This article was written by John Sullivan (Partner, Singapore), Guo Sun Lee (Partner, Hong Kong) and Jerry Choi (Trainee, Hong Kong).
As recent figures have shown, after a two-year slump, Asia Pacific’s private equity (PE) sector registered its best-ever performance in 2014, with both deal values and exit activity soaring to a new record of US$81 billion and US$111 billion, respectively (Bain & Co Asia Pacific PE Report 2015).
A closer look at the Asian PE market reveals encouraging signs across the board in fundraising, deals and exits. Improved activity levels have also resulted in interesting trends in the market with many general partners (GPs) adopting new strategies and approaches in an attempt to stand out amongst their peers in an increasingly overcrowded market.
These developments are in stark contrast to the challenges of previous years when analysts described the Asian PE market as having “hit a wall of reality” after high expectations pre-2011. However, it remains to be seen whether these activity levels will continue into 2015 and beyond.
More broadly, Asia’s private funds market (including other alternative asset classes such as real estate and infrastructure) is at an interesting juncture, with macroeconomic and demographic factors implying increased demand for Asian investment over the longer term. We are also seeing the emergence of Asian limited partners (LPs) as Asia increasingly becomes a source of capital as well as a destination for investment.
PE fundraising and deals
2014 was, compared to 2013, a much more positive year for PE fundraising, with Asia-focused GPs raising an impressive US$35.9 billion, marking an 18% increase over the previous year.
The results are buoyed by the closings by a number of regional heavyweights, as CVC Capital Partners, TPG Capital, and the Carlyle Group closed Asia-focused funds for more than US$3.5 billion, US$3.3 billion, and US$3.9 billion respectively.
While some perceive that there is now overcrowding in the market, many smaller funds in Asia continue to struggle in raising capital as LPs gravitate towards known brands.
On the deal side, 2014 was also a strong year. Bain & Co noted deal values and exit activity were at record levels (although there was diversity among countries). Meanwhile, there is still significant dry powder. Bain & Co estimates that Asia-based GPs were holding in excess of US$132 billion of unspent capital by the end of 2014.
With all this unspent capital, fundraising may slow down somewhat going forward. And with heavy competition for deals, there is also concern about rising asset prices and the inflationary impact of cheap debt funding.
Favoured PE investment strategies
Traditionally, GPs in the region have focused on providing growth capital to relatively mature companies in need of a capital injection to expand or restructure. While growth capital funds will continue to be the favoured type of fund, there appears to be growing interest in buyout funds, which acquire larger controlling interests in their portfolio companies, as LPs grow wary of minority stakes where they have seen mixed results of late.
Bain Capital’s investment in GOME provides a prominent example of how growth capital investments can go awry. In 2009, the US PE firm purchased a minority stake in an electrical appliance retailer, but the acquisition sparked a prolonged corporate governance battle as the company struggled to remain profitable. Bain Capital sold the remainder of its stake in January 2015 at a discount to its pre-deal share price.
Other alternative asset classes – real estate and infrastructure
The broader private funds market includes other alternative asset classes, such as real estate and infrastructure. We have seen increased interest in energy infrastructure funds in recent years and anticipate emergence of further specialized categories of funds, such as mining and resources funds, agriculture / agri-business and timber funds over time driven by fundamental investment demand.
While ‘real asset’ markets have some common features with PE, there are some differences. The longer term nature of some of the underlying real investments is influencing GPs to establish more open-ended or long-term funds, rather than traditional fixed term PE funds which have historically been prevalent in Asia. There has also been an increase in fund restructures for the same reason, as existing PE style funds hit the end of their term but there is investor appetite for the funds to continue.
Further, in infrastructure in particular, there has been a trend towards large global funds in recent years to enable scale and portfolio diversification across key investment markets globally.
We expect these trends to continue as they are driven by ongoing investor demand in the relevant sectors.
Significance of institutional and sovereign wealth fund investors
Larger investors, particularly the institutional pension plans, insurance companies and sovereign wealth funds, as well as development finance institutions (“DFIs”), continue to have an important role in the development of the market. We mention below a number of areas where their influence is being felt.
More generally, we are seeing greater outbound investment from key groups of Asian investors as they look to increase the diversification of their portfolios (as a result of regulatory change or otherwise). For example, Chinese insurers are starting to emerge as a force, particularly so far in real estate and infrastructure. Similarly, there has been a resurgence from Japanese and Korean investors looking outbound in recent years.
Co-Investments and flexible arrangements
There have also been interesting developments in the relationship between LPs and GPs over the past few years. For example, there are an increased number of co-investments taking place across Asia. Larger investors, in particular institutional pension plans and sovereign wealth funds, find co-investments an attractive proposition in addition to investing in the funds themselves.
Despite the lower management fees expected in a co-investment deal, co-investments grant GPs access to much-needed capital, and allow them to build rapport with such investors, a necessary step towards solidifying their LP base for future funds. In response, GPs have been developing innovative approaches to gain support, adopting alternative investment structures to attract LPs who are seeking more flexible or tailored arrangements, and wish to play a more active role in investments.
This trend is likely to continue with the steady emergence of Asian LPs as significant investors, both established players and newcomers, like the Chinese insurers. Some newcomers wish to dip their toe into direct investments and this is a perfect way to do so.
A number of established larger investors have developed significant ‘direct’ investment capability in-house, which has contributed both to this trend and also to increased competition for underlying investments, as they seek to invest directly. In real estate and infrastructure, clubs, joint ventures and consortia are frequently being formed to bid for investments, either together or in competition with traditional funds.
Funds going onshore
As competition grows in Asia, another positive trend for the Asian private funds market has been that more funds are being established onshore as opposed to the traditional offshore hubs like the Cayman Islands. This trend is likely to continue with increasing scrutiny of offshore jurisdictions by regulators and investors in relation to corporate governance and tax matters.
Singapore and Hong Kong are attractive alternative locations for fund establishment. Singapore has more than 70 economic and tax treaties with other countries, and has introduced attractive tax incentives for funds and managers such as the Singapore Resident Fund Scheme. Hong Kong will be introducing similar tax incentives in 2015.
Increasingly, many GPs are hoping to attract LPs (such as DFIs and other highly regulated investors) who wish to invest in onshore – as opposed to offshore – entities. Typically, these LPs prefer to avoid being associated with offshore investments; although their reputation is somewhat undeserved given most of these offshore jurisdictions are on the OECD “White List”.
Increased ESG awareness
While easy to market, environmental, social and governance (“ESG”) policies were often a matter of lip service for some Asia-based GPs in the past, given their focus on maximizing returns and the practical difficulties of implementation, especially taking into account cultural differences and local practices.
LPs investing in Asia are now putting a greater emphasis on ESG issues. More sophisticated LPs are pressuring GPs to adhere to sound ESG principles and invest responsibly or face losing the relationship and ultimately, their commitments.
While smaller firms have been slow to prioritize ESG given their resource limitations, we are seeing a shift among larger GPs, which are developing ESG programs or enhancing existing ones. ESG is becoming a priority, not just in Asia, but in PE markets globally.
We expect to see more of this as more fund managers see the benefits of ESG from a corporate governance and investor acceptability point of view. Incorporating ESG into existing practices will undoubtedly be difficult, but may be necessary for Asia-based GPs to stay competitive with their peers amongst more selective investors.
Increased global regulation
Increased ESG awareness is consistent with broader trends in global financial services and taxation regulation. Developments such as the European Alternative Investment Managers Directive and the Foreign Account Tax Compliance Act (FATCA) and the Dodd Frank/Volcker reforms have had an important and ongoing influence on the global and Asian markets. You can read more on these aspects in Raising your next fund: the rising tide of global regulatory change.
The road ahead
Despite the soaring figures of 2014, market commentators warn that 2015 may be a tougher year for fundraising and deals as competition and valuations continue to increase. Asia will continue to draw the majority of global capital flowing into the emerging markets, and its private funds market has improved. However, fundraising and deals are still highly competitive. GPs in Asia will need to adapt, as investors scrutinize them even more closely for evidence that they are capable of thriving in the high-risk, high-reward Asian PE market. GPs also need to remain alert to the myriad of regulatory changes which will inevitably affect the landscape for both fundraising and deals. Longer term we welcome the progressive emergence of Asian LPs reflecting Asia’s rise as a source of capital as well as a destination for investment.