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It's no news that Asia offers long-term growth. But the value locked up in its disparate corporate structures means private equity could represent the keenest form of Asian risk, writes Joseph Mariathasan

nderstanding the potential for private equity investment in developing Asia requires an appreciation both of what is common with private equity activity in the developed world, and also of the more specific challenges. "We are now living in the tri-polar world of Asia, Europe and the US," as Bruno Raschle, CEO of Adveq says. "It is possible to make money in each of these markets, but in a different way, as each is characterised by its own dominant theme. With Asia it is growth, with Europe it is consolidation, and with the US it is restructuring."

Understanding the nature of growth in the different markets of Asia is therefore a key factor in successful private equity investment in the region: "If you are focused on investing in export-oriented businesses in China, you do not understand the long-term trends there," says Chris Meads, who heads Pantheon's Asia operations In India. Eighty percent of Kotak Private Equity's portfolio is in domestic demand-led businesses, according to CEO Nitin Deshmukh. The rise of the domestic consumer is the fuel behind the growth of private equity in Asia.

Raschle views European private equity as essentially an annex of the US, in terms of its basic philosophy - although "some of my European colleagues may disagree on the grounds that Europeans were the founders of the buyout industry". However, the speed of the economic transition in Asia makes it very different from the US and Europe and brings its own challenges: "The half-life of business models in Asia, especially China, is getting shorter and shorter. It is very different from the developed world because certain sectors are transitioning so fast." Asia has also had a very different historical exposure to the private equity industry, as Robert Binyon, chairman of Aureos Advisers Asia, explains: "If you are talking about private equity in terms of the OECD experience - that is, high leverage - Asia was never part of that bubble at all. Whilst there were some private equity deals done in China and India that had IPOs six months later, the main feature of large LBOs has never been a factor in Asia."

Finding managers
For fund of fund managers such as Adveq and Pantheon, finding good quality private equity GPs in Asia is not always easy. Private equity investment is still a relatively recent phenomenon in the region, so there are few firms with experience of weathering the ups and downs of business cycles. But a number of new GPs have been established over the past five years.

"There were new managers appearing every month in India in 2006 and early 2007," says Meads. Often backed by US endowment funds, many were spin-outs set up by one or two individuals from global private equity firms or investment banks. "Unfortunately, it got so competitive that they ended up competing with each other even on brokered deals."

Raschle is also wary of some of the new crop of Indian managers. He says: "In India, we found some managers who did not stick to the original strategy that they were selling when the public markets got hot."

While GPs each have their own different strengths and weaknesses, Meads finds that there has been a higher turnover of staff in captive or semi-captive firms. This creates opportunities for a funds of funds investor like Pantheon, which generally prefers independent managers. However, as Meads points out, some independent managers who have paid too much for their investments, or who are under-resourced or whose recent investment policy has been based on riding the wave, will find it difficult to raise the next tranche of funds.

The best international firms in Asia are those that built up strong local teams, according to Meads. But some of the global mega-funds have changed the emphasis in the way they invest, and a few that set up in the past two years face more pressing problems closer to home; Asia is now too much of a distraction. Still, Meads feels that the more established players are there for the long term: "The best domestic firms got to that position by coming first. They took the risk and are now reaping the rewards. It will become progressively harder for new firms to enter the market."

IPOs
One characteristic of emerging Asia is that the stock markets can represent a much smaller fraction of the economies than in the developed countries. Some frontier markets might not have a viable stock market at all. For Aureos, which has a high exposure to frontier markets, the lack of large public exchanges is not generally a problem as most exits, Binyon finds, are trade sales, not IPOs.

But the relative importance of IPOs versus trade sales does vary across markets and with time. At Kotak, as Deshmukh explains, IPOs have been the exit route for more than 60% of their portfolio, but strategic sales are becoming more important. "This has been driven by two factors," he says. "First, the larger percentage stakes in companies that we invest in, as majority stakes are more attractive for trade sales; and second, the global multi-nationals are now targeting India so the interest level is high and the mid-sized companies we invest in are small enough to be purchased easily."

The tremendous volatility seen in the listed markets in 2008 and 2009 had a corresponding impact on private equity valuations. This was particularly so in India, which Meads sees as far more sensitive to foreign capital inflows and outflows. "There is a much greater focus in Indian private equity on direct investment in a listed entity or things closely connected," he explains. As a result, the market collapse led to an immediate drop in valuations, particularly in sectors such as construction and auto exports.

The dramatic turnaround since Q2 2009 had an equally dramatic effect on private equity valuations. "Funds that were trading at accounting valuations of 50 cents to the dollar moved to 200 cents," says Meads. For Kotak, the volatility in the market meant that for most of 2008 and 2009, the IPO market was closed. Deshmukh hopes that markets will remain in good health for 2010 to enable a number of IPO exits.

Adding value in Asia
Adding value is as important in Asia as it is in the developed world. And because it is still young private equity market, it is arguably more straightforward. "What is required in assessing companies for investment is common sense, not rocket science," according to Pantheon's Meads. He finds that few firms know how to sell their products well, so a common fix is to introduce international talent into distribution and sales.

Aureos also finds that small companies often lack access to international markets and best practice, so they bring in a senior person to the board to fill those gaps. "We also help companies expand overseas and look for foreign clients," says Binyon, "and perhaps buy another division if they have the possibility of building market share externally." Deshmukh cites an Indian pharmaceuticals company that Kotak acquired which it helped to expand into the US by acquiring a small US marketing firm. Later Kotak organised an acquisition in Germany that enabled the firm to tender for global clinical trials, while most of the cost base (in areas such as data processing) remained in India.

While an attractive company in Asia might be different from one in the US or Europe, the techniques of identifying and analysing them are much the same. "There is not a huge difference in the way that we see markets and do business," says Binyon. "Asia has more depth as there are larger populations and economies than in Africa. The larger markets and deeper domestic economies mean that exits are more likely to come off." Moreover, when it comes to exits, often it is the same, or similar, multinationals making acquisitions in China as in Europe.

However, one significant area of difference can be in governance and compliance. Standards have generally improved substantially over the past decade but, as Raschle argues, it is up to local and international investors to continue to press for global standards: "My message to the institutional community is to enforce reporting philosophies that are equivalent to what you get on the public equity side."

Of course, this also means that these are areas where common and immediate value can be added. "Lots of businesses we acquire are family owned and can be very disorganised," explains Deshmukh.

Binyon says that it is often possible to add value by setting up new management systems and providing help at board level - "areas like producing decent accounts and cash management, things those managers in small business have not been able to do well. Lots of small businesses go bust because they don't know what is happening to their cash."

This is a view echoed by Meads, who finds that the capital base often needs to be restructured, with firms frequently financing long-term projects with revolving short-term credit. In addition, Meads observes that, if a management team has come as part of a spin-out of a state owned enterprise, you cannot change the team but you do need to change the incentive structures. "The old game was to fleece the foreigners and then go off to the races with the cash, with the view that they didn't need anyone from outside telling them what to do," he says.

"The big discipline that has to be applied is the recognition that the company's management can make good returns too if they have good corporate governance and can therefore sell or float their company. This discipline provides incentives that are more aligned with investor expectations."

Global GDP growth is increasingly dominated by Asia and will be for the foreseeable future. The private equity industry is maturing fast and the turmoil over the last two years has certainly provided a great way of sifting out the poorer-quality private equity firms in Asia. Raschle finds investors in developed economies are more open to India and China, but for many it can still be scary. "They don't understand what is happening in China," he says. The issue for the future, may be whether disclosure and corporate governance standards rise high enough in Asia to allay the fears of the doubters.
 

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