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The state of Asian private equity

The Asian private equity market is at a critical juncture, where opportunities abound but global issues have forced fund managers to reassess their strategies. Dan Schwartz and David Leidl of the AVCJ discuss what lies ahead for the region's private equity industry.

Forget the Iraqi war, SARS, Al Qaeda, and the global recession - that's just the backdrop to more fundamental problems impacting the region's private equity fund managers. More than in past crises, Asian private equity stands at a crucial juncture: opportunities abound, but global forces have converged around the region's fund managers, forcing them to reassess how their investment teams are organised; where to source new funds and deals; and, the skills required to successfully return their LP's money.

This gathering storm provided the agenda for AVCJ's recent breakfast at Hong Kong's FCC, where top executives from several of Asia's leading private equity funds met to assess the state of the Asian private equity market. Foremost in everyone's mind was China, but those looking to the Mainland as ‘the engine for global growth' may well encounter unexpected turbulence. Exits? Crucial, but beyond difficult in today's markets. The fund-raising scene in the region? Problematic. And, convincing potential LPs that Asia really IS different will require overcoming LPs' preference for specialisation in a market that rewards opportunism; and, their concerns about the dearth of past returns in face of the market's more promising post-1997 potential.

China: mirage or miracle?
Nowhere is the dichotomy between promise and harsh reality more evident than in China. Much money has gone in, few exits have come out, and expectations are largely unfulfilled. The consensus: making money in China has grown more difficult than ever.

The Middle Kingdom has pulled in billions in FDI, but around the table, there were few kudos for private equity. Gabriel Li, managing director/Asian venture for the Carlyle Group, falls into the cautiously optimistic camp. He likes some of China's tech opportunities and says situations such as SARS do have a silver lining. ‘There has been clarity on the government side on how they wish to push forward on some of the programs that are interesting to us.'

But there is a cloud around that lining. A country's GDP can only grow at eight per cent annually for so long before unleashing a tidal wave of liquidity - and a wall of cash has swamped China's pricing levels, now at an all-time high. And so are the usual problems: convoluted due diligence with no assurance of a successful buy-out at the end, management issues and all the usual suspects. In a word or two, it's tougher than ever before to make money in China, says XD Yang, managing director and co-head of Asia for the Carlyle Group.

Because Carlyle doesn't have ‘an investment directly in a ‘real' Chinese company,' Yang is cautious. ‘We don't know where “China” is. Like Korea three or four years ago, maybe there are lots of opportunities. Or like three or four years ago in China, people put money in but didn't necessarily make money. That's what we're trying to figure out.'

George Raffini, managing director, HSBC Private Equity Asia concurs. ‘China has been a relatively tough market for us.' ‘Generally, we've not done that well in China.' He adds, ‘we've had some successful outcomes and, overall, have made small positive returns. However, it's been a lot of effort and, importantly, there's been some learning along the way. I see the market as being equally tough today due to the greater liquidity flows into the country. Clearly, this has had an impact on pricing levels and also makes due diligence more challenging. As for the rest of the Asian region, I generally like pricing levels but, of course, other issues can arise.'

Is the ‘gold rush' mentality on the wane? Although the buys continue, opinion around the table is that fewer private equity firms are doing deals in China, their rivalry cooling into caution. Instead, it seems that ‘local money' is eagerly nosing around; money seems readily available and the combination is helping to keep pricing expectations up.

‘It would be a good thing if investment activity in China picks up as, historically, China has been a little under 30 per cent of our investments over our 15-year history,' continued Raffini. ‘On the other hand, it's been a lot less than that over the last five years. The reduced investment pace in China takes one important leg from the stool.' There are exceptions, of course: Carlyle's Li reports a 6.7x return on his earlier (for former employer Orchid Asia) investment in EachNet, which was recently acquired by eBay.

Exits anyone? There have been some decent exits of late (i.e. EachNet and Citia) but don't expect a flurry of activity in the near term, warned the savants. The post-1997 funds will begin to exit in 2004-2005, showing positive returns to tweak investor interest, the market itself will be ‘somewhat starved' for capital and investor interest will grow. Until then, learn to live with the lag effect.

‘We really won't be seeing a lot of exits this year,' mused Kyle Shaw, managing director for Shaw Kwei & Partners (SKP). ‘It's not a good time. Prices aren't high and investors' interest is relatively low compared to the more buoyant environment expected next year in Asia. If you're thinking about maximising investment returns for your LPs, plus your carried interest, why sell now?' KY Tang, Chairman of UBS Capital, goes even further: ‘It's a good time to buy [assets]. A lot of the strategic competition has gone home.'

Or even worse, offered Carlyle's XD Yang. ‘One problem,' says Yang, is that ‘basically, instead of a multiple expansion, we have a multiple contraction. People were looking at an investment that should have been triple or quadruple but [instead] are looking at assets that are maybe only a double. It is difficult to exit if you've barely doubled; you go through the IPO market and you get an illiquidity discount and it seems not worth it; it's too cheap, so it's better to hold than sell it.'

Back in 1989 when Korea hit the wall, a lot of money targeted a lot of traditional buy-out deals. The good news, says Yang, was that almost everyone got the entry prices right, the valuations were ‘pretty cheap' and the companies were ‘pretty decent' and all seemed well for a reasonable exit or even a triple or quadruple multiple . . . but then certain negative factors (i.e. ballooning consumer debt, soggy stock markets etc) came into play.

Gordon Clancy, Asia Pacific head for Citicorp Venture Capital believes the current doldrums were caused by ‘way too much capital going into a market poised for a cyclical downturn. It's a very difficult role anywhere, let alone Asia, to get good returns out of that asset class.'

No help from the corporates either
Around the table, the consensus was the strategic buyers have gone to ground. As one would-be seller put it, ‘it's very difficult to make a lot of money if there are no strategic buyers. There should be.' The ones that are here, such as the big multinational corporations who continue to snuffle around for their smaller Asian equivalents, also take a comparatively longer time to line up and land.

Compare Asia to the US, where preparing an investee for sale to a strategic buyer might take a year. Even today, trade sales account for about half of all exits. Asia presents a different picture. In China, for example. Vincent Chan, head of North Asia, JAFCO (Hong Kong), says the prep can take three or four years of intricate work, and there's still no guarantee it all won't go sideways at the last moment. For the Asia-focused VCs, this means more work for less money but with more headaches. Chan estimates that trade sales account for less than 20 per cent or even ten per cent of the action in China.

In Korea and Taiwan, money can be freed via recaps and under the auspices of understanding foreign and domestic banks alike. A very good thing, says Dirk Long, managing director, Olympus Capital. ‘I think it's very positive that banks are willing to let us take money out; it's a psychological hurdle they need to overcome.'

Also, says Shaw, investors likely wouldn't mind the illiquidity of the investment, if the returns were solid. ‘That's probably the biggest challenge. Until the private equity industry proves that more than a few GPs can generate returns, Asian investors are not going to commit to it.'

Payday: of fees and carried interest
That all-too-many GPs are earning their payday through fees - not carried interest is not a happy circumstance for either the managers or their LPs. ‘I'm always surprised at how few Asian PE pros consider the issue,' observes Shaw. In his experience, carried interest has been a ‘most positive and long-term motivator, ‘aligning fund managers and LPs/ investors ‘so we're all working from the same page.' It also bulks up the bottom line as ‘the management fee on a small fund isn't going to generate much for partners; it all comes from the carried interest.'

Asian private equity IS different
Fundraisers should do more to educate overseas LPs about Asia's strength and counteract the misleading perception of economic weakness. PAMA Group chairman Michael Kwee points out that currency reserves are solid and getting larger. Lay out the regional economic foundations, he suggests. JP Morgan Chase economists in Hong Kong have calculated that, by the end of 2003, Asian countries combined will have amassed a staggering 70 per cent of the world's currency reserves. In the last ten years, Asia has added $1.2tn to its US dollar reserves, whereas the US now runs an annual trade deficit of $500bn. Meanwhile, Credit Lyonnais Securities Asia in Hong Kong says the money pile is even higher, perhaps $1.5tn.

‘It's very impressive,' says Kwee. ‘I think these [statistics] are the sort of things to get to the LPs first, give them the big picture - ‘Malaysia is not bankrupt, Thailand is actually good and ready to play', that sort of thing - before you talk about exit. ‘Is Asia a place where I want to put my money?' It's very difficult to start them off when they don't understand the bigger picture.'

Sure, most institutional American LPs are more familiar with Europe, and the rise of the euro vis-à-vis the greenback has meant a nice bonus. Europe continues to offer consolidation and yield opportunities but, argues Kwee, that doesn't mean these same LPs aren't interested in Asia. ‘They'll probably tell you they don't want to put a lot of money in, but given the size of the portfolios, all they have to do is put a [small] percentage in.'

Capital Z Asia managing partner Gary Lawrence believes it's vital that the whole portfolio show ‘consistency' in quality and breadth. Yes, there are ‘some great deals and good exits' but in the tough times of late and over the next few years, the bad deals get a disproportionate amount of attention. This isn't necessarily a bad thing, muses Lawrence. It does sharpen one's attention and smarten everyone up.

Fundraising
Keep your priorities straight and, especially when it comes to pitching to overseas LPs, be aware of the danger and/or reward of getting slotted. Or as Lawrence elaborated, most Western LPs or prospective LPs coming into unknowns - such as a complex region called Asia - find it easier to simplify. And that can backfire for them. ‘US investors often look to divide funds into different categories - buy-out funds, growth, mezzanine, significant minority, etc. In Asia, none of these categories has demonstrated a consistent, successful track record.'

Complex, with its own unique problems and strengths, ‘Asia is a volatile investment environment. The volatility presents an opportunity for unique upside. At the same time, it also exposes investors to greater downside risks. We've tried to focus on how to manage our downside risk without paying as much attention to the various fund categories. Ultimately, we hope our results will encourage LPs to find a category for us,' says Lawrence.

Olympus Capital managing director Dirk Long also points to investors' strong interest in yields, especially yield-oriented debt, as a growth area and asset with ‘fabulous' returns. What with all the corporate restructuring going on in Asia, distress funds have achieved ‘20 per cent kind of returns' in the last year or two. Although the take has been declining of late, it's a very lucrative area.

Asian institutional investors have the cash but have been reluctant to commit it. Said one participant, ‘we've definitely called on institutions in Japan and Korea. ‘A lot of work for small amounts of money - America is still interesting despite all of the overallocation and other problems.'

Copyright © 2003 AVCJ

Daniel Schwartz is the chairman and publisher at the AVCJ and David Leidl is a senior writer.

This article first appeared in the Asian Venture Capital Journal in July 2003.

The Asian Venture Capital Journal is the region's leading publication on private equity and venture capital. With readers worldwide, AVCJ provides monthly coverage of fund raising, investments, exits and the people behind them. For more information please visit www.asianfn.com