Speed bumps ahead for Asian private equity returns
Asia Pacific has had a very good GFC – almost too good.
As the proverbially volatile region demonstrates its robust fundamentals and strong economies, some investors may be reminded of the same bubble sentiment that triggered the GFC in the first place. Now, established GPs and LPs in Asia Pacific are cautioning that it is not all skittles and sunshine, and that the receding effects of the last bubble do not negate the formation of a new one.
Investable Asia?
Levels of concern among some more well-established Asian LPs are rising. In fact, as Jason Gull, Partner with Adams Street Partners asserts, “the groups that are already invested here are worried.” And what concerns them most is the unbalancing effect that their newer, less experienced peers are having on market discipline. “While you might have a number of experienced investors that are cautious, there’s just as much money behind them banging on the doors to get in.”
Factors both positive and negative can explain the rush to Asia. One is the relative dearth of returns and activity elsewhere. This lure is exacerbated by the acknowledgment among international LPs, including even Asia domestic institutions, that they have historically been underweight the region, and now have a big rebalancing act to do. Asserts Bruno Raschle, Executive Chairman at Adveq Management, “It’s shifting away from dependence on the West. It will be driven by the East: it’s that simple.”
This new rush of capital is entering a region and an industry that is still young and relatively immature, and where the growth of private equity in some areas has already been staggering. As Rahul Bhasin, Managing Partner of Baring Private Equity Partners India, notes, “you’ve gone in the past decade in India from having eight-odd private equity firms on the ground, to having 550.” And another major GP covering India cites some $30 billion from global and local funds. Yet Asiawide, as a seasoned investor says, “It is a thin group of managers and a thin pool of capital the minute sentiment changes.”
The problem, though, is as much popularity as market immaturity, participants argue. Even Asia’s less evolved private equity ecosystems now have ‘investment-grade’ propositions, and at least some of the market mechanisms in place for a proper private equity environment. Gull confirms that China, “is an investible market … It’s just that valuations and expectations are very heady.”
The China syndrome
“There are so many places in the world – Australia, Africa – that are so dependent on China,” says Raschle. “Currency-wise, public markets-wise, industry sector wise, there is 100% correlation.”
And private equity exposure to this single country market is what matters, according to Gull. Most recent private equity fundraising has either been China-focused, or has seen much of its capital invested in China deals. “The other markets, from a pure capital exposure standpoint, are just not as important.”
Yet the problems attending the China syndrome are not necessarily the obvious ones. Despite the publicity surrounding RMB funds, the RMB environment seems to be less of a problem the closer to the Asian market LPs get. One RMB GP asserts that over 90% of RMB funds are PE vehicles in name only, and can be ruled out of the asset class by asking two simple questions: How are you governed? And: What is your alignment of interests? Most of the funds are still not “institutional grade” and would never be competitors for international capital. For the time being, global money is still unable to enter the RMB space.
China is not a one-way growth driver, though. The PRC is starting to export its inflation. As Simon Pillar, a founder of Australia’s Pacific Equity Partners, remarks, China is “placing enormous inflationary pressure on the economy,” and since “80% of the Australian economy is driven by consumption,” the negative effects on consumer spending and confidence are hampering businesses, including the many private equity-backed consumer plays.
Even LPs who are keen to support other regions and investment styles recognize the effect the overallocation to China growth capital is having on the markets. One veteran regional LP feels that even the more attractive competing propositions, like India, just are not enough of a counterweight to mitigate the knock-on effects that could result from an upset in China. “Until there’s discipline, I don’t see the train wreck being averted,” he warns. “You could jumpstart the Japanese economy, increase demand and growth there: could that help to pull more of the capacity of China? Absolutely. But even in China, trees don’t grow to the sky.”
Racheting up the risk
Other factors are converging to heighten the risk exposure that is coming with the hype. For one thing, an oft-remarked tendency lately for LPs to move away from mega-buyout funds and pan-Asian vehicles towards smaller, more focused, often single-country platforms, may make sense in terms of recent returns, but it is also concentrating capital with the riskier growth capital managers. And, as Bhasin points out, control investment in many of Asia’s developing markets is as much about risk protection as it is about dictating the growth of a company.
Gull is also concerned by the speed with which some GPs are investing. “Many of the firms are deploying their capital within 12-18 months.” And going by historical performance data, he warns, “one of the strongest correlations is the inverse correlation between good performance and rapidity of capital deployment.” The capital tends to be deployed in certain peak periods, and also into currently-fashionable sectors.” And this on top of macro dynamics which mean, according to Bhasin, that, “in markets like India and China, you get pinpoint bubbles.”
Asian LPs, who might be expected to be more thoughtful about their own markets, do not seem to be arresting the process. Partly this is a function of timing. Many local LPs with PE programs have made commitments to mega-buyout funds in large numbers, and thus have completely undiversified PE portfolios. They often turn to the international intermediaries to (re)gain access to their own backyards. And they are as eager to tap into the region’s growth as any. .”
There is also the issue of real returns. Some of the region’s longest-standing LPs, for instance, are concerned about their China exposure for one very good reason: there have been very few cash-on-cash realized returns. And in Asia, where, as one leading GP asserts,” there is still a relatively small community of GPs and funds that have delivered real exits,” the majority of returns have been from the larger pan-regional funds now being shunned by LPs in favor of the smaller single-country propositions. “The more you go single-country and smaller, the more it becomes conceptual or mark-to-market.”
Reasons for the delay and difficulties in converting the theoretical returns into cash are unclear, with the relative youth of the funds and managers’ eagerness to hang on and wait for valuations to rise even further two possible factors. “If they can translate these unrealized gains into realized gains, that’ll take a lot of the risk off the table,” says Gull. But with trade buyer appetite apparently still limited, and IPOs only patchily able to deliver cash to LPs, that prospect still looks quite distant.
Expectations and mindset
One of the fundamental difficulties for Western investors in cutting through the hype to achieve risk-adjusted investments and genuine returns from Asia is the mismatch in expectations and mindsets. Partly this can be a question of distance and data. “The further away the LPs are, the more nervous they are about certain issues,” says one major PRC GP. “The people closer to the scene worry about different sets of issues; there is information asymmetry.” But often more this is a question of more than just information.
In India, for example, picking GPs to deliver the market’s growth to investors is a challenge, Bhasin admits. “But the bigger challenge is not only the people. It’s also that the kind of opportunity in the Indian markets is so distinctly different from the kind that is there in Western markets. People making these capital allocation decisions are used to seeing certain frameworks, paradigms, and have developed certain institutional insights and judgments based on their experience over the past two or three decades, which are from a different opportunity set. They’re calling this animal private equity, but actually the drivers of returns and risks are very different.”
With some investor groups, the problem can be compounded even further by sticking to certain Western preconceptions through complacency, even arrogance, and unbending adherence to certain principles. “Not being able to navigate and deal with an ambiguous environment like you have in this part of the world is going to be a big challenge,” Raschle warns.
The problem can apply on the GP side as well, though. “If one doesn’t understand the needs and risks and opportunities of the market, and tries to copy a model from somewhere else and transport it, one runs a grave risk,” notes Bhasin.
A game of consequences
Many established and risk-averse investors in Asia accept that the momentum towards a peak, and a probable dip, is unstoppable. “International money is not stopping and is accelerating,” a major PRC GP asserts. “People are only looking in the rear mirror.”
However, most feel that the probable correction is not only inevitable, but probably ultimately beneficial. “Like all markets, it goes through cycles,” Bhasin feels. “After the first flush of growth, there will be a phase of consolidation, and then you will have another flush of growth.” And in China, the RMB GP affirms, the consolidation and culling of underperforming managers could be particularly intense when the cycle turns – but again, ultimately leading to a better industry.
Also, aside from the potential negative impact that any well-publicized large PE-invested corporate collapse could have in China, no LP seems to be too concerned about any contagion from individual managers that would imperil the whole industry. The concerns over exuberance and potential disappointment are probably more a matter for individual funds and capital allocators.
Industry participants agree that, if the exuberance itself is the main destabilizer for the industry, the obvious corrective is simple investment discipline. For fiduciaries, this is an obligation anyway, but in frothy markets, it takes tough-mindedness and guts to resist the trend. “Often the right answer is not the mainstream answer: it’s doing what everyone else isn’t,” Gull concludes. And the micro disciplines of manager selection and scrupulous diligence may be the best antidote to the intoxication of Asia’s headlong macro growth.
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