The appetite of UK pension funds for new sources of added value and diversification has become an established trend. Private equity has proved to be a natural first choice, with many schemes adding to their private equity holdings or establishing allocations to the asset class for the first time. In return, private equity has delivered strong returns, over 10 per cent per annum over 10 years and longer.
However, the high demand for private equity and the sheer weight of money being allocated to the asset class, notably in Europe and North America, is forcing ever higher levels of gearing to deliver performance. As a result, investors are seeking new, less risky growth opportunities elsewhere and much of this attention is focused on Asia.
China and India together account for 40 per cent of the world’s population and are among the world’s fastest growing economies. The Asian Development Bank forecasts that year-on-year GDP growth is expected to remain robust, and significantly in excess of developed markets. This growth gives experienced private equity managers and their clients the opportunity to capitalise on two key developments:
- Huge growth in domestic demand for goods, services and infrastructure. The improvement in average incomes means that Asia’s burgeoning middle class is rapidly adopting Western consumption habits. This is fuelling strong demand in industries such as consumer goods, financial services, automotive products, leisure, media, telecommunications and pharmaceuticals.
- Increasingly, well managed companies with highly entrepreneurial owners looking to develop market-leading export strategies, differentiated on quality and innovation rather than cost advantages.
Over recent years, political reform has opened up markets to foreign investors and improved the market environment for investors. Some examples of this are the relaxation of rules on foreign share ownership, steps to reduce corruption by setting up anti-corruption units and new legal frameworks in areas such as intellectual property rights. Regulatory controls and oversight organisations have also been established to support the stability and transparency of markets. At the company level, corporate governance has improved as company owners and management teams recognise the benefits of greater shareholder confidence.
Naturally, these improvements are not consistent across the region, and some markets continue to suffer from relatively weak risk environments. These risks need to be carefully assessed and, where possible, mitigated when making private equity investments, making local knowledge and representation imperative.
Mention has already been made of the increasing willingness of business owners and managers to embrace private equity financing as a source of capital. A large number of businesses in Asia continue to be owned and managed by families who are often not able to fund the growing financing needs of the business by themselves. In parallel, many family owners have begun to focus in earnest on shareholder value and growing the market capitalisation of their companies. In particular, there is greater recognition of the opportunities for wealth creation that capitalisation growth can provide and the currency that it can secure for further acquisitions. But it is not just private Asian companies that are seeking capital to finance their growth – many listed companies are also eager to participate in private equity arrangements. Whereas many listed companies previously turned to the stock markets for capital, they now find that they have a concentrated investor base and are unable to finance their growth aspirations.
Over the past few years, Asian private equity has demonstrated a healthy track record, with exits through trade sales, IPOs and recapitalisations, and the medium-term exit environment in Asia remains positive. Domestic capital markets continue to broaden and deepen, supported by ongoing financial and institutional reforms. International strategic players are keen to increase their presence in Asia, either to improve cost competitiveness or to service growing Asian demand. At the same time, local corporations are increasingly looking to domestic and international merger and acquisition activity to supplement organic business growth.
The opportunities are alluring but, as with all emergent and specialist markets, conditions are likely to favour investment managers with experience and established expertise. In particular, investment managers must be able to build strong partnerships with market-leading owners and management; structure transactions to facilitate exits and protect against downside risks; and actively manage companies’ expansion strategies.
Fast-growing Asian companies provide enormous potential for growth equity financing through the marriage of highly qualified local owners and management with the capital and expertise of experienced private equity investors. Given these opportunities, it is not surprising that large flows of private capital are already entering the region. Research from the Asian Venture Capital Journal (AVCJ) and The Centre for Asia Private Equity Research shows that total capital invested in Asia has grown from just over $69bn in 1999 to more than $106bn in 2004.
In many ways, the private equity market in Asia bears the characteristics of European markets in the early 1980s. Namely, a large number of successful small- to medium-sized companies that are increasingly aware of the benefits of private equity, a limited number of high quality private equity investors competing for deals and significantly improved exit opportunities.
By comparison with current-day Europe, however, Asian private equity offers much better growth prospects from companies benefiting from a significant cost advantage over their European and North American counterparts. The asset class therefore offers opportunities for further strong returns flowing from real growth rather than leverage, and in a business environment where the risks traditionally associated with investment in the region are being eroded. We expect to see a much greater level of interest from investors keen to maintain strong returns from their private equity portfolios.
David Morley is director of institutional business at Henderson Global Investors.
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