Asia PE: Taking the temperature

The participants: Nicholas Bloy, co-founder and managing partner at Navis Capital Partners; H. Chin Chou, CEO of Morgan Stanley Private Equity Asia; Doug Coulter, partner at LGT Capital Partners; and David Lin, managing director at CITIC Goldstone

On what the weak IPO markets mean for exits...

CHOU: Prior to 2004-2005, there was quite a bit of criticism from LPs who said money went into Asia but not much came out. Between 2005 and 2010, performance exceeded expectations with quite robust liquidity from a number of well known GPs. That was very helpful because it acted as a countercyclical measure to what was going on in the US and Europe. The last two years have been slower.

Asia has primarily relied on two exit strategies - the IPO and the M&A market. IPOs have been the primary exit model for two main reasons. Firstly, oftentimes the GP is a minority investor and as a result the IPO is the most aligned route for the controlling shareholder as well as the private equity investor. Secondly, Asia at times has led the world in IPO flow while it has always ranked a distant third in M&A volume.

The IPO market has moved away from Asia but this is to be expected: the IPO market around the world is inherently a cyclical entity and it is unwise and unrealistic to expect it to always be open. At some point the market will come back and you can take a company public, but until then you have to be comfortable holding that investment for the duration

COULTER: As long-term investors, the fact that the IPO markets are closed right now shouldn't concern LPs. What should concern people is that there are approximately 900 companies in the queue for listing in Shanghai. The Hong Kong IPO markets remain more or less shut. If you total up all of the companies in GP portfolios across China that want to use a Hong Kong or Shanghai listing as an exit then there are far too many. A lot of them will never get listed and the question is what becomes of them. But ultimately as an LP, if you are backing the right groups who have backed the right companies you will see liquidity over the medium term.

LIN:The market has effectively been shut by China's securities regulator for two reasons. One is supply and demand, and balance. The other is the unprecedented once every 10-year change in government, which has a trickle-down effect on all of the state-owned enterprises, provincial governments and regulatory bodies. Whenever that happens no one wants to be a decision maker.

You will see the A-share IPO market open up again once all the seats have been settled. In the next 2-3 months there will be 2-3 IPOs each month and by the end of the year it will be back to normal, especially since demand is starting to catch up with supply. A lot of insurance companies are getting the green light to do direct and private investments, so there will be more demand from institutional investors in the public markets.

BLOY: One of the reasons for our unambiguous focus on being the controlling investor stems from the fact we are investing in small to medium-sized enterprises. We are writing equity checks of $50-100 million for 70-100% of largely unlevered businesses and we aim to triple the enterprise value of those businesses over five years.

Even when we come to exit the market cap might be $200-400 million and in our experience in Asia it is practically impossible for a controlling shareholder to exit a medium-sized enterprise on the public markets because there simply isn't the liquidity to be taken out. Yes, you can sell 15% at the time of IPO, and then you are locked up. When you start trying to sell you have to disclose it and the broader market says, ‘Hold on, Navis is selling, they are clearly going to sell down to zero because they have a finite holding period.' That represents a massive overhang of selling pressure and the price just tumbles and liquidity isn't there.

So we focus on controlling investments and only in companies that would be attractive to trade buyers. They are not interested in buying the no.10 player in the shampoo market in Indonesia; they would rather enter the market organically and outcompete that business. But they will pay a premium for a leader or a near leader.

On secondary exits in Asia...

BLOY: About 25% of our exits have been to financial buyers. A lot of new teams have come into Asia and, for those that want to prove themselves, doing a secondary deal is actually quite risk-mitigated, particularly if you are familiar with a particular portfolio company as an LP in a fund. We don't buy secondaries because we feel a lot of the juice has been squeezed, but we see a lot of secondary interest on the exit side - although often not enough to outbid a strategic that is prepared to pay a premium for a company.

CHOU: We feel there is more opaqueness on the buy-side market in Asia. In other words, everything we have done has been characterized as exclusive dialogues with the seller - one-on-one discussions where you set price on a unilateral basis and there is not an agent in between. We would look at secondaries, particularly secondaries from smaller organizations, but only if we felt like we had an angle that gave us a first good look and a timetable to negotiate directly with the seller. And the reality is that most GPs are quite good at selling.

To the extent that we can spend more of our time interacting with entrepreneurs in a way that gives us a direct dialogue, that is still the more attractive route versus interacting with other GPs.

On China's evolving PE investment environment...

LIN: If you are expecting the golden era of Chinese private equity when people were making 5x returns on deals, that may be a little bit more unrealistic today. But trying to generate a 3x return is realistic because you are still getting double-digit organic growth on many of the companies we are investing in. And there is room for multiples arbitrage in China. On the private side, we are able to secure businesses at less than 10x price-to-earnings (P/E) but we can still exit at north of 20x P/E.

In terms of sectors, our focus has been on financial services. Interest rate deregulation has caused the spreads to shrink, which has put a lot of pressure on banks. This has dragged down the entire financial services sector and so we see that as a buying opportunity for some of the other sub-sectors like property and casualty insurance, leasing - things that are less regulated and underpenetrated. Also, under the current Five-Year Plan, China is promoting the automation of its industries so anything that is heavily manually labor-driven, especially in manufacturing, we see an opportunity to buy technology and automate. Then there is mining and energy-related industries, driven by China's insatiable appetite for energy.

CHOU: Back in the mid-1990s when we first started invested in private enterprises our focus was on consumer businesses because they were easy to understand and they don't require a lot of capital to scale. We had a strong view that the consumer market would be dominated by and large by Chinese brands. I think between 1995 and 2006 everything we did was consumer non-durable and these are all now large businesses. We like to find a business that looks like it's going to be a dominant player but maybe the day we enter it only has 10% of the market and by the time we exit it has 30%. Now there are all these behemoths in the consumer non-durable sector it's very difficult to take the same approach.

What we invest in now is more akin to industrial or specialty businesses that are less consumer-oriented - we have done two pharmaceutical businesses, one OEM auto parts business, two specialty chemicals businesses. When we invested they had small market shares but we felt they were going to be the dominant players over the next 4-5 years and as the country industrializes.

On more control deals in China...

CHOU: We recently assumed control of the largest convenience store franchise in Beijing and I don't think that transaction would have been available 4-5 years back. It's less an issue of the Chinese economy per se but more that as private equity - along with all the intermediaries we use to create transactions - has been in the market for 10-15 years we have found that once in a while an interesting situation might come up where control is available. For the next five years, I would say that China will still be about growth minority investing but I would be very disappointed if there weren't a few control deals.

LIN: If you are looking to exit in Hong Kong or on NASDAQ maybe you can do control deals, but if you are trying to access onshore China deals where the company is looking to exit on a domestic exchange, control transactions are not doable. If there is a change in control, the CSRC requires a three-year waiting period before you can file for an IPO, it takes more than two years for the filing to get approved, and then there is a three-year lock up on the majority shareholder. If everything goes right, it will take eight years to exit, which is not a reasonable timeframe for traditional PE funds. That is why we are still doing minority growth transactions.

On managing LPs' growing appetite for co-investment...

COULTER: It's very easy for a very small handful of managers to raise money. Some funds are very much oversubscribed and typically there is either an extremely compelling story or the groups raising capital have good track records and have distributed cash back to LPs. There is no such thing as an automatic re-up anymore. LPs are putting more capital with a smaller group of GPs and trying to build closer relationships with those GPs, often through co-investment, for example.

CHOU: In many ways the co-investment market is an LP-driven phenomenon in that the larger LPs are more important and they are more likely to have appetite for co-investment, often to reduce the fees they bear. Co-investment usually follows a deal timeline and these tend to be very hectic. What we have found is the LPs more suited to co-investment in Asia have people who are located broadly in our time zone and understand the Asian economy.

LIN: We are trying to satisfy co-investment needs but it's difficult. The larger LPs are very important in the current fundraising environment and luckily we have two anchor LPs, but their appetite for co-investment is very strong and they can write very big checks, which makes it very difficult to manage the appetite from smaller LPs. Clearly, if you have an office in the region it helps because you are in the time zone and the staff are usually local-language speakers. When I started 10-15 years ago there were few Mandarin speakers in the LP community but today almost every LP that comes to China brings one with them.

I would add that if you want to see co-investment, supporting the GP for the first close is the most impactful way to build a relationship. It doesn't guarantee co-investment but it goes a long way to ensure the GP remembers.

COULTER: It's competitive finding great deals and the last thing you want to be worried about is shepherding a bunch of unwieldy LPs to the finish line when you have a deal that you are trying to close. It is something that GPs need to think carefully about. On the other hand, it's a tough fundraising environment and there is a group of LPs, ourselves included, that like co-investment to reduce the fee drag and get more exposure to the GP itself. And if you have a great deal why not share it with some LPs rather than with your GP competitor down the street?

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• Topics
• Greater China
• Southeast Asia
• Fundraising
• Investments
• Exits
• China
• Fundraising
• buyout
• Growth capital
• Southeast Asia
• Exit
• Morgan Stanley Private Equity Asia
• Navis Management
• LGT Capital Partners
• Goldstone Investment