Portfolio: Warburg Pincus and ESR

Eight years ago, Warburg Pincus teamed up with two Chinese entrepreneurs to build a real estate logistics business from scratch. Now known as ESR, it has grown into the largest platform of its kind in the Asia Pacific region by gross floor area (GFA), accumulating $20.2 billion in assets under management – most of it held through third-party funds – and achieveing a market capitalization of $6 billion following a Hong Kong IPO in October.

The company is a standout example of two traits of Warburg Pincus’ investment strategy in Asia. First, the pursuit of scalable business opportunities – often seeding new platforms – whereby meaningful dollars are put to work through lines of equity or staged investment structures. Second, targeting real estate in expansion markets as a proxy for consumer growth that also offers an element of downside protection.

The firm’s real estate investment activity in China started in the early 2000s. It initially backed for-sale residential developers, such as Greentown China and Guangzhou R&F, before shiting into areas like logistics and industrial real estate some 10 years ago.

“More than 90% of the listed real estate companies in Hong Kong were home builders at that time. In the US, it is only 6%. The balance is primarily retail, office, logistics, and hospitality. So, we made a conscious decision to create the leaders in those segments of real estate,” says Jeffrey Perlman, head of Southeast Asia at Warburg Pincus. He also serves as chairman of ESR, having been involved in the investment from the outset.

In 2006, the firm invested in budget hotel chain 7 Days Inn, helping the business grow from seven to 2,500 establishments during the holding period. A year later, it backed Red Star Macalline, which went on to become China’s largest furniture and home products retailer. Logistics became a prime target in 2011, when it was still a nascent trend in China real estate. Earlier this year, a PwC Asia real estate survery found it was the only segment in which investor opinions were uniformly bullish.

“There are very few larger secular opportunities than this. It hits so many important criteria. The total addressable market is massive. You’re essentially having a once-in-a-generation secular shift in how goods are consumed and therefore the infrastructure that’s needed to support it. You can do this in an asset light manner in a fund management model, which allows you to grow much faster and generate high levels of return on equity,”says Perlman.

David vs Goliath

ESR was initially known as e-Shang. For Jinchu Shen, one of three founders alongside Perlman and Dongping Sun – who went on to establish D&J China, a built-to-suit industrial parks operator also backed by Warburg Pincus – the biggest question mark hanging over the new platform was how it would compete with his previous employer.

Prologis remains the largest industrial real estate company in the world but its Chinese business spun out as Global Logistic Properties (GLP) after the global financial crisis. Shen served as a senior vice president at Prologis and then GLP between 2003 and 2011, holding responsibilty for Eastern China, which accounted for half of the country portfolio. He noticed the nascent e-commerce trend and decided to bet big on it to take on GLP.

“In 2009 and 2010,  I was in contact with many emerging e-commerce retailers as part of my role at GLP. Although not all of them stayed in the industry, I was convinced that the prosperity of e-commerce would change the logistics ecosystem and the operation of inventory warehouses,” he explains.

The biggest difference between an e-commerce warehouse and a facility serving brick-and-mortar retailers is size. The volume and velocity of goods moving in and out every day required space – Amazon, for example, typically uses warehouses of 100,000-200,000 square meters.

However, GLP was at the time unable to meet this demand because most of its properties were fully rented and terminating large existing customers was difficult. One solution is to offer the same amount of space across several logistics parks, but this can lead to inefficiencies: a consumer might place orders for five items that come from five different warehouses, which means sending five separate packages. This increases delivery costs. “It was hard to push e-commerce from inside GLP,” Shen recalls. “The inertia was large.”

E-commerce was therefore part of e-Shang’s DNA from the beginning – indeed, the company’s name was a combination of “e” and the Chinese word for “commerce.” The founders obtained the three-year development plans for major e-commerce companies and built their business accordingly. Amazon became the first large customer, and it was followed by JD.com and Cainiao, Alibaba Group’s logistics affiliate. As of June, 45% of ESR’s 1.6 million sqm in leased area was occupied by e-commerce tenants in China.

Data is one of the most valuable assets of these companies. JD.com knows exactly where its customers come from, what they have purchased in the past, and how much they tend to spend per order. Location-based information is detailed enough to identify individual streets and buildings. This influenced how ESR built out its warehouse footprint. The company has 3.8 million sqm of completed properties in China and a further 2.8 million sqm under construction or held for future development. Most of it is concentrated on first tier-cities.

Fair value gains on properties account for the bulk of ESR’s profit. For the three years to 2018, net profit came to $105 million, $201 million and $213 million, respectively. Fair value gains were $107 million, $195 million and $172 million. This translates into cashflow as mature assets are spun off into funds or real estate investment trusts (REITs). As of June, funds and other investment vehicles held 72% of ESG’s 15.3 million sqm in GFA and 85% of its AUM. The company gets fees for managing these vehicles.

Even though e-commerce giants like JD.com now build and operate their own warehouses, Shen is confident ESR will remain their go-to partner. JD.com claims to have the largest fulfillment infrastructure of any e-commerce player in China, with 12 million sqm of space across 550 warehouses in 81 cities as of December 2018. However, only one third of these warehouses were constructed by JD.com.

“In fact, the scale of land we hold and the size of the warehouses we’ve built in China’s first-tier cities exceeds those of the e-commerce companies. But their business scale is the largest in these cities, so they need us to fill the gap,” says Shen, adding that JD.com is ESR’s largest customer in China.

This competitive advantage also makes ESR a logical partner for China’s emerging logistics giants like SF Express. They build storehouses in transport nodes that best fit the most active delivery routes, and rely on ESR for inventory warehouses that serve as conduits for last-mile delivery in major cities.

Proof of concept

Once a Warburg Pincus real estate platform demonstrates proof of concept and begins to achieve meaningful scale, it raises third-party capital to support continued growth. In the case of ESR, this was when the warehouse manager became a fund manager as well. Demand for exposure from investors is strong.

“Capital from large global investors is trying to flow into Asia, and especially into real estate where they’re so under penetrated,” says Perlman. “What they’re looking for is tried and tested businesses that they can trust to deploy capital at scale through those platforms. There are few platforms outside of the residential space that allow them to do that. This is where our strategy has been so successful within real estate.”

In 2014, e-Shang launched its first US dollar-denominated logistics development fund in China. The main LP was Dutch pension asset manager APG Asset management. Shen soon came to realize that these large investors were looking for similar assets in other parts of Asia. “It’s basically the same group of people deploying capital across Asia,” he says. “By building a regional platform covering different markets, we could deploy capital more effectively and achieve a larger business scale.”

Later the same year, Warburg Pincus backed a spin-out from Prologis led by Thomas Nam, the company’s Korea head. The business became a subsidiary of e-Shang and a Korean logistics development fund was duly established, with APG and Canada Pension Plan Investment Board (CPPIB) coming in as LPs.

E-Shang continued to raise capital from outside investors and now boasts a shareholder roster that features the likes of Goldman Sachs, the General Electric Pension Trust, China Everbright, and StepStone Global. A significant M&A event came in 2016 when the company merged with Redwood Group, which added 1.2 million sqm of properties in operation or under development to the portfolio. Just as importantly, the alliance took e-Shang into Japan. The combined entity has since expanded into Singapore, India and Australia as well.

On the tenant side, the same logic works too. Amazon, e-Shang’s first customer in China, now works with the company in Japan and India. For a regional head of Amazon or DHL, the pain point is to finding reliable local developers across different Asian markets, Perlman observes, adding that “the capital follows us and the tenants follows us as we go across multiple markets.”

Recruitment efforts are made easier by dipping into the Prologis alumni network. In addition to Shen and Nam previously working for the company, Stuart Gibson, one of the co-founders of Redwood, helped set up Prologis in Japan. Shen and Gibson now serve as joint CEOs of ESR. “The cost of cultural integration was relatively small,” Shen observes.

Staying relevant

ESR will continue its expansion within the region, with Southeast Asia viewed as the most promising market. The company’s experiences in China are expected to be beneficial, especially as the same e-commerce trends that played out there are visible in Southeast Asia. Warburg Pincus – which counts China and India as its two most successful markets in Asia over the past 15-20 years – is already scaling up its own activity in the region.

“If you look at most of our global peers, their top three markets are the more mature markets of Australia, Korea and Japan. At the end of the day, if I’m talking to an entrepreneur in Vietnam or Indonesia, the two markets they want to know the most about are China and India. We want to take the things that we’ve done successfully in China and India and replicate them down where appropriate in Southeast Asia,” says Perlman.

Meanwhile, ESR must also keep up to speed with the changing dynamics in the retail industry. Online-offline integration is a high on the agenda. When ESR first started working with the likes of Zara and H&M in China, it was purely for their online business. Now it covers offline as well. In other markets, relationships that were offline oriented are moving online.

This has significant implications for logistics providers because previously separate inventory streams must be brought together. For example, Nike or Adidas might rely on a third-party logistics provider like DHL to serve its brick-and-mortar outlets in China and then establish a virtual storefront on Alibaba’s Tmall or JD.com for digital customers. Combining these channels creates additional complexity, but it can also bring down delivery costs.

“As the size of our warehouses gets larger, delivery of online and offline goods can come from a single physical location instead of several warehouses in different cities,” says Shen.

Manufacturers of consumer brands are expected to become key customers for ESR. Indeed, they are already making their presence felt: three of the five largest tenants were manufacturers as of June, up from two in 2018 and zero in 2017.

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• Topics
• Greater China
• Real estate
• Consumer
• Expansion
• China
• Warburg Pincus Asia
• Logistics
• e-commerce