Asia private equity: Tipping point?

Could 2019 turn out to be a golden period for PE investment? KKR implied as much in its third-quarter earnings call last month. "In our experience, volatility in the market is a good thing for our business because if you have $58 billion that is ready to be put to work, and that capital cannot be taken away from you, it's good news when things get cheaper," Scott Nuttall, the firm's co-president and co-COO observed. 

The message was clear: the US is on the brink of a valuation adjustment – though not necessarily a severe one – that has been a long time coming. A combination of post-peak earnings growth, tightening monetary policy, and potential margin pressure due to rising wages, oil prices and interest rates is bringing the market down from its record highs. Meanwhile, other nations are already in bear territory, with KKR increasing deployment in Asia to take advantage of moderating valuations. 

This view is shared by numerous private equity investors across Asia – with the caveat that it is almost impossible to time the market. Jean Eric Salata, CEO of Baring Private Equity Asia, notes that his firm has tried to stay disciplined on entry valuations, which is in part responsible for a reduction in investment activity over the last 12 months compared to the two years before that. Now, though, volatility is revealing pockets of opportunity around the region.

"It's hard to call where we are in the cycle. But if you look at the next two or three years, we are likely to see a pretty big pullback in asset values and maybe we are seeing the beginnings of that," Salata adds. "With interest rates rising around the world and with dislocation in the public markets – and bearing in mind the run-up we have seen in the last 10 years – it feels like a pullback could happen. This would be a positive development for the industry as a whole."

However, KKR and Baring have different takes on where value can be found. While the former's recent activity in Asia has focused on healthcare and technology, the latter singles out those sectors as too hot to handle. This speaks to a wider uncertainty among investors. It is generally agreed that the current cycle is long in the tooth and that has prompted some industry participants to modify their deal underwriting in anticipation of an economic slowdown. But no one really knows when, where and at what valuation to re-engage.

Reading the runes

One of the challenges is rearranging the fragments of various global macroeconomic trends to create an accurate outlook on a local level. Rising interest rates in the US implies a rising cost of capital, and all other things being equal, this leads to lower equity prices in public markets and lower transaction multiples in private markets. In addition, volatility – whatever the origin – often prompts capital flight and adverse foreign exchange movements, particularly in emerging markets currencies.

Versions of this are already playing out in Asia to different degrees. Pakistan has asked for an IMF bailout because it can't pay its debts, India and Indonesia's currencies have come under pressure, and stock markets region-wide endured a miserable October before rallying in the past week. At the same time, although China has a sizeable domestic demand base that can insulate it from global macro shocks, its public market lapse predates the others. Growth is slowing, liquidity is tightening, and trade tensions with the US have hurt investor sentiment.

Ilfryn Carstairs, Singapore-based co-CIO of global alternative investment firm Värde Partners, describes the current market dynamic as the slow-moving turnaround at the end of a super-cycle as the search for yield in other asset classes is eclipsed by a return to traditional fixed income. This might be the big picture trend, but he argues that people often fixate on the world as if it is consumed by a single cycle or acts as a single market.

"Things don't have to connect together and create a global financial crisis-style cycle where everything gets cheap simultaneously," Carstairs explains. "What you normally see is individual cycles in different places that don't necessarily connect together and create a big global cycle. To me, that is more what we are headed towards under the current circumstances, with the large asterisk that a number of big geopolitical factors could change the game quite significantly."

The uncertainty attached to these geopolitical factors – of which the trade war is the most significant, given how deeply it can reach into supply chains – is reflected in rising demand for information among PE investors and corporate executives. Andrew Thompson, Asia Pacific head of private equity and sovereign wealth at KPMG, claims he has never seen so many clients take briefings on how quickly global level issues could cascade down to portfolio asset level.

"Over the last five years, corporate boards have been very concerned about digital transformation and new economy and how it is going to hit their business," he says. "They remain focused on that, but they are also concerned about the global macro position to a much greater extent than in the past. There are real black swan events coming out of some pretty big economies."

Economic considerations feed into expectations of a valuation adjustment alongside a suspicion that private markets have soared to possibly unsustainable levels across several metrics. According to the 2018 iteration of Bain & Company's Asia Pacific private equity report, average EBTIDA-to-enterprise value (EBITDA/EV) multiples fell slightly to 14.1x but still exceeded the US level of 10.3x. Meanwhile, funds were sitting on $225 billion in dry powder by the end of last year, up from $170 billion in 2016.

A lot of this dry powder is held in a small number of large-cap funds. Excluding renminbi-denominated vehicles, one-third of the approximately $62 billion raised by Asia-focused managers last year went to three funds, each at least $3 billion in size. With $82 billion raised in 2018 to date, that share is roughly the same across five funds, including the record $10.6 billion vehicle closed by Hillhouse Capital.

"In terms of dry powder relative to GDP, which gives an idea of how much capital is available relative to the opportunity set, Asia still compares favorably to Europe and the US," says Doug Coulter, a partner at LGT Capital Partners. "The problem is the concentration of that dry powder. While it is hard to say categorically that too much capital is chasing those big deals, there is clearly more competition in that segment of the market."

Beleaguered buyouts 

Asia private equity investment stands at $150.3 billion so far this year, already the second-highest annual total on record but unlikely to surpass the $206 billion deployed in 2017. Growth-stage technology deals are still very much part of the landscape. They account for $48.4 billion of the investment total – up from $15.5 billion last year – and if you ask anyone to name deals where the valuations have raised eyebrows, they respond with a stream of unicorn funding rounds.

Buyouts appear to be going in the opposite direction. They contributed around 40% of cumulative investment volume in each of the last three years, but the share for 2018 to date is just 23%. While Australian infrastructure privatizations and Toshiba Memory Corporation (announced in 2017) can have a distorting effect on headline numbers, there is no denying that large-cap buyouts have dropped off. AVCJ Research has records of 25 transactions of $2 billion or more announced since the start of 2017. Nine have come in 2018.

If there is a poster child for deals not done it is Yum China, local operator of KFC, Pizza Hut and Taco Bell. A consortium said to feature Hillhouse, Baring, KKR and China Investment Corporation (CIC) lined up a $17.6 billion offer at 15-16x EBITDA/EV only to see it rejected. They did not return with a higher offer. "The valuation was ridiculous. How would they ever get out at that level unless underwriting some heroic growth assumption," says a source familiar with the situation, noting that a $15 billion offer for Yum was in the works two years ago and fell down for the same reason. 

Opinion is divided as to whether private equity firms have become less aggressive in their pursuit of large buyouts. If they are, it isn't due to changes in the debt markets. Leverage levels for senior debt have stayed reasonably consistent, in the 3-5x EBITDA range, depending on the industry, market, and identity of the lender. And while financing sourced out of Asia is not as flexible as the US – where most debt is seven-year paper with zero covenants – banks are accommodating.

"The covenant levels offered by some banks are so loose. Even if you were to breach them somehow, having a conversation with a bank is much easier than having a conversation with an institutional investor," says Asghar Ali, a managing director with Citi's debt syndicate and acquisition finance group in Asia. "People know in Asia there is no real bankruptcy friendly regime, so the only option is to work it out."

As for EBITDA/EV multiples, the willingness to pay up – at least to a point – in the case of Yum China is not uniform across all industries. Education, healthcare, and consumer-retail in fast-growing markets may command multiples in the 15-18x range due to assumptions of a long-term rise in discretionary spending. Most traditional industries are valued at 8-10x.

Christopher Laskowski, head of the global asset managers group for Asia Pacific at Citi, adds that financial sponsors are mitigating higher valuations through cross-border strategies, where underwriting is contingent on generating growth by bringing a product or technology into Asia. This features in the Baring playbook as well, sometimes as part of a broader platform whereby the firm will buy a foundation asset and then making subsequent bolt-on acquisitions at lower multiples, bringing down the overall cost of the deal while at the same time exploiting synergies.

"It's a bread-and-butter strategy for us and very timely. It's really about consolidation taking place in various industries and being able to drive that," Salata says. Portfolio companies in Baring's sixth pan-regional completed 30 bolt-ons last year, deploying $1 billion. That is the same amount as invested by the fund in primary deals. Across all the PE firm's funds, investments that have involved add-on acquisitions have delivered a 500 basis-point higher gross IRR than those that have not.

"Generally, we are in an environment where if there ever were a free lunch there isn't one now. You have to pay high multiples, and so you throw the kitchen sink at these businesses to drive value," adds Alex Emery, a partner and head of Asia at Permira. "At the same time, you must be disciplined. A rising tide floats all boats, so businesses that don't deserve high multiples get them. When the tide goes out, not all the multiples will go down. You need to identify which businesses deserve higher multiples because they have structural growth that will continue despite a cycle turn."

Lessons learned

Most private equity firms tend to dial back the debt burden they place on companies – and ensure balance sheets are resilient – if a valuation adjustment seems imminent. This is one of three major lessons Permira learned from its experiences in the global financial crisis. The others were screening out businesses with cyclical tendencies and avoiding consortium deals. Clubbing up with other sponsors can bring new opportunities in range, but the GP risks losing control over the timing of its exit.

For Navis Capital Partners, the key takeaway was at the portfolio level. The firm went into the crisis with a fund that was almost fully invested but had delivered no realizations. Holding periods were extended and performance suffered, at least in terms of IRR. Now Navis focuses on rapid results: targeting bilateral deals so that improvement initiatives can be implemented before a transaction closes; being able to change management in a company quickly by having a preidentified bench of CEO talent; and starting vendor due diligence early to facilitate an exit when the time is right. 

The objective is to deliver a five-year money multiple in three years and deliver a few quick exits early in a fund's life, so the portfolio isn't left high and dry by an unforeseen macro or micro shocks. Recalibrating team compensation to prioritize IRR over money multiple is another integral part of the process. Navis duly delivered the first exit from its seventh fund in early 2018 with the sale of MFS Technologies for a 3x return – just over three years and three months after buying the business. 

"With the benefit of hindsight, we could have got more, but we would have been running with a fully naked portfolio, no realizations but mostly invested, for an extra period of time," says Nick Bloy, a managing partner at Navis. "I think that is unacceptable when we know we are late in the cycle and we are in a part of the world that is volatile."

While an environment of elevated valuations can be challenging for new investments, it is great for realizations – and the likes Baring, Permira, and Navis have all been in exit mode. The lingering question is whether the recent dislocation in public markets is causing vendors to wait and see how the market shakes out. Eventually, activity will resume, but at a lower price point: good news for a private equity buyer but maybe less so for a private equity seller. 

"Asia had a record year for distributions last year and it's on course for another record year in 2018, based on the annualized data. Money is rolling in, but things can change very quickly," says LGT's Coulter. "What GPs should have been doing for the past 24 months is selling companies. While they need to continue investing, they should be cautious. We will probably look back and say 2017 and 2018 were great years to sell but not particularly good years to buy." 

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• Topics
• Buyouts
• Expansion
• Consumer
• Healthcare
• Technology
• GPs
• Asia
• Growth capital
• China
• Baring Private Equity Asia
• Permira Advisers
• Navis Management
• KKR