Falling back to earth

At the height of private equity's migration East, it seemed like even the most conservative limited partners were enthusiastically allocating funds to China, India and south-east Asia. But these once heady markets have returned to a more sober state in recent months.

China and India, once propelled by red-hot growth, are settling back into single-digit annual growth rates. Formerly soaring local stock markets are off by as much as 50 or 60 percent relative to their recent highs. In the private equity arena, GPs and LPs alike are treading cautiously, much like their counterparts in the US and Europe. Fundraising has slowed, as has M&A activity. Buyers and sellers are regarding each other warily, waiting for clarity to emerge before committing to valuations.

However, Asian private equity markets have been saved from the worst of the carnage by the fact that debt is less commonly used in deals. Funds in these regions largely make growth equity investments, using little or no leverage, so frozen credit markets haven't had the same impact.

At the same time, Asia is better equipped to withstand this downturn than the financial crisis that rocked the region a decade ago because it is more mature. The balance sheets of Asian companies, and of Asian countries, are in far better shape to weather economic travails today than in 1998.

In any case, a market correction is exactly what Asia needs according to many GPs. The short term may be painful, but in the long term the financial crisis may prove good for business. “The hysteria which we saw in the past has gone,” says Luis Miranda, president and chief executive of IDFC Private Equity in India.“There were too many funds raising money; that's going to slow down. There were funds who were willing to pay crazy valuations; that also is going to slow down. From that point of view, I think for the long-term outlook for the business, it's good that this happened because it brought some rationality into the markets.”

PUBLIC PAIN
Plunging public equities are as much a boon as a bane for private equity. GPs that rely on public market exits will find themselves hurting, says Alice Chow, a managing director at Asian funds of funds manager Squadron Capital. “When we invest, we look for GPs that focus less on the public markets as their only exit avenue,” she says. “For GPs that invest in companies that purely rely on pre-IPO flips or PIPE transactions, those types of strategies have only one way out, and right now that window is either shut or valuations are low and liquidity scarce.”

For a well-capitalised buyer, now is a fantastic time to invest, says Paul Carbone, director of mid-market specialist Baird Private Equity. Baird has both an investment team and an operations team in China, both of which are seeing plenty of opportunity, Carbone says.

“The public market indices are down 50 percent or more in China, and we're starting to see private company valuations come down. Access to capital is tightening, making private equity more attractive.”

Private company valuations haven't fallen quite as fast, though, perhaps because sellers aren't yet facing the realities of the new economic landscape.

“People expect that three weeks later everything will be fine again and they will still be able to get their 40 times P/E valuation, but I don't think that will come back,” Chow says. “GPs have been telling me that they're going to wait patiently until sellers become more realistic.”

WINNERS AND LOSERS
Certain regions and sectors are likely to do better than others, of course. Any business that is reliant on exports will be hit hard, as the US and Europe re-trench. Domestic growth, however, is likely to remain strong.

“China does have a meaningful exposure to export activity,” Carbone says. “The estimates are something like 40 percent of GDP for China is export-driven. So China is clearly linked to the rest of the world, and the rest of the world's economic activity. If you look under the covers, that exposure is having an impact on Chinese manufacturers. Those companies, typically smaller, less well-capitalised businesses that are dependent upon the export market, are having a difficult time in today's economy.”

For a market like Indonesia, with a population of more than 200 million, domestic consumption will likely carry the economy though tough times, say Chow. But for its neighbour Vietnam, whose growth has been largely export-driven, the pain may be more severe.

“While all markets we're in have cooled, certainly Vietnam's adjustment – measured by price-to-equity ratios – has been most dramatic,” says Toby Smith, a managing director at Lombard Investments. The San Francisco-based firm invests in Thailand, Vietnam, the Philippines, and Taiwan. “Vietnam's high growth rate and long-term fundamentals, which are still sound, attracted a bit too much investment capital into a very small public market, pushing pricing above realistic valuations. Capital al so flooded into Vietnamese real estate, forming a parallel bubble.”

One sector ripe with opportunity is distressed investing. Rob Petty, a managing partner at distressed specialist Clearwater Capital Partners, says his firm will begin scooping up assets as soon as early 2009, when the full extent of the damage to Asian markets becomes clearer. Clearwater is looking hard at semiconductor companies, businesses hurt by falling commodity prices, and those suffering from currency fluctuations, among others.

“It is a very interesting time to be a distressed investor. We are very thoughtful about what stage of the distressed recovery we are in, and believe that we are a little bit behind the Western economic downturn in Asia, and therefore companies are only in the first stages of realising just how difficult this economy will be. Therefore the restructuring and turnarounds business that we practice really doesn't start until approximately March of next year. At that time we will be focused on getting companies back on their feet which have perhaps taken on too much leverage or whose leverage is too short term, and helping to further equitise balance sheets.”

WHAT NEXT?
When the dust settles, will emerging Asia still hold the allure it once did? Or will LPs, once burned, prove twice shy?

Certainly fundraising has slowed. Only the most established players are in the market now, while untested managers are shelving their ambitions. One Asian LP said that managers are already looking to postpone their closings or delay their fundraising programmes.

“Teams who are trying to launch a new product or new teams trying to launch a fund – right now they are rethinking their strategy and perhaps delaying their fundraising process until the markets stabilise,” the LP says.

LPs that were last to emerging Asian markets may be the first to pull out. This could in turn represent a turning point for the Asian secondaries market, which until now has been small.

Some latecomers wish they had arrived on the scene sooner, according to Chow.

“Some investors that we've been talking to, who are now more educated about Asia, feel that if they had have gone into the market earlier, they wouldn't have all their eggs in one basket right now, and they wouldn't be as tied up in what's going on in the US,” she says.

“They would like to participate in the growth in China or India, which will likely continue to have higher growth in the coming years when compared to the US and Europe.”

THOUGHTS ON EMERGING ASIA
“Clearly the credit crisis and the economic issues are impacting all economies around the world and China is no exception. But what I'd say is it's having a much less significant impact on China. China faced up to many of its problems within the banking sector a few years ago, when they injected significant capital into many of their leading banks to address capital issues those institutions were having as a result of lending practices and other issues. Today, the banks certainly have had some exposure to some of the problem loans, but in general the banking sector has been much stronger today than it has been in the past.”

Paul Carbone, director, Baird Private Equity

“Some investors that we've been talking to, who are now more educated aboutAsia, feel that if they had have gone into the market earlier, they wouldn't have all their eggs in one basket right now, and they wouldn't be as tied up in what's going on in the US. They would like to participate in the growth in China or India, which will likely continue to have higher growth in the coming years when compared to the US and Europe.”

Alice Chow, managing director, Squadron Capital

“The hysteria which we saw in the past has gone out. There were too many funds raising money; that's going to slow down. There were funds who were willing to pay crazy valuations; that also is going to slow down. From that point of view, I think for the long-term outlook for the business, it's good that this happened because it brought some rationality into the markets.”

LuisMiranda, president and CEO, IDFC Private Equity

“The decline of the public market indexes certainly helps private equity firms negotiating new acquisitions, so this is a plus. But we also are seeing postponement of negotiations and new capex plans, and a retreat by some sellers until clarity emerges. It's wait and see for sellers unless they're under pressure.”

Toby Smith, managing director, Lombard Investments

“It is really the time to be playing in distressed. We are keen about the environment. There are companies across industries and across the region that are clearly having difficulties as we speak, and we think the time to really begin to invest starts early next year through the next 18 month period from there.”

Rob Petty, managing partner, Clearwater Capital Partners