From LPs looking for realizations from GPs as well as paper gains, to the factors contributing to more buyout opportunities in China, industry participants give their perspectives on the year to come:
Sentiment has been more subdued on Asia. You will see some fundraising noise that comes through from the timing of some large funds coming to the market, so maybe the figure to focus on is the average over two or three years. But even allowing for that, fundraising is probably down.
There is also a theme of consolidation of GP relationships by many LPs. This has benefited some of the larger funds that are able to raise more money, but some smaller managers are feeling the negative impact of that consolidation. You will see continue to see some oversubscribed funds in the mid-market space, but by and large, the days when you would be able to command a strong fundraise as a new face on the block or as a re-up without much in terms of realizations are past. LPs are more demanding in what they are looking for. Your DPI [distributions to paid-in] matters; your ability to justify your fund size over and above what you raised last time matters.
Regarding China specifically, there are some issues at the political and economic level, but there remains a fair amount of optimism. As long as managers are able to command capital this is quite a good investing environment – there is less competition and more time to conduct due diligence.
I also see some optimism in India, despite the recent demonetization efforts. Fewer firms are able to raise capital, particularly if you strip out VC, but pockets of capital have been raised locally. There is increased realism as to what it is practical to expect of foreign institutional investors, so if managers can rely on local investors to get going that is a sensible strategy.
Australia and Korea will hopefully both continue to be steady, and Japan continues to defy expectations and perform well despite a difficult backdrop in terms of macroeconomics and demographics. This could well be Japan's year in terms of private equity fundraising, because a number of firms are coming to market at the same time.
The pace of deployment has continued on an upward trend, especially in the small to mid-market deal space, and we see signs of that continuing to be robust going into 2017. The pipeline will continue to be driven largely by founder-owner succession deals and some corporate spin-offs.
One thing we see going forward is that succession deals will be coming not only from ageing founder-owners but also those from in their late-30s to mid-40s as they realize the merits of working with private equity firms based on word of mouth and what they're seeing in the market. That's a change in perception that has accelerated over the last year or so and will be driving deals in the future.
Corporate divestments are a bit more cyclical in nature and I think we're at a point in the cycle now where Japanese companies are feeling more pressure to divest and focus on shareholder value. Additive to that, improvements in corporate governance initiated over the past year that make it easier for private equity to participate in larger deals are beginning to take effect with these companies.
We are seeing appetite and opportunity to sell to Japanese strategics in 2017 and foreign companies will begin to take on a role as buyers as well. There are different angles to achieve double-digit growth in Japan, so private equity will focus more on creating value with differentiated products, bolt-on acquisitions and helping companies go overseas.
From next year, it will be a much more challenging environment for private equity in Korea, even for deals over $1 billion, because the spectrum of competition is going global and even the smaller funds will be able to source additional money from LPs through co-investment. LPs, who have witnessed a number of high-return mid- to large-cap deals in Korea, are pushing the global funds to build up their teams in the country and secure more deals.
For the next 3-6 months, the current political instability may have a negative impact on private equity markets because it's not just about politics – it relates to concerns that Korean conglomerates may be accused [of improper conduct], which could delay the important decisions such as portfolio adjustment or M&As.
However, I still think deal flow will be strong for the next 18-24 months because there will be activity in the distress market. There will also be a lot of secondary deals because many PE portfolio companies are mature.
In addition, there are still a number of mid-cap companies that need support for globalization on top of growth capital. PE funds will continue to have a preference for consumer and retail despite the potential macro headwinds, but there are some contrarian views that they could actually be more active in industrial sectors due to cheaper prices. More investors could turn companies in those sectors around with creative deal structures, drive consolidations, or shoot for an industry cycle play.
The issue will be exits because domestic strategic investors are quite selective regarding local deals and pursue cross-border opportunities more actively. We have also never seen any IPOs for majority-owned PE portfolio companies and we've had some political impasses between China and Korea making it hard for Chinese strategics to do deals in Korea. Unless we resolve the political issues with China and the stock exchange allows companies majority owned by PE to go public, it is likely exit activity will face challenges in 2017.
The thing that has struck me most in the last year or two has been the mood swing of many international investors. Those of us within the region continue to believe that Asia represents a very interesting place to invest private equity capital, if done intelligently, but globally the mood seems to have swung broadly against the region as an investment destination. The perhaps excessive enthusiasm of a few years ago has gone away and been replaced by excessive pessimism.
Of course, this can actually create some interesting opportunities, because reduced capital inflows can also reduced competition for deals, potentially making entry valuations more attractive. But the pessimism makes it very challenging for GPs to raise money, especially those still trying to prove themselves.
For the last year or so now, managers seeing fundraising success are those that have proven an ability to get money back to their investors. An attractive TVPI [total value to paid in] alone is not sufficient. Investors want to see distributions, an area in which Asian funds have lagged peers in Europe and North America. So we've seen some of the bigger Asian GPs do really well with fundraising, because they tended to invest more in the buyout space where they can control the timing of exits, or in larger deals where they could get listings on exchanges or do some other form of recapitalization and get money back.
On the other hand, for many GPs managing smaller funds, while the portfolios may look good, fundraising has been very challenging because of the inability to show that they can actually realize returns. I think that's likely to continue to be the case in 2017.
Another development worth noting is the growth of the secondary market in Asia. Many of the funds that were raised in the mid to late 2000s are coming to the end of their lives, and they need to find solutions to their exit problems. So the secondary market is increasingly a way to get liquidity for investors or, in some cases, give new life to a GP by recapitalizing a fund or using other techniques to permit pursuit of a promising investment course.
The Australian private equity market is very stable with a consistent set of competitors, and the economy is heading into its 27th year of continual growth. We therefore don't really see a lot of change happening over the next 12-24 months in terms of dynamics or conditions.
There's a A$2.1 trillion ($1.57 trillion) pool of capital in the Australian superannuation space that continues to grow at a faster pace than the economy, so there's no doubt that investors at a macro level will be seeking to invest that. But I don't think it's going to lead to an oversupply of capital in the local market because a lot of it will be invested offshore. The superannuation funds also invest lower percentages of their funds into PE compared to global benchmarks, and I don't see that changing in the near term either.
One theme that is coming out in Australia, however, is exports of services, which has now overtaken exports of iron ore. We expect that trend to continue, especially in the education sector, which is set to grow off Asian demand. Australia is now said to be exporting more education services than the UK or Canada. New Zealand will have a similar services dynamic with probably more of a focus on food businesses and agriculture.
There has also been a good appetite in the Australian market for services-related businesses to go public. We've seen a strong IPO pipeline since late 2013, but it has tightened up recently so it will be interesting to see how that goes in the first quarter next year. That will depend on what happens in the US and economies around the world in terms of investor appetite.
One trendline is about definitely watching the leading start-ups – the Flipkarts and Olas of the world. In 2014, 2015, and to some extent in 2016, they were also the forerunners for M&A and aggregation and consolidation in this space, and if they're not strong aggregators, then what happens is M&A dies down a bit. And so it's not only the companies themselves to watch out for, but also the lead indicators on M&A activity and late stage investors coming into India. A lot of people have money invested into those companies that they cannot afford to lose. It may swing momentum away at late stage if that happens.
The contrarian trend to that is there's a lot of early stage capital with resident managers in India, whether that's Accel Partners, Nexus Venture Partners or even early-stage funds and angels, but it's far more tentative when it comes to what gets backed. The good news is that models that are more robust, that have more traction, are getting recognized and funded. India-centric or unique-to-India models got a bit of a rough ride from investors in my view, but that is changing dramatically in favor of those companies. Some sectors that we like or we've bet on already are going to get a huge uptick in the next 12 months: healthcare, financial services, education, small business technology, small business enablers, B2B enterprise and software-as-a-service (SAAS).
A lot has yet to be seen in terms of what impact demonetization has on the overall economy. I don't think it's all positive. It's going to hit discretionary spending, and it's going to slow down the economy for the first six months of the year. The full impact will roll out early in the first half of next year. And compounded with that is all the policy uncertainty. I think the government does realize that they have made mistakes in the short term, and to fix that they'll have to throw a whole lot at one layer or the other. So whether it's to facilitate trade, or to boost consumer spending, some of that is going to happen.
If start-ups are able to survive through the next year, my belief is that the end behavior, whether that's in six months or five years, should benefit new age start-ups, because a lot of the frictionless transactional activity, whether it's goods or services, is bound to move online. And anything that piggybacks the mobile internet economy is likely to benefit, if they've executed it well. So apart from payment start-ups and financial services, once you've taken a lot of cash and pushed it through the formal banking system, consumers become savvy enough to operate their cash flows digitally, and the digital service offering suddenly becomes far more viable.
Some business environment factors in Southeast Asia, such as internet connectivity, are quick to change, while others take longer. One important missing element of a healthy digital ecosystem is a stock exchange capable of providing liquidity for technology companies. Before this becomes a reality, an entire generation of equity analysts, traders and investors will have to be educated. Other important factors such as a culture of risk-taking, access to a deep pool of technical talent and availability of experienced mentors are noticeably changing, but likely have further to go.
In terms of investment sectors, although VC enthusiasm for Southeast Asia's e-commerce market – Indonesia's in particular – has subsided somewhat following an intense period of interest, an interesting group of businesses has emerged in its wake. These are the back-end infrastructure systems necessary to support e-commerce operations, such as last-mile logistics, advertising and affiliate technologies, and digital payments.
Certain industries succumb to the hype generated by the global tech ecosystem. In my opinion, financial technology is one area where the current buzz exceeds substance. While there is much talk of disrupting banks and insurers, I find that start-ups whose initial role is to support, rather than replace, financial institutions' processes are more successful in establishing a beachhead from which to advance. Separate from the buzzy fintech space is digital payments, which has been developing nicely in the past couple of years, and where I think we will see some consolidation.
Overseas investors, who deploy the majority of capital into Southeast Asia's tech companies, will continue to have a major influence over events in 2017. For example, we are seeing a resurgence of interest from mainland Chinese investors in certain markets – Indonesia and Singapore feature most prominently, but increasingly also Thailand and Vietnam. This may be why, after almost a decade out in the cold, the amount of buzz around Vietnam's tech ecosystem has risen again.
Over the last year, PE funds that I represent have become very interested in working with Chinese corporates to do outbound investments. And with the recent curb on outbound investment (not formally announced but widely reported), there is certainly doubt at least for the first half of 2017 as to what is going to happen with that flow of investment money offshore.
Some of the funds that I represent are actually seeing this as a potential opportunity for them: Because they have offshore cash available, they can provide a bridge for Chinese companies that are trying to do investments but can't get their cash out. If you figure that eventually the tap is going to be opened again and cash will be able to leave China, then if you are an offshore fund you can make money off of financing those offshore investments in the interim. Many of my fund clients are also focusing on the China NPL [non-performing loan] market, acquiring portfolios of loans and investing in companies that work with Chinese NPLs.
I think that a lot of people are finding other sorts of exits besides IPOs. There are always secondary sales to other funds. There are also a lot of people looking to consolidate businesses in certain sectors like education and healthcare, and often you can just sell your asset to somebody else who is consolidating. We've assisted a number of PE sellers in sales to strategics. In the past, maybe people would have held out and tried to do an IPO, but now they're saying, ‘Let's go ahead and sell this to a strategic.” Often the multiples are actually quite high. People are rethinking IPOs, which are really expensive to complete, assuming you are able to complete them. Indeed, when you look at the returns and factor in the cost and the time it takes to do an IPO – plus the time it will take the fund to sell its shares post IPO – sometimes an IPO is just not the optimal exit.
On the fundraising side, we still see LPs very willing to commit to China-focused funds. I think you're going to have a period with people pausing to sort out between the types of China-focused funds they will invest in and the types of funds they won't. The Chinese economy is slowing, so you can't just invest in a fund if its only strategy is to bet on growth. You need confidence that the people at the fund have real ideas and can figure out an investment strategy that really works.
Domestic consumption will continue to steadily rise – it started out weak in 2016 but ended the year very strong. You'll see that reflected in funds like ours that focus on what people eat, drink and wear. When I think of consumer I think of the mass market premium brands – it's the products and services that people are buying. I really think we will see the most success in that area, which means that strategies oriented around the consumer, mass market, and tangible qualities will continue to see good growth.
We feel very strongly that what we're doing will remain a sweet spot in terms of attractive entry valuations, less competition, and most importantly, the greatest opportunity to add value. You're still going to see enormous opportunity, especially in areas like consumer, to buy established businesses with a strong pedigree and a strong track record, and bring them into the modern age. If you're a younger entrepreneur, and you're at an early stage of running and building your business, you may not see much value-add from private equity. You also may not want to sell your business, and if you need to raise money, you might solicit PE investors but probably as little as possible. So these opportunities are difficult for growth capital to invest in, and those founders are probably not likely to do something even with a buyout firm.
But if you look from a big-picture perspective, there are approximately 12 million mid-size companies in China. And the average age of the established mid-market companies is older, as they were typically started in the 1980s and 1990s, and are now approaching 20 or 30 years of operational and brand history. A lot of those businesses are run by people who are thinking about what's next for their company, beyond their own lifespan, and certainly beyond their tenure as CEO and founder. To the extent there will be competition, it's going to come from domestic Chinese companies rather than from other private equity firms, but they'll focus a little more on the larger and slightly more mature end of the sector.
Increased competition is narrowing the upside in minority growth transactions. This is not necessarily driven by other private equity firms, because there hasn't been that much capital raised, but from from increasingly-developed, deeper, more robust capital markets that are better positioned now to provide meaningful financing. A well-run company looking to raise money, can now get it at very reasonable prices. You don't have to give an arm and a leg to a growth capital fund like you had to five or ten years ago. That investment approach will be challenged, and I don't see the trend reversing any time soon.