Asian PE firms still struggle with tech investments - Bain & Co

Devising workable strategies that take advantage of a broad technology growth opportunity widely seen as too good to pass up, while avoiding the pitfalls, is one of several ways in which investors can drive returns in an Asian private equity market that is expected to face headwinds. Bain identifies others as incorporating advanced analytics into due diligence and introducing strong environment, social and governance (ESG) protocols.

“GPs move up an experience curve when new opportunities start to reveal themselves. The China technology opportunity has progressed at such a pace that there hasn’t been enough time for firms to evolve their capabilities and processes,” said Usman Akhtar, a partner in Bain’s Asia Pacific private equity practice. “When that happens, there is a risk that some people will be swept along with the tide and not do the best possible job in doing due diligence on opportunities.”

Bain’s deal analysis is consistent with that illustrated by AVCJ earlier this year: the buyout share of overall Asia investment fell in 2018, while portion of capital entering growth transactions increased sharply – much of this due to a rise in late-stage technology activity in China. New economy plays accounted for 83% of the growth in investment in Greater China over the past eight years, with $59 billion pumped into tech companies in 2018 alone, more than 20 times the 2010 level.

While the bets are getting bigger – the average deal size was $213 million in 2018, up from $30 million in 2013 – a survey featured in Bain & Company’s latest Asia Pacific private equity report found that 85% of Greater China-focused investors find it difficult to evaluate new economy businesses. The inapplicability of traditional PE valuation techniques and challenges justifying investments in loss-making companies were the two most frequently cited reasons.

Moreover, only 6% of respondents have a proven model to evaluate risks of successfully sourcing new economy deals. None said they are operating at full potential in adding value to companies in this sector. Nevertheless, 80% are considering or actively pursuing new economy deals.

Bain names five common traits among private equity firms that are prevailing in this area: the presence of experienced and dedicated sector deals teams; strong partnerships with companies that have substantial experience and resources relating to the new economy; rigorous evaluation criteria that cover everything from potential disruption risks to early exit plans; and investment committees that are well-versed in the sector and can make quick decisions.

There are already warning signs that speculative investment has helped inflate a new economy bubble that is waiting to burst. Bain points to the build-up of internet and technology-related investments in Greater China over the past five years that have yet to be exited and the disappointing performance of recent IPOs from the sector. Meanwhile, median M&A multiples for internet and tech plays are 31x EBITDA, at least twice as high as other industries in Greater China and for Asia Pacific as a whole.

Even when taken out of the technology context, the median enterprise valuation-to-EBITDA multiple for the region is worrying. It reached a record 14.5x in 2018, up from 12.9x in 2017. Dry powder held by private equity firms in Asia also continues to rise. It totaled $317 billion at the end of 2018, equal to three years of future supply at the current pace of investment. More than 70% of GPs in the region say competition increased in 2018, making it more difficult to find attractive deals.

Bain warns that a deteriorating macroeconomic environment could challenge private equity firms’ ability to create value. With interest rates expected to rise, most survey respondents acknowledged that multiple expansion will not be as strong a source of returns as in the past. The most important factors will be internal: top-line growth, margin improvement, and expansion through M&A.

Asian private equity is increasingly characterized by a polarization between large funds with strong track records that dominate activity across the region, and smaller, less experienced groups that are having difficulty fundraising, Bain argues. “If a recession strikes, vulnerable and less differentiated funds are likely to disproportionately bear the brunt of the downturn,” the report notes. “In other words, the party could end abruptly in 2019 for some investors.”

A version of this scenario has played out before as the gulf between winners and losers was brutally exposed by the global financial crisis. Out of the about 500 Asia-Pacific private equity and venture capital firms that were active in 2007, only 290, or about 60%, raised another fund in the wake of the crisis. In addition, roughly half of the multi-asset-class investors had to withdraw from at least one of their asset classes, Bain’s analysis found.

“We might see something of a shake-out, especially if a recession comes over the next couple of years,” Akhtar adds. “The global financial crisis was an extreme event, but it doesn’t have to be as deep and severe a recessionary event for some shake-out to happen.”

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• Topics
• Greater China
• Technology
• Expansion
• GPs
• Fundraising
• Investments
• Exits
• China
• Asia
• TMT
• ESG