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Economics & Finance

Private equity in Asia: stepping back from the brink

Kevin Tan |

Back from the abyss. That’s perhaps an apt description of the private equity (PE) industry in Asia, which saw deal flows grind to a virtual halt between the last quarter of 2008 and the first quarter of this year in the wake of the global financial crisis.

But with the strong rebound in global equity markets this year, investors are showing renewed interest in the PE industry, even though fundraising plummeted by more than 70 per cent in the first half of 2009 from a year earlier, according to Brian Bunker, an INSEAD alumnus who’s a managing director at PE firm Riverside Capital.

Speaking at INSEAD’s inaugural PE conference in Asia, Bunker says deal flows in the industry started to come back in June amid rising prices for deals. And given the comparatively lower yields of US treasuries, Bunker says he believes that pension funds, sovereign wealth funds and financial institutions will deploy more funds into alternative investments such as private equity.

However, kick-starting the PE industry may not be easy, as “the whole mechanism of price discovery has been completely shattered” in the last six months because of the rapid collapse and rebound of the equity markets, says Vibhav Panandiker, managing director of JPMorgan Capital Partners.

“So both the buyers and sellers really have no clue as to (how) they should be pricing the equity, and that’s really been something that has been holding people back.”

Furthermore the cost of leverage financing has become more expensive because of the credit crunch. But the leverage buyout (LBO) business model remains in play, says Bunker. With the decline in price multiples, the key to doing buyout deals is strong due diligence on target companies, says Bunker. He volunteers that Riverside investigates around 4,000 companies a year, and acquires just one per cent of those. So far this year, Riverside has acquired eight companies.

For Panandiker, the use of leverage financing should be judicious. “I have never gone beyond three times EBITDA nor over 50 per cent gearing in any buyout which I’ve done,” he says. “Principally because, firstly, I’m a very conservative person. I want to sleep well at night. Secondly, I’ve always been investing from the balance sheet of a bank, (and) banks are conservative in nature.” 

Indeed, besides resorting to leverage financing, a ‘buy low, sell high’ strategy can work just as well in generating high returns, argues Panandiker. “In all markets, whether it’s at the top of the bull-run or at the bottom of a Great Depression, you will find deals sooner or later which are priced right for you to go ahead.”

“And one just has to be patient. It’s like being a fisherman: you don’t have to catch every fish, but you have to catch the right one.”

To be sure, the high level of available leverage financing helped lead to the implosion of the PE industry, says Mayukh Mitter, Executive Vice President for Special Investments at the Singapore Government Investment Corporation (GIC).

“Greed got a bit too much,” says Mitter, arguing that investment banks and PE houses were complicit in handing out syndicated loans and investment funds when “the music stopped” and “the house crashed”.

So is there a need to change the model of private equity? The answer, says Panandiker, is “not really”.

“Things will go on as they are. They will progress more and more towards what developed markets private equity looks like.”

Pointing to Singapore as primarily a buyout market, India as a growth capital market, and Indonesia as largely a structured transactional or mezzanine market, Panandiker says Asian markets “will all evolve towards similar models as the economies keep pace”.

Aside from Asia’s more developed markets, Marvin Yeo, Co-founder of Frontier Investment & Development Partners which has investments in Cambodia and Laos and is looking to launch a fund for Mongolia, is bullish about the economic prospects of these frontier markets, which are rich in natural resources. His reasoning is simple: India and China’s need for natural resources will drive the economic growth of these markets.Asked if it is too early for international investors to invest in Cambodia and Mongolia, Yeo, an INSEAD alumnus who previously worked at the Asian Development Bank as a senior financing official, says the two countries have seen improvements in the last few decades.

In the case of Cambodia, the country has a dollar-linked economy with no foreign exchange risks. Companies can be fully foreign-owned and there are no capital controls. Plus its oil and gas reserves, which will come onstream in two years, are expected to result in its GDP growth doubling. Cambodia also boasts cheap arable land and low labour costs.

“For us it’s almost a no brainer to get into these countries early, understand them, line up the deals. We expect the Chinese to be a main source of exits.”

“Over the next few years, China is not going to go far away to get access to resources that it has in neighbouring countries. So we think the timing is absolutely right.”

As for his own exit strategy, Yeo will be looking to secure public listings for his portfolio of companies in the region rather than list in their home countries.

On the lack of regulatory frameworks in the frontier markets, Yeo says he avoids doing business with the authorities to side-step another layer of tax. Instead, he conducts due diligence on his prospective local business partners before investing in them.

“Essentially our business model is we bet on established local entrepreneurs whom we deem to be credible and trustworthy. And, with the right support, we’ll be able to stand up to international investors’ scrutiny.”

Over in India, making successful PE investments can be fraught with challenges, not least from Indian entrepreneurs who can be like “a ninja at taking your money away”, says Atul Kapur, Managing Partner of Indivision Capital Management, which has US$1.2 billion under management and focuses exclusively on India’s PE & real estate markets.“So you have to hone your martial arts until you’re the seventh dan black belt at making sure you protect your money,” said Kapur, to laughter from the audience.

Kapur recalls major foreign investment firms that have dispatched their employees to set up shop in India over the years because of pressure from their investors.

“Those guys (the employees) will go to the same 10 intermediaries who will show them the same (investment) reels that they show to all the other people. And then they will take a look at the prices and fall off their chairs.”

“And they do that for nine to 12 months until someone at the head office loses patience and says ‘you guys are not doing deals, meanwhile I’m spending five million dollars on infrastructure. So close the office’.”

“And you see this cycle, it’s a movie that plays over and over again. I think this is a market where you have to have physical presence on the ground, and you need to not just have physical presence at the overall (local head office) in Bombay (Mumbai) with seven guys. That model doesn’t work.”

“For us, the only way you make money in India is actually not just being present on the ground but also making sure that you have enough by way of control, enough by way of influence and enough by way of surrounding the entrepreneur - four different ways that he can’t take your money away.”

Indeed, it is vital that investors are able to ensure that,  should they invest in an engineering, procurement and construction (EPC) company, that it does not switch to making films down the road, says Kapur.

“You need to be able to understand who you’re investing with, what his desires are. You got to go hang out with the families. You got to make sure that ultimately the guy is going to see the world the same way.”

“We have a saying in our business, ‘that until you invest, the entrepreneur has the vision and you have the capital. Once you invest, he has your capital and you have the vision.’ You’ve got to make sure that the capital and the vision are all stuck together until you exit. After that he can do whatever he wants.”      

Kapur adds that the challenge for major PE firms, such as Bain Capital and The Blackstone Group, is finding deals that are large enough (that is, around US$200-300 million) to be meaningful.

Extracting alpha from growth investing

“For growth investing, we think that having operating capability and operating expertise is an absolute imperative. Without that, you make money, but you make money in a beta fashion. But you can buy the markets for that. In order to extract alpha, you have to get involved in companies, there’s no way out.”

Atul Kapur, Managing Partner of Indivision Capital Management.

In terms of India’s attractiveness as an investment destination, Kapur says the impact of the global financial crisis was limited, as there was no systemic risk in India’s banking system. He believes that over the next 24 to 36 months, India’s nominal GDP growth will reach 10 per cent (including inflation of 4 per cent), which will make for “an attractive environment to deploy capital.”

In China there are few buyout opportunities, as “people are very risk-averse at the moment”, says Riverside’s Bunker. He says buyout deals accounted for 20 per cent of all PE deals in China in 2008, but that figure fell to just three per cent in the first half of this year. And as for available buyout opportunities, the business owners typically want to retain a large minority equity stake of 40 to 45 per cent – an unattractive proposition for PE investors.

Indeed, China may not be the attractive investment hotspot it’s cracked up to be. Bunker argues that the history of PE growth capital investments in China is “littered with problems and disappointments.”

“My personal view is that if you can’t do a 100 per cent buyout in China, you probably don’t want to be deploying (investors’) hard-earned money.”

For instance, some joint ventures still require unanimous board approval for key decisions, which could impede business progress, Bunker notes.

In addition, there have been many instances where the local business partners develop their own separate agendas even though the joint ventures were doing well at the beginning.

“There’s a saying in Chinese, ‘same bed, separate dreams.’”

“Unless you have a high degree of control, you have your own CFO, unless you have appointed your own general manager, very often you find you don’t really know what’s going on.”

“You don’t really know what’s going on with the money. There’s a lack of transparency, and there are issues around accounting standards. From my perspective, (when) deploying private equity into China, try to do a 100 per cent buyout. If you can’t, (it’s) probably best to walk away from the deal.”

Another way to invest in China is to invest in companies in Taiwan, Singapore and Hong Kong that have significant exposure to China. Bunker says it’s much easier to do due diligence and have control as the regulatory frameworks are more developed.

But with much investment attention focused on North Asia, China and India, is Southeast Asia becoming irrelevant?

For JPMorgan’s Panandiker, investing in Southeast Asia made his previous employer (Standard Chartered Private Equity) more money than investing in both China and India.

“We deployed twice as much capital in India and China compared to Southeast Asia, but in terms of returns, we actually made little more than both those countries put together.”

Panandiker says that was because his previous company’s focus on buyouts meant it had full control in terms of setting direction for the portfolio companies. In addition, valuations for deals were “far more sensible in Southeast Asia” because so much liquidity was chasing fewer deals in India and China.

“It’s no great secret. You have to buy low and sell high to make money and that’s what happened in Southeast Asia.”

Panandiker says he has yet to do a single deal after looking at almost 130 opportunities in India this year, but he is looking seriously at a couple of opportunities out of almost 75 in Southeast Asia.

INSEAD launched the Global Private Equity Initiative (GPEI) in August 2009 to combine the energies and talents of the school's research and educational capabilities with INSEAD's alumni and global professionals in the PE industry. For more information please contact GPEI's Director, Laura Morales.

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