Stimulus and response

Private equity’s reputation as a counter-cyclical discipline was one of the major casualties of the recent financial crisis – at least in the rarefied world of asset allocation. The asset class whose long-term patient capital supposedly could ride out the troughs in economic cycles and still deliver outsize returns was shown to be unexpectedly vulnerable to very short-term capital markets shifts and to follow the downturn like everyone else. Whether and how far this actually happened is still debatable, but the 2008-09 period certainly shows, for better or worse, that private equity investors cannot simply trust to the microeconomic fundamentals of individual companies, and disregard macroeconomic trends at their peril.

A stimulating year ahead?

Expectations are strong for continuing high performance in Asia Pacific economies. Siva forecasts “a further 30% upside to Asian markets over the next 12 months,” based on the average economic performance after recessions dating back to 1950. While conceding that “the first year of recovery has always been the best year,” Sakthi Siva, Head of Asia/GEM Strategy at Credit Suisse, notes, “the rally doesn’t stop there. There is life after the sweet spot. Even in the second year, the average gain is about 19%.”

“Asian prospects look bright for 2010,” according to Hugh Simon, CEO of Hamon Investment Group, part of BNY Mellon Asset Management. “We expect a strong uptick in corporate earnings … We also expect Asian economies to continue to post healthier GDP growth rates and build from the low base of 2009.”

The stimulus packages introduced by practically every major government, and notably the PRC, during 2008-09 are one primary crisis management tactic that have had a direct impact on private equity investment, in Asia Pacific as elsewhere. Some time during 2010, the consensus goes, Western and Asian governments alike will have to ease off their stimulus programs and start to move to more sustainable longer-term recovery plans. However, few observers are betting that this will happen soon, with political will being a major factor.

“What do politicians fear most? They care about social stability. They care about jobs,” asserts Dong Tao, Chief Economist for Non-Japan Asia at Credit Suisse. “Until the exports are stabilizing, until the job market has confirmed a recovery on a sustainable basis, I do not believe that Beijing is going to go to decisive austerity.”

“There’s still the fear that the recovery is driven by stimulus, and once the stimulus has been is withdrawn, things are going to roll back,” concurs Siva. But fears are also building that China may have overreacted and be distorting its economic base through excessive – and inappropriate – stimulus.

“The problem in China is very different from the problems in the US and Europe,” avers Tao. “The Chinese banks have not been damaged by this crisis. The Chinese consumers did not have the problem of high leverage. The illness of the Chinese economy is different from that in the US and Europe. China shouldn’t have been taking the same pill. At least China should shorten the period of treatment and cut down the dose.”

Cyclical and Counter

One of the residual effects of the 2008-09 crisis that refuses to go away, for very good reasons, is the overhang of uninvested capital raised by GPs against pre-crisis expectations of deal size and valuation metrics. “Private equity firms have more than $500 billion of ‘dry powder’ or capital commitments from their limited partners for new deals,” asserts Kirk Radke, Partner at Kirkland & Ellis. “This is committed money poised for investment, which will expire if not invested during this period.” Broadly, Siva agrees, “there is still a lot of cash sitting out there.”

Some firms, of course, may follow the route recently taken by Candover, and simply return the money to LPs. This is not the private equity industry’s usual practice, though – to put it mildly. The obvious outcome is that the money will find investments, one way or another, and large deals will get done in 2010.

“We are very confident of 30% earnings growth next year,” Siva confirms. We are going to get into a very strong period of momentum of global growth,” Tao agrees. “In 1Q10, we look for 4.1%, in 2Q10.” For the whole of Asia Pacific, he sees around 8% growth during 1H09. However, he adds, “following that, as the stimulus starts to fade away, growth will come down.”

In addition Tao warns that, due to the necessary adjustment in US savings rates, “US spending over the next five years across multiple business cycles will remain pretty subdued. US potential consumption will not look the same, even if we get out of the current recession.”

“The global recovery, including that in Asia, is unlikely to follow a smooth path,” warns Jie Gong, vice president in Morgan Stanley's Alternative Investments group. “In 2010, Asian GPs should brace themselves for the bumps ahead. Continued discipline on valuation and vigilance on company profitability will be critical.‬”

Engagement with portfolio companies may yield more than just incremental performance improvements, though. Existing portfolio companies will be an extraordinary source of deal activity,” Radke believes. “These firms face a refinancing ‘wall’ from debt incurred during 2006-07. In the US alone, these portfolio companies have more than $400 billion of debt that will become due between 2010-13.”

“As private equity firms refinance the debt of their portfolio companies,” Radke continues, “they will engage in all types of deals – ranging from selling a business (or certain of its divisions) to strategic buyers or other private equity firms, to IPOs, to, in some circumstances, restructurings and debt-M&A transactions.”

New cycle, new horizons

There are also good reasons to believe that 2010 will not play out like the recovery from previous cycles, which could bring even more benefits to an Asian region already enjoying a relatively ‘good’ crisis. “Look for more global investments,” Radke counsels. “In the previous two periods following recessions, private equity opportunities were limited to the US and Western Europe. Today's private equity firms have global reach and investment focus, and we may see the best investments during this cycle made in markets outside of the US and Western Europe. Private equity firms have the two key ingredients on Asia this cycle – investment professionals and committed capital dedicated to Asian investments.”

“China now becomes big in the global growth outlook,” notes Tao. “China’s contribution to global growth is roughly equivalent to the US, Japan and Europe together.”

Asia Pacific public markets actually fell far further than they had in most other crisis periods back as far as 1950.“If you look at the average fall during recessions, normally Asia only falls 23%; last year it fell 54%,” notes Siva. Therefore, Asia’s rebound is likely to be stronger and the potential greater. Corporate valuations also showed a sharper dip, and are likely to rebound just as strongly.

However, the extent of some of the changes, and responses, of late, make firm macro predictions for the year ahead even more problematic than usual. In some senses, the global economy is in uncharted territory.

“In the first seven months, the Chinese banks lent out $8.7 trillion. This is something that we have never heard in China’s or the world’s economic history,” cautions Tao. “We have never seen new lending as a percentage of GDP reach such a magnitude, and this is a big problem in China.”

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Deals
• Fundraising
• Greater China