect funding for takeovers," said Shane Oliver, strategist at AMP Capital in Australia. "You're seeing this a bit in Australia with firms finding it a little harder to find finance than they used to have access to," he added. The diminishing private equity interest in Australian retailer Coles Group, which is up for sale to Perth-based conglomerate Wesfarmers Ltd., is an example of how tightening credit is affecting deals. Several private equity players, including TPG Capital L.P. and Wesfarmers' original bid partner Permira Advisers, abandoned the sale process, citing fears of a global credit squeeze. Private equity firms have gotten a huge lift in recent years by the low costs of debt worldwide. But with central banks trying to keep a lid on inflation, long-term interest rates are rising. Credit spreads are rising as well in the U.S. after two hedge funds run by Bear Stearns were forced to sell off about $4 billion of assets to meet margin calls, due to bets on the wrong side of subprime mortgages. "The extent to which borrowing costs have increased so far hasn't hit hard in Asia," said James Dubow, senior director at Alvarez & Marsal Asia, a turnaround consulting firm that works with many private equity firms. "The cost of debt in Asia is going up, but it's getting hit less hard than other places," he said. "There aren't that many things to invest in debt-wide in Asia. If anything comes in with a good business story," it gets snapped right up, he said. Moreover, there has been a widening of the spread between bond and bank debt, so firms in Asia always have the option of taking on bank debt if bond debt is not available, he noted. But it's unclear how long that can last. "The bigger question is whether there are (private equity) funds that are going to have issues because of the amount of leverage they have internally," Dubow said.

Effects Felt In More Sophisticated Financial Centers

Slowing in the leveraged buyout market could eventually hurt Asian share markets. "Lots of support for equity markets globally has come from the private equity world," said Peter Douglas of GFIA, a Singapore-based hedge fund consultant and head of the Singapore chapter of the Alternative Investment Management Association. If it becomes more difficult for private equity to go ahead "there goes one leg of support for equity markets." So far, the effects of a rise in defaults in the U.S. subprime mortgage market have been felt particularly in sophisticated financial centers, such as Australia, where a number of funds have focused on structured credit investments that until this year had offered solid returns. Australia's Absolute Capital Ltd. suspended withdrawals from two of its funds Wednesday due to a lack of liquidity in the local markets. The move came soon after another Australian fund manager, Basis Capital, also suspended withdrawals from two of its funds and follows a string of similar measures taken by funds globally as the U.S. subprime woes ripple out to credit markets, widening yield spreads on riskier debt and reducing the value of debt investments. "It's not that there is huge Australian appetite for CDOs, but it's more open and sophisticated" than the rest of Asia, said Douglas. That said, "my instinct is that two datapoints don't make a trend." Hedge fund managers say Asia, where some markets - China, for instance - even forbid short-selling, has relatively little exposure to the U.S. subprime blowup compared to the U.S. and Europe. The majority of funds in the region are focused purely on equities with anywhere from 51% to 75% of them being equity long-short funds, according to industry watchers. "Even when they are credit focused, they are Asian focused, said Christophe Lee, chairman of the Hong Kong chapter of the Alternative Investment Management Association. According to Eurekahedge, about 4% of Asian hedge funds focus on fixed income or credit. Multi-strategy funds, which make up about 14% of hedge funds in the region, could also have some exposure, though it's hard to say how many multi-strategy hedge funds have exposure. Hedge funds, unlike mutual funds, are not required by regulators to disclose their holdings publicly.

Japan Could Be Impacted

Still, as investors start looking at the lower-ranking portions of other non-mortgage-linked collateralized debt obligations, some of Asia's more sophisticated markets such as Japan could see some impact. With CDOs showing both a "fairly sensible yield" and investment grade ratings, the holdings "would have been irresistible" to Japanese banks and insurance companies, said Douglas. Japanese casualty insurers' shares have been dropping on concerns over their CDO holdings as many life and non-life insurers invest in securitized debt, traders say. Japan's casualty insurer industry is large, with combined annual revenue totaling around Y7 trillion, and foreign investors have big stakes in the major players. Although Japanese insurers say their exposure to U.S. subprime debt is small, the extent of their exposure to related products remains unclear, keeping investors on edge. Last week, Japanese investment banking giant, Nomura, wrote down $260 million of its exposure to U.S. subprime loans and jitters over the firm's involvement in that market helped push its shares to their lowest level in eight months. Nomura Holdings Inc. (8604.TO), said Wednesday it posted losses in residential mortgage-backed securities (RMBS) of Y31.2 billion for the April to June quarter after booking losses of Y41.4 billion in the previous January to March quarter and is considering to exit the RMBS business. Many of the subprime loans have been sold to investors as RMBS. Major Japanese banks are also thought to hold a large amount of securities backed by U.S. subprime mortgages. A recent UBS report said as of June 30, Japan's nine largest banks held slightly more than Y1 trillion in subprime loans-related securities. Banks with exposure include Mitsubishi UFJ Financial Group Inc. (8306.TO), with an estimated Y100 billion in subprime loans-related securities; Mizuho Financial Group Inc. (8411.TO) with an estimated Y50 billion; Sumitomo Mitsui Financial Group Inc. (8316.TO); Sumitomo Trust & Banking (8403.TO) and Shinsei Bank Ltd. (8303.TO).