Private equity popping up on the institutional radar
Category: Asia, China, Asia-Pacific
By Paul Mackintosh
Asian growth signals great potential for the future
Asia-Pacific private equity (PE) has long been considered an alternative asset class in an emerging region. Post-global financial crisis (GFC) and the European sovereign debt meltdown, the situation is very different. The macro attractions of Asia remain highly compelling, even allowing for some slowdown and instability in China and policy stagnation in India. “The concerns about China, while some of them are real, are completely overdone by the Western media,” asserts Doug Coulter, head of private equity, Asia-Pacific at LGT Capital Partners. “There are issues, of course, but per capita incomes in China are somewhere where Japan was in the 1950s, so you’ve got potentially one-to-two decades of above average growth ahead.”
Institutions definitely seem to have come round to the attractions of both the region and the asset class. David Pierce, CEO of independent regional fund of funds Squadron Capital, says: “Continuing interest in getting exposure to Asia. Investors are still relatively underweight where most Asian economies are concerned. Also, there’s long-term conviction about the growth trajectory in Asia.”
Some even feel now that Asia is more attractive for private equity than the more established regions post-crisis. “Asia has come out of the crisis looking better relative to the other regions for private equity,” affirms Emmett Thomas, head of Asia at Advantage Partners. “Asia probably has a better risk-adjusted profile than the US and Europe does.”
And the industry, structurally, is definitely investment grade. Squadron Capital’s latest survey of Asia-Pacific private equity fund terms and conditions, polling 104 general partners (GPs) engaged in fundraising during 2011, found that, “Asia-Pacific private equity funds continue to demonstrate best practice in a number of areas”.
As expectations for returns moderate across all asset classes, private equity outperformance becomes increasingly attractive. “We live in a very low-return world right now; not just in PE but across all asset classes,” Mr. Coulter says. “It is conventional wisdom that this is going to be a low return world going forward, and private equity is also likely to be lower return than it was. But PE should continue to see a very healthy outperformance over public equities, at least top-quartile PE should continue to generate returns at least 5% to 10% over the relevant public market indices, and the best thing about private equity (unlike public equities) is that past performance is to a great extent a good indicator of future returns.”
Limited partners (LPs) can have different reasons and priorities for allocating to private equity as an asset class, but in the case of Asia, at least, Mr. Coulter identifies one important reason to favour it for anyone looking to tap into the region’s dynamism. Asian private equity, he remarks, broadly exhibits “relatively less volatility compared to public markets, and relatively higher levels of corporate governance compared to public markets”. And crucially, “these PE portfolios are generally a much better mix of the underlying economies in the fastest-growing areas such as healthcare, services and other consumer-facing areas. If you buy the stock market index in Hong Kong or Shanghai you’re getting an index that is very overweight towards SOEs, financial institutions and natural resources, and has very little exposure to the fastest-growing areas of the economy. For that reason alone, we think PE is a very interesting way to play the Asian growth story”.
Not every institution feels the same way, though. “Institutional investors in general are having more of a bias towards liquidity than before the GFC. Obviously that tends to work against PE,” concedes Mr. Thomas. “There’s been some reasonable sector of investors that have reduced or eliminated their allocation to PE. My sense is that it’s for liquidity as much as anything … Long-term, things will probably swing back towards PE, because there’s not that many asset classes with the yield people are looking for.”
“In general, LPs have moved away from private equity and are allocating more capital in alternatives to infrastructure and credit,” affirms Grant Fleming, partner with Australia-based advisory and asset management firm Continuity Capital Partners. “This reflects LPs’ desire to focus on yield-oriented asset classes rather than on those that generate most of their returns from capital gain. Notwithstanding this, there are several private equity strategies which are very attractive and the leading LPs are exploiting these opportunities.” And, he adds: “Asian private equity is one area where the most experienced LPs are trying to invest more capital.”
Strategy in fact is becoming a more important component of investors’ approaches, perhaps reflecting the growing maturity of Asian private equity, but also the greater caution and higher expectations of institutions post the crisis. “While the market is still interested in private equity, LPs are becoming more sophisticated as well as more interested,” remarks Mr. Pierce. “There is a greater appreciation of the need for careful and knowledgeable manager selection.”
“While there still are hot markets and hot managers in Asia today, the fund-raising environment for Asia-focused funds is generally more measured,” observes Joshua Kahn, director overseeing primary, secondary and co-investment activities in Asia with Hamilton Lane in Hong Kong. As he says: “Many LPs are beginning to realise that they have historically approached the region with too broad a brush, given that the fund manager universe is still only maturing. It also reflects [the fact] that, in uncertain times, investors tend to put a premium on liquidity, and so tend not to gravitate towards private equity strategies.”
“There’s a lot more attention being paid now to careful portfolio construction, being quite selective in the numbers of relationships overall,” confirms Mr. Pierce.
With investors more cautious and parsimonious than hitherto, GPs are evidently going the extra distance to attract LPs and build fundraising momentum. The recent Squadron survey found that some 20% of its sample of GPs (up from 5% in 2010) now offer preferential management fee terms to a select portion of their LPs, while 15% (up from 6%) are offering preferential terms on carried interest. And the tendency, previously more prevalent in India, is now evenly distributed region wide.
“The big advantage for LPs today in Asia is choice – as there is less patient capital available for GPs, LPs are able to be more discerning with regards to which parts of private equity and which GPs to invest in,” adds Mr. Fleming. “We have invested in Asia for 15 years and we think that the current environment is probably one of the most attractive – but like all good strategies, implementation is key.”
Part of the strategy focus for LPs is picking the right management style. As might be expected, leverage-driven investment strategies are going out of fashion, but the jury is out on whether this represents a shift in substance or just marketing rhetoric by GPs.
“Less leverage is available globally for private equity,” Mr. Coulter believes. “Banks are more discriminating in terms of who they offer leverage to. When it is available, it is in lesser amounts. There was a time when a lot of the value creation was via deleveraging and boosting returns through cheap debt. The implication would be that you have to work the assets harder and provide more post-investment value add to generate the returns. That said, private equity, particularly in emerging Asian markets such as China and India has never been dependent on leverage, rather returns have been dependent on growth.”
Mr. Kahn sees excessive leverage as even actively risky in the current environment. “We view leverage as a means to optimise returns rather than being the primary source for returns – the economic volatility associated with the ongoing sovereign crisis increases bankruptcy risk and emphasises the need to approach the use of leverage accordingly.”
“There is no doubt use of high amounts of leverage during the period of credit expansion took place in Asia, especially in some large deals,” says Mr. Fleming. “This works if you can sell the business easily, after paying down debt, and the company can be refinanced. The reliance on leverage to generate a large proportion of your return has resulted in some poor returns to general partners and their investors. In the long-term I am not convinced investors will learn from the current cycle: behavioural finance tells us we are slow to learn lessons from the past and one day leverage will be used – perhaps predominantly – to generate returns.”
“Speaking about Asia, there has never been very large amount of debt in deals, especially in China and India,” Mr. Coulter continues. “China is now indisputably the largest PE market in Asia, and there are very few leveraged deals. The question becomes how did people make money in China over the years, and part of the answer is multiple arbitrage, buying low and selling high. In today’s world, one difference now compared to five years ago is that everybody, even managers without much post-investment capability, is talking about adding value to companies post investment. The question is how many of them are actually doing it? Probably only a handful have the capabilities. But it is a growing theme and it will become an increasingly important part of value creation in Chinese private equity over the next ten years.”
Liquidity and secondary deal flow
Shifts between strategies are part of the increasing emphasis on portfolio construction, which is bringing with it new reliance on liquidity options, such as secondary transactions. The secondary market in Asia appears not only to be growing to meet long-held expectations of secondary fund managers, but also fulfilling an increasingly important function in the regional private equity infrastructure as a reservoir of liquidity.
“Private equity, while a long-term asset class, is not as illiquid as often perceived given the developing depth of the global secondary market,” says Mr. Kahn. “And importantly, the long-term structure of private equity is, in fact, ideally suited to benefit from market dislocations that the sovereign debt crisis will invariably generate – having a stable capital pool to call on during volatile periods can itself be the source of investment opportunities.”
Although he describes the market as still “nascent”, Mr. Fleming says: “Buying fund interests from European, American or Australian investors who have decided to move out of private equity for strategic reasons, we have been one of the most active buyers in the region and the approach is paying good dividends for our investors.”
Mr. Coulter attributes the trend partly to new regulations. “There’s been a steady increase in secondary deal flow in respect of Asian assets – though relative to the West the Asian secondary market is still small as most LPs are underweight Asia and increasing allocations, not selling. And while it’s not growing dramatically, volumes are growing,” he notes, remarking on “the large global banks essentially selling off PE portfolios due to regulatory changes. That’s one of the big things, and that’s going to continue for quite some time. We have been one of the largest buyers of Asian secondary assets over the past five years and also see this as a great way to profit from periodic downturns like the one we are currently experiencing.”
Regulation and the ecosystem
Regulation and oversight is in fact becoming more of a constant, if not a concern, for GPs and LPs alike. “Across the market, both in the sources of capital and the places where capital is being deployed, you’re seeing regulatory change,” warns Mr. Pierce. “So we’re in a period of change right now, and it’s likely to continue for quite a while.”
“Broadly speaking, LPs expect a lot more than they used to: as they should,” confirms Mr. Coulter. “Obviously there have been issues in the industry in the last few years. People expect more transparency; there’s a lot higher level of due diligence expected before people commit large amounts of capital, and that’s all good.”
Mr. Fleming believes that the industry’s record on this is at best uneven. “Unfortunately there are still large variations in how well general partners are meeting investor and compliance demands. Some general partners have invested in high quality investment support personnel and deliver timely, accurate information. Others have yet to make the transition to this new environment. On the whole, we think general partners understand the need for greater oversight and accountability, but there is always more you can do in this area.”
Expectations and performance
The regulatory environment, however, appears unlikely to tarnish the relative merits of the asset class or diminish the appeal of Asia. “There was this huge explosion of interest and activity in Asia during the last decade. There were some unrealistic expectations on the part of both LPs and GPs as to what kind of returns that sort of activity could produce,” Mr. Pierce observes. But, he added: “Clearly the macro story remains. The Asian economies, with only a couple of exceptions, are very interesting, growth is occurring now, with great potential for the future.”
“Global macroeconomic conditions have not altered our view of where opportunities in Asia lie,” says Mr. Kahn. “In fact, in some ways, current conditions have confirmed our approach, as a receding capital tide has helped to reveal that selectivity is a critical ingredient to successful long-term investing in this region today.”
“Private equity as a percentage of overall assets in many institutions continues to climb and much of that goes back to living in a low-return world,” Mr. Coulter concludes. “If the conventional wisdom is that equities are going to deliver flat to low-single-digit returns over the next few years (not much better than what we’ve seen over the previous ten years), and that you’re going to have to suffer relatively high levels of volatility over that period. If you look at other alternatives like hedge funds that haven’t necessarily done what they’re supposed to do, then PE does not look so bad, we know that if you’re able to get access to top-performing groups historically you have quite a lot of outperformance and there is no reason to believe that will not continue.”
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