Five golden rules for investing in emerging markets private credit

<div class="grid grid--33-66-col"><div class="col"><img loading="lazy" src="/getContentAsset/6f31815b-059e-4f86-9965-83418930642d/cb87803a-320c-480f-ab75-7b9029eaaf79/GEMCORP_10_11_2020_Parvoleta_0086_V2.jpg?language=en" alt="Parvoleta Shtereva" title="Parvoleta Shtereva" style="width: 180px" class="fr-fic fr-dii"></div><span style="font-size: 12px"><div class="col"><strong>PARVOLETA SHTEREVA<br></strong>CO-FOUNDER, CIO &amp; BOARD MEMBER<br><br><p>Parvoleta Shtereva is one of the co-founders and CIO, responsible for the firm’s investment portfolio, as well as execution and management of investments. She is also a member of the Investment Committee. Parvoleta spent most of her career managing credit portfolios for Black River Asset Management and Goldman Sachs. She has more than two decades of experience working across Eastern Europe, Africa and the Middle East.</p></div></span></div><hr><p>Gemcorp Capital has been investing in emerging markets private credit for over a decade, with our CIO, Parvoleta Shtereva, at the heart of our activities. We recently interviewed her to find out what she sees as the five golden rules for success when investing in the asset class.&nbsp;</p><p><br></p><h2 style="font-size: 2rem"><strong><span style="color: rgba(101, 13, 27, 1)">1.</span> Avoid currency risk</strong></h2><p>Currency risk has been a destroyer of returns for many investors in emerging market assets, and it is something we take very seriously.</p><p>A country’s foreign exchange rate may be a shock absorber, acting as a rapid adjustment mechanism in response to external shocks or unorthodox economic policy. While investing in emerging markets currencies isn’t dangerous in itself, it needs to be monitored and managed actively. Private credit isn’t the right vehicle to do that.&nbsp;</p><blockquote><p>“Private credit isn’t the place for taking local-currency risk.”</p></blockquote><p>As such, we are careful to avoid both primary and secondary currency risk, and we only lend in hard currencies, typically in USD..</p><p>That’s not to say that we only service borrowers that earn hard currency, such as exporters. Doing so would limit our investment universe substantially. &nbsp;For example, we might lend to a telecoms company that has strong cashflows but earns in local currency by definition. This borrower, however, would need to be based in a jurisdiction with a functional and relatively liquid foreign exchange market.</p><p>We always consider the FX market of the country a company operates in. We’ve never lent to companies only earning local currency in countries that have dysfunctional or only sporadically liquid FX markets. Other countries – some of which might come as a surprise to investors – have liquid enough FX markets for companies to exchange their local-currency profits into hard currencies to repay their debt.&nbsp;</p><p>To assess whether this is the case, we consider factors such as a country’s external accounts and macroeconomic policies, how its FX market works, how liquid it is, and whether there are multiple exchange rates or frequent backlogs.&nbsp;</p><p><br></p><h2 style="font-size: 2rem"><strong><span style="color: rgba(101, 13, 27, 1)">2. </span>Structuring for success</strong></h2><p>You have to structure deals so they’re good for both parties – it needs to be a win-win situation.</p><p>Firstly, we aim to structure a facility that doesn’t unduly tax the borrower. We examine the existing cashflows, the timeline of the project that our loan is funding, the future revenues it can expect as a result of the project and how those revenues will be structured. We can’t make it impossible for the firm to service its debts or overload the business such that it gets into difficulty and shareholders are tempted to starts behaving in an unwanted manner. In short, the borrower has to get good utility from what we’re offering which plays directly into their willingness to service our loan.</p><p>On the other side, we have a duty to protect our investors. This involves obtaining a good place in the capital structure – our loans are typically senior secured. We look for borrowers whose capital structures are fairly simple where we are able to control the stack. We also look for tight covenants and extensive information rights which give us good visibility over the business and how the firm is executing its business plan. And we create a single point of enforcement – typically offshore – so we can react quickly should any problems emerge. We also take into account external factors like the macroeconomic policy and regulatory environment of the borrower’s country to create something that’s solid.</p><blockquote><p>“By considering the needs of both sides, we achieve a final structure that is good for everyone.”</p></blockquote><p>By considering the needs of both sides, and with a lot of creativity and problem-solving, we achieve a final structure that is good for everyone involved. This is an intensive process and involves a lot of effort working with the borrower to tailor a solution.&nbsp;</p><p>I’d also point out that, from the outset, we designed our firm to be a complete private credit investor, with expertise all the way from origination, through structuring and legal, to, of course, portfolio management. This enables us to be creative and respond to financing needs quickly and creatively.</p><p><br></p><h2 style="font-size: 2rem"><strong><span style="color: rgba(101, 13, 27, 1)">3. </span>Know your borrowers</strong></h2><p>The first two rules are quite specific to emerging markets, but this one is more universal.&nbsp;<br>As they say, a leopard never changes its spots - by looking at the shareholders’ and company’s history you can pick up a lot of indicators about likely future behaviour, whether they be red flags or positive signs.&nbsp;</p><blockquote><p>“By looking at a company’s history you can pick up a lot of indicators about likely future behaviour.”</p></blockquote><p>One of the most cited concerns of investors in emerging markets is the potential for corruption and fraud, so we have to be forensic in our analysis. In performing our due diligence, apart from detailed background research, we look at a company’s business model, the market it operates in, the regulatory environment, the macroeconomic backdrop, the political cycle. There’s a lot of intricate and multidisciplinary work to due diligence and structure a solid investment.&nbsp;</p><p>Very often in the past when an investment has gone wrong those involved blame it on the inherent governance risks in the emerging markets. But when you scratch the surface, it becomes clear that some questions about the investment just weren’t asked, or potential risks were not explored. Having said that, everyone makes mistakes, including us, and it’s vital to analyse them in depth and learn from them.</p><p><br></p><h2 style="font-size: 2rem"><strong><span style="color: rgba(101, 13, 27, 1)">4.</span> Being proactive</strong></h2><p>We invest in private credit with a private equity mindset – we don’t just write a cheque and wait to get our money back in a few years, which is the approach investors with very large and unconcentrated portfolios may adopt.&nbsp;</p><blockquote><p>“We don’t just write a cheque and wait to get our money back.”</p></blockquote><p>We try to get involved with the governance of the companies we’re providing loans to monitor how they’re executing their business plans and the projects we’re financing and hopefully make a positive impact in terms of processes. Where possible, we always look to introduce companies to other lenders, equity investors or even customers.&nbsp;</p><p>I believe there’s a special affinity between people who have set up and grown a business – we’ve built two over the past 11 years, and we understand the challenges that entrepreneurs face in what are often difficult macroeconomic environments. We have a lot of patience if things go wrong because of unanticipated exogenous shocks. We have no patience if trust is broken because of bad behaviour aiming to dissipate value, impair or disregard lenders’ rights, in which case we would step in very quickly to remedy the situation. Sometimes we need to take hard decisions to protect the rights of our investors – we do not shy away from enforcement to preserve value.</p><p><br></p><h2 style="font-size: 2rem"><strong><span style="color: rgba(101, 13, 27, 1)">5. </span>Avoiding the crowd</strong></h2><p>We’ve seen so many times in history that overallocation of capital results in misallocation of capital. When it comes to credit, that typically means we start seeing borrower-friendly terms such as second-lien, covenant-lite or uncollateralised loans become more frequent. Essentially, in the late stages of a bullish cycle people start taking equity risk and dressing it up and pricing it like credit risk. But by this stage, mispricing the least of the problems – the biggest causes of value destruction have historically been, firstly, fraud, and secondly foregoing lender protections and lacking the ability to intervene quickly to preserve value.&nbsp;</p><p>We don’t like being in competition. Not because we don’t like competition in general, but because we refuse to be forced to water down elements that are very important to us such as covenants and security. This links in with the structuring for success point – by being the only lender, we’re able to ensure the loan is structured in a way that suits everyone.</p><blockquote><p>“We refuse to water down elements that are very important to us.”</p></blockquote><p>Of the five rules, avoiding the crowd is actually my number-one rule and it reflects the vision of our firm – to be brave, expeditionary and intellectually curious. To supply capital where it is in very short supply and where others fear to tread.&nbsp;</p>