Philippines private equity: Please be patient

"When I talk to my clients about why they are not interested in having further discussions with one of you they say, ‘They are too short term, they only think of being here for 5-7 years.' This is an idea of how Filipinos think in terms of relationships - 5-7 years is the blink of an eye. You can think about more creative ways of extending that or join a company like GIC that doesn't advertise exits."

So said Dennis Montecillo, executive vice president and group head of the corporate client segment at Bank of the Philippine Islands (BPI), in a remark to GP delegates at the AVCJ Philippines Forum in September.

GIC Private is indeed a good example. The Singapore sovereign wealth fund deployed more than $550 million across three direct deals in the Philippines in 2014, helping take private equity investment in the country to $869 million, more than the previous three years combined.

There are all these really attractive market fundamentals yet the volume of private equity investment remains stubbornly low - Todd Freedland

With minority stakes in liquor producer Emperador, canned foods distributor Century Canning Corporation, and the hospital business of Metro Pacific Investments Corp, GIC has exposure to companies that cater to domestic and export demand. In each case, the ultimate owner is a family patriarch with sufficient wealth to warrant a place in Forbes' Philippines rich list.

Family-owned businesses - small and large - lie at the heart of the Philippines PE opportunity, but cultivating the relationships required to secure such deals takes considerable time and effort. It is one of the reasons why the country has failed to live up to the investment promise conveyed in its economic growth prospects.

"[Private equity] is today less than one half of one percent of GDP, which is very low even in the Asian context," Todd Freedland, director general in the private sector operations department at the Asian Development Bank (ADB), told the forum. "There are all these really attractive market fundamentals yet the volume of private equity investment remains stubbornly low."

Economic appeal

These attractive fundamentals are rooted in steady economic expansion, fiscal responsibility and a youthful and increasingly consumption-oriented population. Fueled by inbound remittances from expatriate workers and a modernizing export sector characterized by a robust business process outsourcing industry, the Philippines has achieved average annual GDP growth of 5.5% in 2004-2008 and 6.3% in 2010-2014.

To this can be added a resilience underpinned by high foreign currency reserves, a current account surplus, and a debt-to-GDP ratio that is among the lowest in the region. "We really don't think the Philippines is going to be that affected by the global financial situation tilting because it is fundamentally very strong; we think it would be one of the least affected countries in the region," said Shanaka J. Peiris, the IMF's resident representative to the Philippines.

The Philippines' ability to buck global economic trends was one of the factors that brought CVC Capital Partners to the country in 2011. Having seen control investments in more developed Asian markets struggle during the global financial crisis due to their reliance on US and European economies, the private equity firm wanted to vary its geographic exposure.

Indonesia was the first market to catch its attention, for much the same reasons that the Philippines appeals now: favorable demographics, rising household incomes and consumer demand, and a modernizing economy, which overcome concerns about corruption and infrastructure. The firm invested in a department store chain and in a cable TV provider.

CVC's two Philippines deals - Rizal Commercial Banking Corporation (RCBC) and BPO player SPi Global - follow the same economically resilient and consumer-oriented theme. "When we look at the Philippines in the context of our regional investment strategy we have to thank the global financial crisis for helping us get here," said Brian Hong, a partner at CVC.

While CVC was an early mover in the Philippines, it is estimated that in the last three years every global and regional private equity firm with a presence in Asia has made exploratory visits to the country. However, this has resulted in relatively little concrete action.

Subtract the cumulative value of CVC's investment in SPi and GIC's three deals from the annual totals for 2013 and 2014 of $580 million and $868 million, respectively, and the surge no longer seems as profound. For 2015 to date, AVCJ Research has records of a handful of transactions worth about $55 million between them.

Other investments are almost certainly happening beneath the radar, but as BPI's Montecillo noted: "The ratio of deals completed to trips made to the Philippines is quite low."

The image these data cast of the country's private equity market is that of a barbell: a cluster of large deals at one end, a host of smaller investments at the other, and very little in between. While there are also broader economic factors at work, industry participants routinely cite a lack of transactional mentality on the part of business owners for the relative scarcity of deal flow. Any decision to sell equity to a third-party investor is largely emotional and driven by the founding family's long-term objectives.

It is very difficult for PE firms to achieve a breakthrough with these founders if they don't have a presence on the ground and - as Montecillo indicated - a willingness to develop relationships over a sustained period of time. If they are not, particularly at the top end of the market, plenty of domestic conglomerates with a low cost of capital and a long-term investment horizon are looking to do deals.

When Navegar was set up two-and-a-half years ago, the idea was to go where other PE firms were not and target investments in the $10-20 million space. The firm, which operates as a joint venture between Swedish alternative asset manager Brummer & Partners and a local management team, remains one of few local GPs to get traction with institutional investors, raising PHP5 billion ($120 million) for its debut fund.

There has been no shortage of deals to look at. Since its inception, Navegar has considered 186 potential investments, signing 12 letters and completing three transactions. While noting that competition is less intense for smaller ticket deals, Honorio Poblador IV, a partner at Navegar, stressed that the market can still be difficult to navigate. IPOs are increasingly an option for capital-hungry companies but an equally pertinent threat comes from other quarters.

"Even in our space we are finding some of the larger conglomerates have dipped their feet into select opportunities. If they are not doing it then it is the junior conglomerates - businesses that have grown over the last 20 years and collected enough cash to deploy to other non-core businesses," said Poblador.

The value-add gambit

This tendency to move towards the smaller end of the market in search of deal flow is not limited to domestic conglomerates. Mikko Perez, founder and CEO of mobile payments start-up Ayannah, claims that hedge funds are also looking at earlier-stage opportunities.

"PE investors have to come in with smaller bite sizes and identify entrepreneurs that are earlier in the stage of their lifecycles," he said. "These entrepreneurs now have more choice as to where to raise capital from so it is important that the private equity investors provide more than just cash if they are to compete with strategics that can offer a lot of synergies."

Foreign GPs in particular can play a role here, providing strategic advice and using their global networks to connect companies with potential suppliers, customers or partners. They can also exploit the fact that the high concentration of corporate ownership in the Philippines is not good for everyone: mid-tier players may fear aligning themselves with domestic giants because they could end up overwhelmed and ultimately absorbed. Private equity does not pose this kind of threat to management.

In this sense, the key to success in the Philippines is finding a way to work within the existing corporate dynamic rather than trying to displace it. The ABD's Freedland noted that, even among private equity firms that have been active in Asia for decades, he has seen "a bias towards control and towards a certain style of deal-making" that is effective in the West but doesn't necessarily work in the Philippines.

"It is not the mindset, it is not the approach, it is not the culture," Freedland said. "You have this large concentration of family ownership and you have to figure out a way to be compatible with and value-added to families that may have slightly different objectives to the traditional buy-and-flip-type investor."

For CVC, which typically looks to write equity checks of $100-200 million, it is difficult to avoid the largest and oldest family-owned businesses. These companies are multi-generational and usually financially stable, so in the absence of a succession planning or turnaround investment thesis, the emphasis is placed on partnerships.

The private equity firm entered RCBC as a minority investor but was comfortable with the family stakeholder and management team and what they wanted to do with the business. In the case of SPi, while CVC did obtain control, the previous owner - Philippines Long Distance Telephone (PLDT) - stayed on as a partner and minority shareholder.

"In six weeks we are never going to understand a business the way a founder who has been running it for 30 years understands it. We may look at it differently, but he is going to know his employees, his customers, the market, and his competitors in a way we do not," CVC's Hong said. "We channel that, we respect that. He respects what we can bring and we outline what that would be in the beginning, and we agree to work together."

Reform agenda

The ideal scenario for private equity is a halo effect: if more of these partnerships prove to be mutually beneficial, understanding of the asset class will spread throughout the business community. This may result in increased deal flow. However, investors stress that the industry selling its story is only part of the solution; the government must also take action - or continue to take action - in a variety of areas.

Stability from a policy perspective and continued deregulation are essential to making foreign investors comfortable with the commercial environment and able to deploy capital easily. There is also a need to remove systemic inefficiencies in two areas, financial services and infrastructure, which have implications stretching far beyond those sectors.

On a macro level, the financial system is dominated by banks lending to large corporations. Deeper capital markets that offer a wider variety of capital-raising options to these corporates would spread the risk and encourage banks to focus more on consumers. Limited access to financial services, particularly among individuals looking to borrow less than PHP1 million who don't have bank accounts, is a key contributor to social inequality.

Meanwhile, the country's infrastructure stock as a percentage of GDP exceeds Indonesia but trails Singapore, Malaysia, Thailand and Vietnam. As for the quality of infrastructure, the Philippines is ahead of only Vietnam, according to the IMF. Peiris noted that productivity and investment, though improving, remain low by regional standards. "To continue to improve this level of activity and to continue to benefit from investments from abroad we need to have a better infrastructure capital stock," he said.

The barbell effect that characterizes the Philippines' PE market reflects the broader economic dynamic. In the absence of structural changes that encourage smaller companies to scale up and dilute the concentration of activity in the top tier, it will be difficult to generate enough deal flow to sustain a middle market.

"Until you see more trickle down and some of the MSMEs [micro small and medium-sized enterprises] becoming SMEs that are beyond the venture capital stage, generating cash flow and attractive to private equity, I think it will be a little bit of a chop," said the ADB's Freedland.

Though bullish on the Philippines, he and others warn that the country will not realize its potential overnight. "You've got to patient," Freedland added. "This isn't a 3-5 year window; this is a 10-25 year window."

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• Topics
• Southeast Asia
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