
Operational value-add: Sign of the times

Budding interest in operational value-add marks a new level of maturity in Asian private equity. Trial-and-error experimentation has progressed slower than the macro motivators
One of the ironies of the private equity industry in Asia is that investors’ efforts to modernize the region have made their jobs harder. Despite all the benefits that come with more robust social and financial infrastructure, the happy hunting grounds of the Wild East are disappearing fast.
Rising competition among GPs and a more nuanced understanding among target companies of what private equity could and should bring means that deals are no longer easy pickings. The transition is best illustrated in two overlapping datasets. According to AVCJ Research, Asia PE fundraising amounted to $341.7 billion for the four years to 2017, compared to only $134.1 billion in the preceding four-year block. Meanwhile, capital deployed in buyouts has risen from $162 billion in 2010-2013 to $423 billion in 2014-2017.
Further evidence of maturation in Asian markets can be seen in uncertainties about technological disruption and China’s gradually changing growth model. These factors have contributed to an environment in which it’s increasingly rare for investee companies to passively float up with overall market growth. As a result, more founders recognize the need for outside assistance and might be willing to relinquish control to get it, but this is contingent on PE investors demonstrating an ability to deliver operational improvement.
“It’s not as easy as it was a few years ago to just bet on the right sectors with a minority stake and make money based on Asia’s growth,” says Waldemar Jap, head of the Greater China strategy and operations practice at PwC. “Now, you actually have to do something with companies. We’re seeing more PE firms influencing the direction of companies and sometimes even morphing specific projects within the businesses. It’s not the like US or UK yet, but there are signs Asia is moving in that direction.”
In Asia, a transition is occurring where family-owned business sectors are becoming more entrepreneur-led. The trend implies the emergence of a new, educated class of business leaders who understand the importance of teamwork, leveraging new resources, and engaging with a more diverse range of partners. Meanwhile, an element of storm-proofing has entered GPs’ value-add playbooks in recent years as expectations around a macroeconomic slowdown have become more acute.
“It’s clear to me that there is a mind-shift around focusing on value creation and realizing operational alpha,” says Ben Jelloun, a China-based deal strategy partner at KPMG who is conducting a survey on value-add strategies in Asian private equity. “The industry has realized it needs people who can deliver results, which is a different proposition than just having a good deal team. You can see it even in the way PE firms are buying services because they really want deal advisors that have operational capabilities.”
Model approaches
A number of adoption styles have come to the fore. These include fund managers where all senior leadership have experience in operations which allows them to combine deal making and company development work in a relatively seamless process. This model tends to bring together various industry experts into a diversified GP or group similar specialists into a more targeted fund. Most models, however, have segregated deal and portfolio teams.
Hybrid versions of these set-ups have proliferated as well, often including the use of loose networks of experts that may or may not be on the payroll or exclusive to the firm. KKR, which is widely regarded as the industry leader with a global team of some 90 full-time operating partners, takes a unique approach. Its KKR Capstone unit is an independent business although it licenses the name and aims to ensure alignment by working exclusively with the GP. Capstone partners rarely sit on the boards of KKR portfolio companies.
The closest parallel to this model is the engagement of an independent third-party team of operations specialists. James Dubow, head of Asia at Alvarez & Marsal (A&M), says that global firms like his are seeing signs of industry uptake, including improved access to wary portfolio companies and rising competition among contractors. But while A&M claims to have notched a significant uptick in business in recent years, the conducting of deep operational sweeps is still not the norm in Asian private equity investment processes.
“The way it was typically handled before was getting an industry expert in to take a look at the company and ask him questions about it,” says Dubow. “That’s fine, but it’s not the same as having a team of six to eight people crawling over the whole business and really understanding the details. Frankly, that kind of operational due diligence is more expensive, but there’s growing awareness of the value of it, especially in places like China that are opaque and you can make more mistakes.”
There remains, however, a significant amount of self-selection in the industry regarding operations. Essentially, firms that have historically dabbled in operations are now ramping up while those that were always standoffish remain cautious about buying fixer-uppers when straightforward growth plays still appear to exist.
A&M highlights this point by the fact that the vast majority of its clients already have in-house teams and are simply looking to reinforce their existing capacity. This tendency also helps explain industry observations that large GPs using hybrid operations models are scaling back their teams and outsourcing more.
“Because recruiting in this market is so difficult, the bigger a GP’s team, the more likely it is that they’ll have pockets that don’t meet the standards they’re looking for,” says Dubow, noting the budgeting difficulties of optimally deploying senior operations experts in full-time roles. “So the trend in the industry of smaller teams is not about de-emphasizing operations, it’s more about outsourced versus in-house type of practices and people looking for the right balance.”
Finding that balance has been a matter of staffing up for most operationally focused firms. Anecdotal industry feedback suggests the average operations team for mid-market private equity firms has ticked up from 2-3 partners some five years ago to 5-7 today. Talent shortages have kept this expansion in check, along with practical requirements. As each operating partner usually oversees 3-4 companies, a compliment of 5-7 often satisfies the average-sized portfolio.
Slowness to achieve competency in this area could prove to be a significant problem as fast-developing markets continue to shift the playing field. Cooperation between deal and operating teams as well as compensation schemes that ensure both parties are properly incentivized have emerged as the most indispensable mantras of informed players. Yet there is little talk of momentum in these matters in Asia, where most examples of proper in-house integration are found in the regional arms of global firms.
“Changes in the market are making it harder for an investment thesis in year one to still be true in year five,” says Lian Hoon Lim, a managing director at Alix Partners. “One of the habits of due diligence in Asia is to focus on market trends and growth plan risks while paying much less attention to core operations. You may then find that a company’s ability to execute against an aggressive growth plan is actually not there because the core operations were not as scalable as initially assumed – or that changes in market conditions expose a weakness in operations. That’s a real risk and we’ve seen it happen.”
The ESG angle
Asia is expected to see traction, however, in at least one of value-add’s strongest undercurrents. Environmental, social, and governance (ESG) standards have become a major theme in the region given the history of sustainable development initiatives and the pollution crackdown in China.
Strict oversight in ESG belies how its origins in red tape and exclusionary investment policies have progressed to include more of a value-creation opportunity set. In this frame of mind, ESG standards are embraced to optimize supply chain operations, for example, as much as to avoid embarrassing infractions. As that sentiment continues to evolve, a more pervasive crossover of commercial and social agendas is expected to influence operations.
“Generally, LPs that care about ESG want to see your polices, implementation processes, and to some extent, your reporting. But we’re at a turning point now,” says Steve Okun, CEO at APAC Advisors. “As GPs position themselves as providing both financial and social returns through an operational focus, LPs will want to know how the GPs are defining impact investment. Demand is growing for the industry to put definitions around that framework.”
Technology is another area where Asia could prove to be a trendsetter in new value-add approaches, especially through the use of artificial intelligence (AI) and investor partnerships with large platform providers such as Alibaba Group and Tencent Holdings. When GPs plug their portfolio companies into these ecosystems, it’s a quick but potent win in terms of access to markets, data, and networking capacity. It could also be a sign that Asian PE is slowly forging a new model for operations programs.
“It speaks volumes to the sophistication of the market when you see firms moving into more operational and value-creation activities,” says KPMG’s Jelloun. “I’ve been impressed by the capabilities of some regional Asian firms in the use of AI in productivity improvement and data analytics in due diligence. In some ways, the Asian GPs are on par if not even better than some of global PE houses in implementing the value creation playbook locally.”
SIDEBAR: LP perspective – CDC Group
There appears to be a fine line when it comes to LP appetite for operational value-add teams in private equity firms. There is enough trepidation about the costs related to such programs that global GPs with large operations units are now said to feel pressured into scaling back. But in many cases, patience for insufficiently aggressive strategies has all but evaporated.
Certain institutional investors are more than just supporters of industry momentum around adopting value-add practices – they’re among the principal drivers. CDC Group, for example, wants more exposure to large control deals in Asia and it is demanding concrete examples of how GPs’ operational strategies have been successful in the past.
“LPs want more than just me-too funds to back, and one of the main differentiations that they’ve tried to show is that they’re much more hands-on in adding value,” says Alagappan Murugappan, a managing director at CDC. “We want them to convince us that they can either source the right people or have credible in-house people to do that. There are pros and cons to each model, so it’s difficult to say which is better. But I think it’s vital that the talent is integrated and incentivized.”
The UK government-owned development finance institution has tightened a broad developing markets commission in recent years into a focus on South Asia, investing about $100-150 million a year in the region with a double bottom line of social uplift and financial returns. This mandate supports the firm’s value-add ambitions by leveraging a trend within India of operational talent becoming available to financial players.
“There are a lot more professionals leaving cushy jobs in midcap companies to take on these more entrepreneurial ventures where they’re compensated on the basis of performance, and in fact, we’ve come to a stage where operations people are only willing to join a company if it is backed by a PE house,” says Murugappan. “There is a risk-taking ability which as increased significantly in the corporate class.”
CDC’s push for more investment industry integration with this corporate class has a significant transparency component, especially regarding environmental, social and governance (ESG) requirements. The firm is recognized for its ongoing ESG workshops, elaborate reporting standards, and compliance check-up visits to GPs. But the philosophy behind these conditions is as much about operations as optics.
“ESG is an extremely important evaluation point for us, and it’s not just development financial institutions,” says Murugappan. “A lot of pension funds and other LPs are focusing on this and saying not to look at it as a chore but as an opportunity. In all our investments, there is at least one person who’s responsible for ESG, but in areas where there are higher risks such as infrastructure funds, we insist on having two dedicated resources.”
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