Asia's middle market: Lost in space

They call it the “Hillhouse effect.” Last year, Hillhouse Capital raised $10.6 billion for a fund that is generally seen as a broad China play – it will back domestic companies with growth potential as well as global businesses with a China angle. This has effectively encouraged a slew of other China managers, that pursue similar strategies, to revise their target fund sizes upwards. “Isn’t sub-$4 billion the new upper mid-market for China GPs?” one LP asked recently, only partly tongue-in-cheek.

The issue of what constitutes middle market arose with the publication of EMPEA’s latest global limited partners survey last week. Over half of respondents said they are actively seeking out middle-market investment opportunities in emerging markets, even as an ever-larger share of capital raised goes to large-cap funds and venture capital. EMPEA defines middle market as funds of $100-500 million. Since 2016, AVCJ Research has records of only about a dozen final closes in the range by US dollar-denominated PE funds focused on China. Between 2012 and 2015 there were twice as many.

The hollowing out of China’s middle market is not a new phenomenon. It’s just that the managers previously identified as candidates to fill the space don’t meet the criteria. DCP Capital closed its debut fund at $2.5 billion and is looking to write checks of $100 million and above, which more or less puts it in competition with global and regional players. Centurium Capital may find itself in similar territory, having set a hard cap for its first vehicle at $1.98 billion.

Even CDH Investments, which launched a growth fund because it was seeing many opportunities that were too small for its flagship vehicle, is moving up the size spectrum. The first growth fund exceeded its $600 million target to close at $800 million, with both US dollar and renminbi pools. CDH is looking to raise $1 billion for the successor vehicle. It’s also worth noting that the strategy is described as venture and growth capital, giving the GP license to back tech start-ups as well as the more established business typically associated with middle-market PE.

57 Stars, an emerging markets-focused fund-of-funds, restricts itself to sub-$1 billion territory. Managers in this space are deemed most likely to invest at reasonable entry prices, help portfolio companies deliver value through organic growth and roll-up strategies, and find willing buyers among larger private equity firms. Yet Stephen O’Neil, a managing director with 57 Stars, also recognizes the size dilemma. “Funds need to be of sufficient scale to deliver on that promise,” he said. “If a fund is too small, it may not have the resources to build out a team that can help portfolio companies.”

Perhaps this contributed to Boyu Capital’s decision to raise a reported $3.6 billion for its latest fund, up from $2 billion in the previous vintage. Last year, CITIC Private Equity and Yunfeng Capital also completed meaningful step-ups in fund size, with Primavera Capital and CITIC Capital set to do the same in 2019. As recently as 2011, they were all around the $1 billion mark. Now they are $2 billion-plus.

The definition of middle market varies by geography. In India, for now at least, there still appears to be a fundamental discomfort with the notion of managers breaching $1 billion. Australia has two local managers that are definitively mid to large-cap. A third, Quadrant Private Equity, treads a careful line between the two spaces, surpassing A$1 billion ($702 million) for the first time in 2017. Earlier this year, it launched a A$300 million fund for small and mid-cap investments.

Meanwhile, Japan is worth watching closely. Several GPs scaled back their fund sizes after the global financial crisis and it wasn’t until last year that the $1 billion threshold was crossed once again. Japan Industrial Partners was responsible, closing its fifth fund at JPY148.5 billion ($1.3 billion), with an additional JPY46.2 billion for co-investment. Polaris Private Equity is looking to join the club, targeting JPY166 billion for its fifth vehicle. Fund III closed at JPY39.1 billion in 2013.

LPs must decide whether these managers are sensibly evolving alongside the opportunity set or careering dangerously outside of their sweet spot. The middle market has historically been synonymous with proprietary deal flow, operational nimbleness, and industry-leading returns. Woe betide he who wears the badge but cannot deliver.

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• Topics
• Fundraising
• GPs
• Greater China
• Australasia
• Southeast Asia
• China
• Australia
• India