China uncertainty will not weaken APAC’s PE outlook, says EY

Asia remains a hotbed for private equity activity, with Japan in particular expecting busy months ahead, according to Luke Pais, Stella Yuan and Kenzo Nagaoka at EY.

This article is sponsored by EY

How has the APAC private equity landscape developed over the past two years?

Luke Pais
Luke Pais

Luke Pais: Globally, there is a lot of money sitting in the hands of private equity, and a lot of that is finding its way to Asia. The dynamics are interesting because the global private equity funds are all very active in the region and the sovereign funds are all increasingly playing more of a direct game, with Indonesia one of the latest to enter that space.

When you look at markets like Southeast Asia, China and Korea, there are large family conglomerates that look very much like private equity, because they have private money and their style of investing often behaves like private equity, albeit with slightly different risk characteristics. If those families have a lot of conviction, they can take risk, which creates a nice collaboration point between families and private equity. Those families have portfolios that are maturing, and private equity can be an attractive exit route.

In the last two years, Singapore has really positioned itself as a high-net-worth centre. It attracts a lot of private wealth, and Hong Kong has to compete with that.

Historically, a lot of those families took a passive approach to investing in money markets or fixed income; now, many are setting up family offices with direct investment teams, so a lot of private equity people and investment bankers are joining those and pursuing direct investment strategies. That started in real estate and is moving into other sectors.

Another point of development is the rise of alternatives. The region used to focus on private equity, but now credit is becoming a legitimate asset class – especially in Australia, but also increasingly in India and Southeast Asia. In China, the opportunity is more nascent because many companies have been well banked, but credit funds are expanding their footprints. Other asset classes like renewables and impact investing are also coming into the mix.

In terms of deal volume, the impact on private equity firms in 2020 was broadly not so bad, and most managers came through the covid-19 pandemic reasonably well. By the end of 2020, most were looking for new deals, while deals that had been put on hold were restarted.

Initially, we expected a lot of the activity to be around stress, but that didn’t happen: instead, the sectors that have been very active have been technology, healthcare, education, consumer thematics, financial services – very much with a fintech flavour – and renewables. So far this year we have been flat out; I have never worked harder.

What megatrends have you seen emerging in China in the past year, and what do you expect to see in the coming 12 months?

Stella Yuan
Stella Yuan

Stella Yuan: Private equity has been compelling for Chinese investors as a means to capitalise on the region’s growth for some time. Despite the global economic disruption, mainland China’s GDP still grew 2.3 percent in 2020, and there were a few favourable policies introduced in Hong Kong to support the growth of private equity. The new Hong Kong Limited Partnership Fund is meant to boost Hong Kong’s standing as a private equity centre for Asia, and the introduction of a carried interest regime should also enhance activities.

In mainland China, the introduction of the Foreign Investment Law and Catalogue of Encouraged Industries has helped investors access growing sectors, which is really a step forward.

But it’s not all good news for private equity: China’s regulatory change in a few industries, and restrictions around listing on foreign stock exchanges, remain fundamental issues. In the education sector, regulation has made some business models unworkable, there has been a tightening of the regime in the gaming, sharing and platform economies, and the introduction of a new data privacy law is an issue for companies looking to list overseas. These all add complexity and create uncertainty over exit timelines for investors.

On the other hand, Hong Kong has proposed a new listing regime for SPACs, and Beijing also opened a new stock exchange in November to serve small and medium-sized businesses. These will provide exit opportunities to portfolio companies in the region and bring companies back to the Asian capital markets. Investors have responded to regulatory change by shifting their focus to sectors that are less prone to regulatory impact, such as technology innovation.

During the period of China’s 14th Five-Year Plan, the country will accelerate the establishment of a new development pattern of ‘dual circulation’, where domestic and foreign markets can boost each other. We believe that China will push forward with opening up, which is compelling for PE firms looking to capture the growth of domestic demand and create value through technology and innovation.

In the short term, our view is that a lot of investors are concerned about regulatory change that could impact the allocation of resources to China, but longer-term, China still has a very strong economy and is a market that cannot be ignored.

What are you observing with regards to PE deal activity in Japan right now? How has the sector rebounded?

Kenzo Nagaoka
Kenzo Nagaoka

Kenzo Nagaoka: We are seeing three themes playing out in Japan today. First is carve-outs from large conglomerates, driven by many giant Japanese companies aggressively reviewing and restructuring their portfolios. A lot of carve-out deals are happening now and will continue to occur for several years.

The second theme is private equity selling to private equity buyers in secondary buyouts. Given fundraising has been strong during the recovery from the covid-19 pandemic, private equity managers are accelerating building new funds, closing current funds and exiting their portfolio companies. As a result, other firms are increasingly present as potential buyers, in addition to strategic buyers.

Finally, we are observing the growing importance of operational due diligence. Because of the increasing number of secondary deals, as well as an increasing presence of auctions, valuations are getting higher, and buyers are struggling to justify those valuations to their investment committees. That means the importance of operational due diligence is growing drastically, as buyers want to understand and quantify value creation opportunities before bidding.

Will ASEAN be the next engine of growth for the Asia-Pacific region?

LP: China has historically been the biggest recipient of money for private equity deployment in the region, but it is currently experiencing a bit of tension in relation to shifting policies and geopolitics. While that plays out, Southeast Asia continues to welcome everyone, so private equity teams have really scaled up operations in Singapore in the last few years.

Southeast Asia is one region but many countries, with more developed PE markets like Singapore and Malaysia, Thailand getting more sophisticated, then Vietnam and Indonesia, and finally more early-stage opportunities in markets like Cambodia, Myanmar and Laos. There are different types of value to be had in different markets, and that keeps shifting. At the moment, the hot story is Vietnam, which may be the beneficiary as companies shift production out of China.

Across the region, the dominant theme for private equity investors has been the rising middle class, with populations in this region being very young. Singapore and Thailand have an average age of around 40, and elsewhere it is under 30. So, we are talking about massive numbers of people with high aspirations starting to build careers and driving demand in the core consumer, healthcare, education, financial services, ecommerce and logistics sectors.

Another thematic is technology, which started with consumer tech. We have seen a number of those companies reach unicorn status and are now talking about US IPOs. The next story is enterprise tech, which we see driving the next wave of private equity
investment.

Then there is the theme of urbanisation and smart cities, where we see massive populations gravitating towards Jakarta, Ho Chi Minh City and other centres. There is a lot of pressure on governments to provide infrastructure, whether that’s connectivity, real estate or environmental quality, and governments are underfunded. That creates a massive opportunity for private equity, where we already see investment in data centres, telecoms towers, cyber-infrastructure and real estate, in areas like student accommodation.

Finally, there is manufacturing: we expect to see Southeast Asia benefiting from global supply chains moving part of their operations out of China, which will drive private equity back quite strongly into the sector.

There are a lot of family-owned conglomerates in Southeast Asia that are currently passing from first to second or third-generation leadership. Historically, those companies have been reticent to sell divisions, but new leaders are bringing in professional management, creating the potential for carve-outs that will be attractive to private equity managers.

What changes should investors expect in APAC private equity in the coming years?

LP: Over the next 12 months, we expect to see very active markets. We anticipate super active private equity, likely setting new records in terms of new investment as a result of available money.

Value creation will be a big driver of investment, as will the rise of technology. Over the next five years, we expect returns to come not from the market growth story, but from value creation, with funds taking very active steps to drive expansion. Otherwise, digitisation is a big topic, with funds themselves digitising their operations and become more sophisticated with deal sourcing and portfolio management. Then of course there is ESG, which has become such an important topic that investors aren’t even touching certain sectors anymore.

We expect Japanese carve-outs to feature as a continuing trend, as well as the big funds maintaining a close focus on China. The other big theme will be the rise in maturity of other alternative asset classes in this region, with investors moving beyond a pure private equity play.

Luke Pais is EY’s APAC private equity leader; Stella Yuan is Greater China private equity leader; Kenzo Nagaoka is Japan private equity leader