The way we were

THE STORY OF THE PAST 18 MONTHS is one of a flight to quality and a complete re-assessment of fund models, managers and opportunities. While Asia’s macroeconomic strengths and relative resilience during and after the crisis appear to be well in tact, there has been a clear shift on the part of LPs, who are requiring more from the funds in which they invest.
Dennis Montecillo, CEO and Senior MD, Diamond Dragon Advisors, explained, “For 2010, the hype was a bit ahead of the reality. In theory there was a lot of money available globally, but the process is still slow and there was no real incentive for LPs to deploy capital in an expeditious manner. ”

LPs’ new level of discernment has affected fundraisings, with a smaller number of seasoned professionals able to raise more money. Secondly, it has affected the way that fund managers go about their daily business, keeping in mind that the bar has been set much higher and money is no longer free. And thirdly, it has made the industry refocus on the task at hand – making businesses better for returns based on hard work and effort.

“Have you made money for anyone?”
It was Weijian Shan, Group Chairman and CEO of Pacific Alliance Group at the AVCJ Hong Kong Investment Forum who asked this question. And in reality, after all the discussion, analysis and opining about the big, bad ways of the private equity world, LP allocations all boil down to this. If a manager understands the market (both its risks and rewards), can source deals at reasonable valuations, and can use operational know-how to improve the business by doing more than simply riding the macro trends, he will make money.

That said, groups have learned that financial structuring is not a replacement for elbow grease and the operational improvements that many of these companies need. “We want to help the entrepreneur to grow,” said Jean Eric Salata, founder of Baring Private Equity Asia. “The operational component is more important for all firms, because it is about relationships; we are not just deal-makers.”
There is some questioning among LPs about just who is capable of creating this kind of value add for companies – not simply buying at the right price and flipping it at fair value. Chris Freund, the founder and managing partner at Mekong Capital explained that in speaking with many LPs, “They assert that successful GPs could be attributed to pre-deal terms, or simply making the right decision on an investment target. Very few [GPs] have validated that they can add value.”
For private equity professionals from around the world, driving companies is becoming harder, and the discussion about operations and expertise is one in which everyone is participating. Steve Barnes, MD at Bain Capital believes that active management works but that “the market is evolving faster in Asia,” which makes the process more difficult.
Fundraising numbers, particularly in the buyout space, show just how picky LPs have been lately. In Asia, 107 funds raised $17.7 billion in the first half of the year. [fig 2.2] Of this number, about one-quarter went to six buyout groups ($4.2 billion), indicating that the flight to quality is firmly in place.

“The bar is pretty high right now,” says Freund. In China there have been several exceptional funds – Hony, CDH, New Horizon and Bain spring to mind – that have led to a new level of expectations “in terms of returns and track record.”
From the other side of the fence, Montecillo believes “it has been set high in a good way, because performance and track record are back on the radar [as the most important criteria], which is supposed to be how the market works anyway.” Any big win in the alternatives market, he feels, “is a big plus in the industry – it shows you can produce alpha.”
One nuance of this is that understanding Asia and which managers can produce Alpha requires local knowledge and regular LP-GP interaction, something that is becoming increasingly the norm. “The decision-making power has shifted to Asia,” Freund maintains. “For our first three funds, it was almost all groups from the US and Europe. Now the Asia offices of fund-of-funds” or strictly Asia-based investors are playing am more prominent role.

Exits for everyone

What certainly did bolster the spirits of GPs and LPs alike this year was the improved exit environment. The exit market in 2009 was dire; the inability to see liquidity and demonstrate exits hurt many GPs. With many stock markets far too volatile, across the region, $16.5 billion in trade sale exits were transacted in 2009 – less than 50% of value achieved for 2008. In 2010, according to provisional numbers and supported by headlines from Sydney to Singapore, trade sale exits have jumped back and $23.5 billion has been seen in returns. Every quarter has seen better exit numbers than the last, a trend that is slated to continue.
Other exits from the past 12 months indicate that LPs may be seeing more of the exceptional returns that Freund indicated above. 3i made a 7x return on its 2004 investment in Hyva, offloading it to Unitas Capital in a secondary buyout. Actis capital exited Paras, and Indian pharma group, making 10x on the deal. The year’s biggest exit goes to MBK, with its sale of the 60% stake in China Network Systems to HKSE-listed Want Want for $2.4 billion.

There was no shortage of IPOs this year either, with many VC and PE firms seeing returns of a 2007 nature on individual investments. Greater China IPOs tripled the value of capital raised in the US, and in particular Chinese technology companies appear to be the darling of the IPO space. Youku, SouFun and Dangdang made record debuts in New York, while closer to home Hopu floated Minsheng Bank in China and China Pacific made Carlyle money in Hong Kong.
In Australia, the story has been a dual-track exit preparation, with exits of late falling predominantly into the trade sale category. Case in point, Ironbridge recently sold oil rig company Easternwell to Transfield, an engineering and maintenance services provider, for $567 million after having groomed the company for an IPO while shopping around for investors.

Moving northwards, India and China tend toward the public markets, while industrial groups and companies that see growth fueled by domestic consumption often find interested buyers abroad. Both countries are experience significant levels of speculation on the public markets, which many believe is a bona fide asset bubble waiting to pop.
Equally rampant is the proliferation of RMB fund across the PRC. The trend, like growth in the China market, has had mixed reviews. Some, like the GP quoted above, question the trend, because of the lack of experience of many of the managers and indeed the lack of knowledge on the part of domestic LPs in terms of private equity as an asset class.
Johannes Schoeter, Founding Partner at China New Enterprise Investment remarked, “Many RMB funds do not understand risks and are undisciplined in due diligence, often paying high prices for targets.”
The RMB fund market in China is “new, it’s nascent, it’s not proven and we haven’t even seen it yet,” said Baring’s Salata, but its emergence in China is “natural.” And while foreign LPs seem anxious about competing with these local funds, the market’s tiered structure has delayed this, at least for the time being.

Foreign groups keen on being treated like a local have lined up as far as the eye can see to launch RMB funds – usually backed by local governments. These pilot programs are gen liberalization of the Chinese market for corporate control, but also because, with investment activity in China still not dazzling, they are under great institutional pressure to show movement in the market. As Western markets continue to stagnate and core franchises in the US and Europe face smaller fund sizes, head offices are looking to do something in China, and at least an RMB fund is a start.
Blackstone and Carlyle held first closes in July, and this fall, TPG launched two – one in Chonqing and the other in Shanghai. In October, New York Pacific Capital launched a Zuzhou-partnered RMB fund, and Morgan Stanley just this month signed an MOU for an RMB fund in Hangzhou.
Global majors like Bain and KKR reportedly have no immediate plans to follow suit, but 3i is exploring the option, as are a host of other firms looking to gain access to the growing pocketbooks of mainland investors.
But it is not just funds that are looking to capitalize on the China story. Placement agents, advisors, law firms, accounting firms and other service providers are all popping up and canvassing the market for new opportunities. In the spring, CP Eaton launched a new RMB platform. CP Eaton saw other changes, including losing senior executive Edward Greene to a new venture with Dennis Montecillo, Diamond Dragon Advisors, Asia’s first locally headquartered private equity placement agent and advisory firm. Portfolio Advisors set up shop in China, and Stepstone did the same about a month later.

Everyone is banking on China, but is it a sure-fire bet?

“We’re not there yet”To borrow from Dan Scwartz, Chairman Emeritus of AVCJ in his recently published book, “The numbers alone tell us that the world will change.” And, while recovery is on the horizon and GPs seem smarter, more humble and more disciplined, it may not yet be time to breathe that collective sigh of relief. “We’re not there yet,” said David Bonderman, co-founder of TPG in mid-November. Coming down from the panic of 2009, there is euphoria today that in 2010 the world did not cease to exist. But, he believes a “crisis of expectations” is on the horizon. Inadvertently perhaps, investors and fund managers appear to be preparing for this.

LPs have clearly become more discerning, and GPs are largely paying less for assets. In the buyout space specifically, in the first half of 2009, 498 deals totaled over $23 billion; in the first half of this year 588 deals totaled under $20 billion. [fig 1.1] The average price per transaction for 2010 is a full 20% lower than in the bull market of 2007, showing a reality check realized.

An extension of this reality check is a changing view on the private equity model. Wilbur Ross, Jr, chairman of WL Ross & Co told Scwartz in The Future of Finance: How Private Equity and Venture Capital will Shape the Global Economy, “Historic modeling implicitly assumed that tomorrow would look a lot like today. But the truth is major credit crises come about when tomorrow turns out very different from yesterday.”
Some in the industry look back at the past few years and see nothing more than an inevitable cycle. “There will always be a cycle of boom and bust,” believes KY Tang, Founder of Affinity Equity Partners. But is there too much hype around Asia? “That is a dangerous question to answer… I would say the hype is over and now there is optimism and keen interest.”
Semantics aside, logic would imply that the amount of capital that is looking for a home in Asia is more than the region can handle, and that Bonderman’s “we’re not there yet” label could equally be applied the equilibrium of private equity interest in such places as China. The counter argument is always GDP, though that can be incredibly misleading in emerging markets that do not have the sophistication and maturity of the market that is required.

Anecdotally however, GPs are not worried. Says Montecillo, “I have not met a GP that has said that there has been an increase in competition,” due to the emergence of so many new players in the China market. “Ultimately, the proof is in the ability of a manager to originate deals and produce returns.” Rather than being a macro issue based solely on capital inflows, the situation is “much more of a micro decision.”
Going into 2011, he notes, “I tend to be in the same camp as the optimists. We won’t reach the 2006-2007 era, but it will be a much more rational market, where people don’t take exceedingly long to raise money.” This does not simply apply to China. The dollars on the sidelines – the “non-China dollar” needs a home as well, and managers outside the PRC that have proven themselves may well find 2011 a much better environment.

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• Topics
• North Asia
• Southeast Asia
• Greater China
• South Asia