Southeast Asia's shadow capital: Out of the darkness

Reeling from a COVID-19-driven collapse in travel, Indonesian online travel services business Traveloka saw revenue hit zero in March and April of last year. Three months later, Qatar Investment Authority (QIA) led a $250 million round, with additional contributions from existing backers GIC and EV Growth.

The deal is described as a classic demonstration of the power of long-term capital. Sovereign wealth funds are among few investors in Southeast Asia capable of looking beyond immediate challenges and placing their faith in management teams, buoyed by the fact that they are not subject to the confines of a fixed fund life. As many other players pulled back in 2020 – tech sector investment came to $4.8 billion, breaking a four-year streak of increases – sovereigns stood relatively firm.

"This is not a trend that has suddenly emerged, they've been quietly growing in prominence in Southeast Asia in terms of investment, in terms of capabilities. But it took COVID-19 and a real pull-back by their fixed-life fund peers, especially in the first half of the year, to showcase how important their role has become," says Alex Boulton, a Southeast Asia-based partner with Bain & Company. "They have been deploying with metronomic certainty."

This resilience underpins the rise of shadow capital in the region to unprecedented highs. Bain has calculated that principal investors such as sovereign wealth funds, government pension funds, family offices and corporates participated in nearly two-thirds of PE deals across all sectors in Southeast Asia in 2019. This compares to 53% in 2018 and 44% in 2017. Tech was the primary beneficiary: three-quarters of the 30 largest start-ups by funds raised have received shadow capital.

These investors enjoy a larger market share in Southeast Asia than other major geographies in Asia, anecdotal evidence suggests. In 2020, it did become more significant, especially in growth rounds. Around 35 minority deals of $35 million or more were announced, AVCJ Research's records show. Shadow capital featured in three-quarters of them in some capacity, across all sectors. In 2019, it was two-thirds of 45 deals. The proportions for tech deals alone are about the same.

There might be a rebalancing in 2021 as financial investors regain their vigor, but industry participants do not expect the situation to turn on its head. Shadow capital will remain a significant part of the mid to growth-stage investment landscape and start-ups must figure out how best to use them. Sovereigns, corporates and family offices can be helpful and patient as strategic allies – and paths to exit for earlier investors – but they also bring idiosyncrasies and present challenges.

Inexorable rise

Shadow capital is an uncomfortable term. It captures a wide variety of check sizes and remits, with the likes of Temasek Holdings sitting alongside Indonesia's plethora of corporate VC units. Moreover, investors don't care for the name, citing its negative connotations. However, they don't dispute the rise of shadow capital. Choon Hong Tan, co-CIO of Northstar Group, identifies global PE firms, corporates, and sovereigns are more active players, but emphasizes the growing role played by sovereigns.

"It is partly a result of realizing that Southeast Asia tech is getting a lot of traction," he says. "Maybe two years ago, when we talked to sovereign LPs, there was still some uncertainty about how the relevant trends were catching on because the ecosystem was not so well-established. In the last 12 months, we have seen a lot more interest. They still want to write large checks, but they are willing to do mid-stage deals."

Growth capital accounted for 57% of all PE and VC investment in Southeast Asia's technology sector last year. This is in line with the 2019 share, when overall investment reached a record high of $6 billion. As recently as 2015, it accounted for 12% out of $1.4 billion deployed.

About 400 deals were announced in 2020, more than double the 2015 figure, but growth-stage transactions are scarce. There were about 20 last year, down from 36 in 2019. It wasn't until 2017 that the region consistently hit double figures. These bets have also been highly concentrated, with approximately 80% of all investment since 2014 going to half a dozen start-ups. It gives credence to growth investor Asia Partners' claim of a funding gap in the $20-100 million equity check space.

The attractions of Southeast Asia technology need little introduction. Google, Temasek and Bain estimate that the region's internet economy will be worth $300 billion by 2025, a 3x increase on 2019. It is a key beneficiary of the three secular trends that underpin General Atlantic's global investment thesis: a transition to a digital economy, a shift in economic growth towards emerging markets, led by Asia; and the globalization of innovation, characterized by the emergence of new technology hubs.

Around 30% of General Atlantic's global capital is now deployed in China, India, and Southeast Asia. It expects the latter two to become the next preeminent hubs.

General Atlantic already sees a late-stage feeding frenzy around Indian companies such as education technology platform Byju's and interest is now mounting in Ruangguru, a similar Indonesian business. As to the participants, Sandeep Naik, the firm's head of India and Southeast Asia, claims they are much the same.

"They have tasted success with these business models in China or the US, and now they are asking where it can be replicated in emerging markets.," he explains. "They go to India and then say, ‘What about Southeast Asia?' It is pattern recognition. Some markets in Southeast Asia aren't easy, but you can look in the rearview mirror, see what happened in China and India, and think about how these businesses might scale in other markets."

Mixed bag

Below this upper niche, Shane Chesson, co-founder of Openspace Ventures, describes the mid to late-stage space as "extremely distributed." GIC and Temasek are the most active sovereigns, and then foreign strategic interest mainly comes from China, the US, Korea, and Japan. Private equity firms fall into two broad tiers: global and pan-Asian GPs that can write checks of $100 million or more; and local managers with growth-stage funds as well as VCs that have raised opportunity vehicles on top of their core early-stage offerings. Check sizes are in the $20-100 million range.

Other investors float in between these planes or defy categorization altogether. Of the two major forces in shadow capital, corporates are more difficult to pin to a specific stage. While global players tend to target larger deals, an increasing number of local captive VCs operate at the smaller end of the spectrum. MDI Ventures, which is controlled by Telkom Indonesia, claims five strategies – an accelerator plus four funds – that span the entire start-up journey.

However, there is variety within the sovereign community as well. EDBI, for example, is a government-owned investor that pursues financial returns but is also tasked with promoting Singapore as a global business hub. It is several steps removed, in terms of equity commitment and agenda, from Temasek or QIA.

Last year, EBDI and Temasek-owned Pavilion Capital participated alongside Square Peg Capital, an Australian VC firm that also targets Southeast Asia, and Malaysia-listed hospital operator IHH Healthcare in a Series B round for Singapore-based telemedicine specialist Doctor Anywhere. Kamet Capital Partners, a Singapore family office that led Doctor Anywhere's Series A, re-upped.

Dealing with a variety of participants – in a transaction taking place at a relatively early point in the company's lifecycle – requires careful management of potentially conflicting interests. PE and VC investors claim to see corporates as collaborators more than competitors, pointing to the commercial upside created by business partnerships. But they are wary of portfolio companies taking corporate money too soon and on potentially comprising terms.

"Do they want to acquire the company? For me, that's the biggest issue as a financial investor. It limits the upside, it limits the path to exit, and it limits the ways of optimizing the return for financial investors. We would advise pushing out any investment from a strategic investor as far as possible," says Kuo-Yi Lim, co-founder and managing partner of Monk's Hill Ventures."

Questions are also asked about the nature of any collaboration with the corporate parent and what specific benefits this brings in terms of product distribution, commercial insights, and brand awareness or endorsement. At the same time, the corporate parent will want access to the start-up – perhaps as part of wider efforts to offset technology disruption in its core operations – and so issues around confidentially and trade secrets must be addressed.

"Once you've got around those things you start to think about check size, whether you want them as lead or co-lead, and what board rights they will have because you don't want them listening in on every decision," says Amit Anand, founding partner at Jungle Ventures. "Founders must also be mindful of signaling issues or competitive barrier issues."

Market perception is a powerful force. In aligning itself with one corporate, a start-up might limit its scope to work with others. The dynamic in Southeast Asia is not as stark as in China – where Tencent Holdings doesn't like its partners to have relationships within the Alibaba Group network and vice versa – because individual companies do not have the same stranglehold on the ecosystem. Nevertheless, factions have emerged around the likes of Grab and Gojek as well as around some family groups.

One investor makes a similar observation regarding sovereign wealth funds, suggesting that start-ups pay attention to politics. A close relationship with an entity from one country could be problematic when trying to navigate regulatory issues or IPO pathways in another.

Other potential drawbacks to working with sovereigns involve certainty and speed. "Often they don't want to lead multiple rounds in a row because they don't have price discovery, so if you get them too early you might not be able to utilize them," says one Singapore-based M&A lawyer. "That said, I don't think any start-up would say no now and only take them later on."

The decision might be taken out of a start-up's hands if its timeline doesn't fit in with that of the sovereign. Courting these institutions is a protracted process – although some are now moving faster than others. Donald Wihardja, CEO of MDI, recalls being unimpressed when Temasek said it would need a year to conduct due diligence on any mid-stage investment opportunities presented to it. Three months later, he heard that the group moved quickly to get into another deal.

"The rules are changing. Sovereign wealth funds may not be nimble, but they have sister companies – groups with single-LP funds – that are nimble," Wihardja explains. "It is just a matter of asset allocation. You have the big deal guys managing 80% of the fund and the remaining 20% is managed by others who are nimbler."

Internal capabilities

Temasek made LP commitments to several early-stage VCs in Southeast Asia, creating a stream of information on start-ups that might be nearing follow-on rounds, Lim of Monk's Hill observes. It participates from Series B onwards. Kee-Lock Chua, CEO of Vertex Venture Holdings, which is owned by Temasek but raises capital from third-party investors, adds that there are limits to what Temasek will do directly. For example, early-stage activity tends to be restricted to sustainability themes like protein replacement, which are less penetrated mainstream VCs. 

Still, executing direct transactions requires in-house investment resources and Temasek is one of several sovereign or government-owned players with teams focused on technology. With more corporates establishing captive VC units or extending their coverage into the region, demand for experienced talent outstrips supply. This might be the most meaningful impact of shadow capital on financial investors, not competition for deals.

"Several aggressive sovereign wealth funds in our backyard are expanding teams, capabilities, asset classes, and the types of alternatives they are going into. That in itself is creating a bit of a talent crunch in the focus markets like Singapore and Indonesia," says Bain's Boulton.

More advanced moves made by PE firms in expanding their regional presence offer insights into how this will play out. General Atlantic opened a Singapore office in 2011, while still getting a sense of the region. A few investments followed. About 15 months ago, it decided to establish an on-the-ground presence in Jakarta.

"If you want to do deals in Indonesia, you have to be local. There are so many subtleties and nuances – if you try to cover it from other regions you miss out on a lot of what is happening on the ground. We needed a local team that could track and underwrite deals for us, not just a representative office with one person doing relationship meetings," Naik explains.

There are now three investment professionals in Jakarta, who form part of a single Southeast Asia team alongside four colleagues in Singapore and nine in India. Country head Ashish Saboo was recruited from Indonesian conglomerate CT Corp, while the two other executives came from Baring Private Equity Asia and PwC, respectively. General Atlantic deliberately sought a mixture of backgrounds covering local corporate knowledge, PE deal-making experience, and due diligence expertise.

Others are targeting talent residing in venture capital firms in the region. Wihardja claims to have lost several principals at Convergence when Vertex opened its Indonesia office several years ago. The situation is hardly easier at MDI. The firm's early-stage team is supposed to expand from 20 to 50-60 people, but some professionals are walking out the door even as others enter.

"We have a horrible retention rate because we are like a school. Everyone in the 2015 and 2016 batches are heavily poached," he says. "For VC, the investment analysis is different to investment banking, which is more PE-related, and a background in start-ups might mean you are crossing the divide. Everyone wants people with 2-3 years' experience in VC, but given there wasn't much VC in Indonesia three years ago, how can you get that talent unless you poach from Singapore?"

Much depends on the structure of the corporate or sovereign unit. The VC teams at Cisco and Google, for example, have teams in Singapore and India overlooking the region, so financial expertise might be prioritized over specific local knowledge. Meanwhile, some GPs prefer to develop talent internally rather than compete for ready-made solutions.

Northstar has repositioned itself as a technology-oriented investor in recent years, but this has not involved extensive hiring, according to Tan. The firm leveraged its exposure to Openspace – which started out as a VC affiliate of Northstar – and its links to Gojek – an early investment in the ride-hailing giant has led to collaboration with its captive VC unit – and developed the existing team's capabilities. Apart from Henky Prihatna, a 10-year veteran of Google Indonesia, new hires with technology experience have been junior levels.

Similarly, Jungle didn't advertise for a middle management role until it decided to hire a head of strategic development last year. On the investment side, the tendency is to hire young and provide a lot of training. Below the three partners, the average age of the investment team is 26-27.

Staying power

Retaining this talent might become more challenging with larger investors launching recruitment drives, but there is no guarantee that people will move. Michael Di Cicco, global private markets leader for Asia Pacific at Korn Ferry, observes that the biggest challenge for corporate VC is compensation; it can be difficult to replicate the alignment between performance and payment in systems where carried interest is an alien concept.

Hiring opportunities, therefore, are limited. "It might be very specific, firms that have a good track record and then got squeezed because a fund size is down or because a partner is retiring. It's like trying to find a needle in a haystack: experience, track record, and a change in situation that means it's the right time for this person to move into your platform," says Di Cicco.

Even where corporates are willing to offer attractive packages – sovereign wealth funds have made some progress in this area with long-term incentive plans – there are questions around autonomy, resources, and staying power. Incoming investment professionals want reassurance that they will be able to operate with a degree of autonomy from the parent, that they will have enough people to execute deals, and that the corporate won't fold the program within three years.

The latter point can be hardest to gauge, and it goes to the heart of the debate as to whether shadow capital will remain a dominant force in Southeast Asia's technology ecosystem. It is here where the two primary forces – sovereigns and corporates – diverge. The former are regarded as stable, long-term backers; the latter might also play this role, but captive VCs exist on the whim of their parents. Downturns, shifts in strategy, and leadership changes can result in withdrawals.

Vertex's Chua recalls bringing one corporate into a Series A round as a minority participant in the expectation that this investor would lead the Series B. However, when the time came, there had been a turnover in senior management at the corporate. Not only had it lost the will to re-invest, it wanted Vertex to acquire its existing stake. "There's another corporate I talk to regularly and they have changed people twice in the last three years," he adds. "Every time the strategy is different."

But the overriding issue for all investors – financial or strategic, sovereign or corporate – is returns. Much of the excitement around Southeast Asia, as with all emerging technology ecosystems is built on expectation. It is only relatively recently that many of the first wave of start-ups have begun to demonstrate scale and sustainability. Over the last five years, the annual average number of tech exits is 12. Investors will want to see more money returns if they are to put more money to work.

"The bigger issue for Southeast Asia is the exits," says Kyle Lee, co-head of the venture practice at Singapore law firm WongPartnership. "Whether it is IPOs or trade sales, the market is still catching up to more developed jurisdictions. SPACs [special purpose acquisition companies] are the flavor of the month, and as a form of listing, I think if founders and shareholders can get a good valuation, they would take it. There has been a lot of talk about exits, but we haven't really seen them materialize to date."

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• Topics
• Southeast Asia
• Technology
• Expansion
• Growth
• Venture
• Singapore
• Indonesia
• Sovereign wealth fund
• corporate venture capital
• MDI Ventures
• General Atlantic
• Vertex Holdings
• Openspace Ventures
• Monk's Hill Ventures
• Jungle Ventures