Asia GPs must get smarter on target selection, costs - Bain & Co

“Pressure is mounting: dry powder is at historically high levels, LPs are keen to see distributions, and many GPs haven’t delivered a meaningful exit or investment for some time,” said Elsa Sit, an Asia-based vice president in Bain’s private equity practice.

“We should see increased activity in 2023, but how do investors identify potential winners? And how can they continue to grow portfolio companies so that when the exit window arrives, they can get out successfully? These are the key questions.”

Investors surveyed by Bain identified healthcare, business services, infrastructure, and technology as the most attractive sectors, although there was a notable aversion for technology in China, given recent regulatory headwinds. Two-thirds of respondents said that solid business fundamentals and good cash flow are their top criteria in deal selection.

Bain advocates scenario planning as part of due diligence to assess a target’s resilience – for example, the implications of rising inflation for pricing, cost structure, and capital expenditure – and setting realistic goals based on competitive positioning. During ownership, cost controls in areas such as procurement and supply chains are expected to be a point of focus.

“We see more investors trying to get a comprehensive scan of their portfolios and then initiatives for individual companies are different,” said Sit.

“Given the macro and market uncertainties, it will be difficult to maintain high revenue growth, so cost improvement becomes ever more critical. But it’s not easy. Cost controls often involves cuts. For example, if you automate processes you may end up optimising headcount.”

Two-thirds of survey respondents said they meet top-line targets on many or most deals, but only half of these investors do so for margin expansion. Nearly half expect to take a very active role in portfolio company cost reduction initiatives, up from just over one-quarter in the past 2-3 years.

Asked to identify the biggest driver of returns, half highlight top-line growth, which is consistent with recent years. However, 23% opted for cost improvement and capital efficiency, up from 5% five years ago; over the same two periods, multiple expansion fell from 40% to less than 15%.

Coming off the back of a record-breaking 2021, fundraising, investment and exits in Asia slowed last year, with investment and exits returning to 2020 levels. Slower economic growth and declining consumer confidence and manufacturing output, as well as rising inflation and heightened geopolitical tensions, contributed to general investor wariness.

With slower deployment, dry powder held by Asia-focused funds rose to an all-time high of USD 676bn, up 20% on the previous year. Meanwhile, median enterprise value-to-EBITDA multiples slipped from 13.1x to 12x, ending a three-year run of consecutive increases – potentially creating attractive entry points for investors, although high valuations are still cited as a point of concern.

Despite more than half of survey respondents saying that poor deal-making conditions are likely to persist through 2024, Sit believes sentiment is improving. She noted the survey was conducted in November 2022, prior to China’s post-pandemic re-opening, and that notwithstanding, the responses still represent an improvement compared to 2022.

“The consensus view is that 2023 should be better than 2022. Sentiment is better than last year, although that’s not yet being reflected in the number of deals closed,” she added.

Median net IRRs reached 15% in 2022, up from 13.9% a year earlier, but more than one-quarter of managers surveyed expect returns to decline in the coming 3-5 years. Rising competition, weakening portfolio performance, fewer exit options, and declining multiples were given as reasons.

However, Sit observed that the strongest vintages often come during and immediately after downturns. She pointed to an increase in gross IRRs for US buyout funds in the early 2000s following the dotcom bust, with returns hitting 41% and 33% for the 2003 and 2004 vintages.

Much the same was seen in the early to mid-2010s as economies recovered from the global financial crisis and then the euro debt crisis. Gross IRRs on US buyout funds climbed from 17% for the 2008 vintage to 26% in 2012. Returns in 2013, 2014, and 2015 were 39%, 33%, and 46%.

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• Topics
• Exits
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• Asia
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