12 Jul Finding Opportunities in Asia
Thinking Man Series #27
Over the last 15 years, Asian economies have lead global growth and significantly increased their importance as a share of global GDP and output. China’s economy increased in size by over 14 times from 1990 to 2010; India’s economy grew five times in size in the same period. The mega growth these and certain other Asian economies experienced in the past will be nearly impossible to achieve going forward; instead these economies are transitioning to a “new normal” where growth has slowed, but will likely be less volatile and more sustainable. Even though growth has been meaningfully reduced, relative to other regions in the world, Asia still remains the global growth engine, as demonstrated by the table on the next page. The Economist Intelligence Unit predicts that in the next two years (2017), China will be the world’s largest economy. Goldman Sachs predicts that in the next 15 years (2030), India will become the third largest economy in the world. Looking even further out in the future, analysts predict that by 2050, Asia will account for over 50% of global output. Another factor which makes Asia a strategically important region is the population dynamics of China and India, the world’s most populous nations. China (1.36 billion people) and India (1.25 billion people) represent about 37% of the world’s population. The next most populous country, the US, is a distant third, with only 0.32 billion people. China’s population is set to expand: in 2013 and 2014, a total of 29 out of 31 provinces loosened the one-child policy by allowing families to have a second child. China will also benefit from their new powerful consumer class, which we discussed in the Thinking Man #10.
In this note, we discuss our current exposure to Asia, where we believe we can find value, and finally, how we propose clients to invest in the region.
Limited Portfolio Exposure to Asia in Client Portfolios
Despite the large and increasing importance of Asia, our clients typically have a limited direct exposure to securities in the region, with our average client portfolio having less than a 5% allocation. Many of our portfolios do have more exposure to Asia, but indirectly. We have historically mainly obtained exposure to Asia by investing in multinational companies with significant focus in the area (for example, a US based company whose strategy is focused on growing sales by capturing the Chinese consumer). This is partially due to our investment philosophy which puts a high value on corporate governance and shareholder interests: both of which have not always been consistently strong points for Asian companies. However, we are looking to meaningfully add to our exposure to Asia, given its increasingly important role in economic and financial markets, and higher growth profile relative to US and Europe. The BigSur Investment Committee has been looking for a “pure play”; a good vehicle in order to more directly access this asset class and better capture the opportunity set in Asia.
Finding Value in Asia: Private Companies
When evaluating ways to invest in Asia, we first take China as an example. When you look at the onshore Chinese stock market, about 90% of market value of the stocks are state-owned enterprises, or “old world” economies, such as steel or manufacturing. However, if you look at the GDP growth in China, about two-thirds of this has been driven by privately owned enterprises, particularly those in the service-based industries. Additionally, 80% of the job creation can be attributed to these private companies. The Chinese government has recognized the significance of these private companies, and has started to implement reforms in order to accommodate their growth. For example, in July 2014, for the first time in history, the Chinese Banking Regulatory Commission approved three private banks funded with private capital. The government is also opening the market to non-government enterprises in an increasing number of areas including: railways, telecom and petroleum. All of this should benefit these private companies, allowing them to play a larger role in China’s economy. Finally, the China lifted its 14 month freeze on IPOs in January 2014. There were several successful IPOs out of China, most notably Alibaba, which in September 2014 was the world’s largest ever IPO. These conditions all benefit private companies, which are normally hard to access for investment. The way we propose for our clients to gain exposure to such companies is through private equity managers who provide capital to these local Chinese enterprises.
A further positive force for investments in China are the potential for valuations to increase of their state-owned enterprises (SOEs). In addition to reforming private companies, China aims to increase efficiency of SOEs by choosing which industries and sectors would be most suited and profitable to be state-owned and also introducing the concept of “mixed ownership”- converting some of these strictly state-owned companies into partial state and partial private sector owned companies. One manager believes that these reforms could potentially increase valuations of these SOEs from anywhere between 5-8x over the next decade, which will help expand private equity valuations.
Another example is Japan, where the private sector is also looking to undergo meaningful business and industry restructuring. One manager sees a good opportunity in small and medium enterprises (SMEs) that are facing declining profits and market share in the domestic market, and are now, more than ever, very willing to have private equity firms invest and help them expand their business abroad (particularly to China) and to improve their competitiveness. Many of these companies also call themselves “undermanaged” and are seeking private equity funds to improve their operations and margins. This comes at a time when many of the large global private equity players have exited the Japanese market (including: Merrill Lynch, Unitas and Vestar). This manager also sees entry valuations of these deals as low and attractive, especially when considering the valuations of the public equity market: while multiples have decreased in Japanese public equity markets since the peak cycle in Asia (January 2007), private equity multiples are at a much deeper discount. For example, the manager told us, at the height of valuations in private equity in Japan, they were paying a 18.1 entry multiple to get into deals: in 2014, that number for similar deals was 5.2 (representing a 70% discount). The public markets, on the other hand, were trading at PE multiple of 26.8 in 2007, and in 2014 at 18.2 PE multiple (representing only a 30% discount).
Private Equity Environment in Asia
Capital invested in Asia private equity has grown over the last two years (in 2014, there was about $80 billion invested), but has still not reached its 2007 peak ($97 billion). Private equity is still “underdeveloped” in Asia, whereas flows continue to saturate the US private equity market: in 2014, US private equity funds raised six times more capital than Asian private equity funds (US: $266.2 billion, Asia: $44.2 billion). Private equity in many Asian countries is still in a nascent stage, with a small but growing number of local firms that are not easy to access. Some of the ‘major’ US and global firms may be active in the largest deals, but they often do not have a significant-enough local presence and/or are too large to access some of the more interesting deals and managers in the SME sector.
Conclusion: Importance of Manager Selection
Given that we believe private companies are the appropriate play in Asia for our clients, we have been vetting private equity managers in Asia. Below are some of the key characteristics we have used for our evaluation.
- Boots on the ground: A strong local presence is important for us when selecting an international manager, and in emerging countries, we feel it is extremely important. We like firms to have analysts who have local knowledge, understand local corporate culture, government, consumer habits, etc.
- “Network effect”: a local presence is not only important to understand the investments. It is also important to develop a network and access top tier partners. As we mentioned earlier, shareholder rights may not be as protected in Asia. Instead, there is a large emphasis placed on trust and reputation. Thus, it is very important to work with a group that has an established and well-respected local presence, a strong network, with the aim of selecting companies and deals in which we can feel confident.
- Knowledge of the different markets in Asia: Asia, similar to Latin America, cannot be categorized as one story. Therefore, it is very important that a manager understand all the intricacies of each country’s economy and opportunity set. For example, one top tier manager told us their views on India: capital markets are overstocked (the Bombay stock exchange has over 5,000 listed companies, making it the exchange with the most companies listed in the world) and thus, private equity is generally competing with public equity. This manager found that in most deals they look at, investors are paying public market valuations and are not being compensated with enough of an illiquidity premium. This manager chooses to only invest in early stage technology companies in India which are aiming to become globally significant, because that’s where they believe investors can earn the best risk-adjusted returns. India’s publicly traded equity markets is an area we see potential value; we are researching this further, and may be writing a follow up Thinking Man on that opportunity.
- Co-investment opportunities: Private equity funds can offer additional return potential when there is an opportunity to co-invest alongside a manager in direct deals. Some managers may have limited capital or restrictions on how much they can allocate to a single investment in a certain company. At times, these companies are looking for additional funds, and if a manager has high conviction in the company, they may offer their fund investors the opportunity to participate in a co-investment in the company. These direct co-investments have the potential to enhance returns and are very difficult opportunities to access.
- Manager track record, team experience, and investor base: As with all of our investments, we consider the manager’s qualifications and track record of performance as key factors in our decision making. We like managers who have been specializing in their market for years, and who have earned a reputation of being a top manager in their space. Given our goal of introducing clients to “institutional caliber” managers, it is also important for us to understand who the other investors in a fund would be, and if they represent “smart money.”
We have identified a manager who we believe fits many of these characteristics and will be a well suited vehicle for those clients looking for exposure to Asia. We will be following up with more details and information on the specific opportunity.
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