A glimpse into the future

As was highlighted recently in AVCJ, there appears to be a quiet settling of the much-talked power struggle between LPs and GPs as a result of the global financial crisis. As one fundraising professional explained it, "There is always a cycle of greed and fear. We are nearly past the fear now." This puts the industry into a bit of a sweet spot. Lessons have been learned and new expectations have been set, and in general everyone in the playground is getting along.

There are other factors at work in the industry, as Lunar Capital's Founding Partner Derek Sulger commented. "We expect 2011 to be a year of worrying over inflation and asset bubbles, but a relatively soft landing for the Chinese economy. Certain asset bubbles will persist but inevitably a crisis of confidence will cause others to deflate, contributing to revaluations that will hurt over-exuberant, momentum-oriented investors and multiple arbitrageurs, but favor focused value-seekers".

For the lucky group that falls into the latter category, they may be doubled blessed with conditions coming into 2011 as LPs will need to deploy capital, which always helps to soften the edges of a prickly market. This has knock-on effects, however, one of which is compiled by the ever-growing interest in emerging markets allocations strategies: competition.

Out-sourcing the competition

The increased activity in markets like China, India and Southeast Asia are seeing more and more competition for deals. Chris Leahy, Head of Greater China and Southeast Asia at Kroll explained that "2010 was all about too much money chasing too few monster deals in China. While overpaying will continue, GPs are now hunting down smaller deals in second and even third tier cities."

Many GPs claim that their proprietary deal flow is strong enough that they do not have to compete, but given the reports out of China and India indicating that these same firms are battling it out for assets, one would imagine that they are indeed feeling the pressure to differentiate themselves.

Johannes Schoeter, a Founding Partner of China New Enterprise Investment expects that in spite of the already crowded market, that "the PE industry will continue to grow strongly in China in 2011. One of the main reasons is: strong demand for private equity from many fast-growing enterprises and the increasing supply of PE funds, especially local RMB funds with government backing." But GPs are not the only ones having to prove their worth.

LPs are also feeling the same pressure, with GPs who do have the track records and the returns able to hand-pick their backers. In many cases, they tend to choose LPs who can commit large amount of capitals.

One Hong Kong-based LP told AVCJ, "Global LPs have to be more cautious [right now] because funds that have track records and [have made great returns], who have likely been in the market since early 2000, will be over-served." The source added that this has led to competition among investors for space in new fundraisings.

There are several textures to this, notes Dennis Montecillo, CEO of Diamond Dragon Advisors. One is that "when you go with a brand name [fund], nobody second-guesses you." Many global LPs played it safe in Asia Pacific with large names. Today, "the first trend is that they need to take the time and think about what would be called ‘emerging managers', or people that are competent but don't belong to the brand name firms."

There are particular pros to this argument, especially in places like India, where having a brand name can actually hinder the private equity investment process. "There is a perception that somebody should overpay [if they come in with a brand name] in India," said one fund manager who declined to be named. While investors "love the macro fundamentals, it's really expensive, and the more money that comes into the region, the worse that is going to get."

With many of the larger deals overpriced in these markets, another trend for 2011, beyond just China and India, is a smaller deal size.

Smaller Deals

Already 2010 has highlighted this development, and no doubt it will continue. In India mega-buyout names have been participating in deals as small as $50 million. In China, the lack of buyout opportunities de facto means that deal sizes have come down. Many companies across Southeast Asia are not big enough to command a higher price, while North Asia and Australia - typically home to big-ticket buyouts - have seen a shift to decidedly middle-market opportunities.

A Korea-based GP told AVCJ, "We expect to increase investments in SMEs in 2011. While a number of players are looking at investment opportunities in China, we will remain active in Korea and find good deals without the heated competition."

In Japan, the same trend is being seen. With lenders continuing to tighten their belts in a country with a number of outstanding risk factors, it is still difficult to get large deals done. Senior Director of Nippon Mirai Capital Masao Nakagawa, said that after the "Lehman shock, when nearly all leverage providers stopped providing any financing to PE firms, banks have gradually started to be involved in PE investments, and they seem to be more active this year. However, the private equity market is unlikely to recover the levels of 2006 and 2007 in Japan." Coupled with this is the fact that Japan is growing older and Japanese entrepreneurs are increasingly having to seek out a way to sell their businesses in the absence of a succession plan.

Whether family-run or simply at the right stage for private equity investing, Australia is seeing more rational deal prices, in part because banks are not willing to go to 8x EBITDA any more, and in part because middle market firms are maintaining a clear focus. CHAMP recently acquired Contellation Brands' UK and Australian business for $290 million, $230 million of which was in cash. In December Catalyst paid around $150 million for Home & Décor Holdings. There are still $1 billion plus deals to be done in Australia, but industry players note that the mid-market space is not as expensive as it once was.

Across the region, as deal sizes become smaller, on the other side of the investment equation, exits will become more prevalent.

Getting returns

The year ahead will be one of seeing the value out of portfolio companies held onto for potentially longer than planned. Both the IPO markets and the overall M&A landscape looks positive for 2011. With the public markets still the principle market for investments, prognosticating what may happen privately takes its cue from the public markets. Save an external catastrophe, this implies that the industry should get a boost with more exits, returns realized, and money returned to investors.

One GP source explained, "We predict more exits made by funds that were formed before the Lehman shock. While the economy has been stabilized moderately, corporates are becoming more involved in the M&A market. It is important to see how portfolio companies will be able to bring returns to private equity players now that their value has increased under new direction."

Other players take a slightly different view. Mukul Gulati, MD of Zephyr Peacock, believes that the exit environment will continue to flourish in India, and that in this context it is a sign of the maturation cycle of the market overall.

Whatever the push behind the exits, it is without question a positive for the industry. Many firms were just two to three years into a fund cycle with the crash hit, which means that they have had a more difficult, uphill battle demonstrating their abilities and worth to investors. All signs, however, point to 2011 being a better year for all concerned.

 

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• Topics
• LPs
• GPs
• Greater China
• Southeast Asia
• South Asia
• Investments
• North Asia
• Australasia
• Performance
• CNEI
• Lunar Capital Management
• Johannes Schoeter
• Derek Sulger