Bespoke strategies for successful investing in emerging Asia's mid market
By Kenny NG and Ningzhe KOW
With a combined GDP of nearly USD 3 trillion, Southeast Asia is an economic powerhouse in the Asia Pacific to be reckoned with. Its melting pot of cultures and unique business ecosystems within each country offers investors multiple opportunities for capitalizing on its growth. While the news headlines may have been dominated by mega-deals of over a billion dollars, a significant under-served market of deals within and below the USD 100 million bracket remains relatively unexplored. Manas Tamotia, Partner at L.E.K. Consulting, speaks with leading private equity investors to shed more light on Southeast Asia’s under-served mid-market segment.
The emergence of Southeast Asia’s mid-market
According to Darren Massara, Managing Director at NewQuest Capital Partners, a secondary focused investor, even with the attractive market dynamics, GPs continue to find exits challenging in the mid markets space. Of the USD 150 billion of deals closed in 2018, more than half of this is attributed to deals above the billion-dollar mark.
For us, what we found is that the mid-market is probably the most interesting space across Asia… because that's the area where exits have been the most challenging over the past 10 years. For example, for 2018, roughly USD 25 billion was invested across Southeast Asia and USD 3 billion was exited, so you see that gap. - Darren Massara, NewQuest Capital Partners
But challenging exits may not necessarily be limited to just one lackluster year of deal making. According to Bain and Company’s 2019 Asia-Pacific Private Equity Report, intensifying competition and macroeconomic headwinds could put more pressure on exits.
Despite challenges, the mid-market in Southeast Asia remains on track for growth. Discounting 2017’s figures which saw exceptional privatization megadeals for GLP and ARA Asset Management, there has been a steady uptick in investment activity since 2015. Preqin data further points to an 8.6% assets under management (“AUM”) growth in the ASEAN region from 2017 to 2018. For the Asia-Pacific region as a whole, aggregate deal values have risen to an all-time high of USD 165 billion in 2018.
Growth in the mid-market segment creates many new opportunities for investors. Edan Lee, Managing Director at Olympus Capital, which manages more than USD 1.3 billion in AUM, operates both private equity and credit funds, highlighted the financing gaps observed in Asia’s mid-market lending sector. Olympus Capital’s credit fund, which focuses on collateralized mid-market lending, is well positioned to capitalize on mid-market funding requirements.
Sizing it up
There are two ways to triangulating Southeast Asia’s mid-market, one approach which is to size this up quantitatively. Loke Wai San, Founder and Managing Director of Novo Tellus Capital Partners, defines deals below USD 500 million in the mid-market zone while Edan Lee uses a range of ticket sizes between USD 25 to 75 million.
An alternative approach offered by EQT Partners’ Head of Southeast Asia, Chung Tak Wai, cites features in companies such as family ownership or founder-led businesses, geographical concentration and/or a relative lack of digitization in its operational processes. Companies that demonstrate one or more of these attributes tend to also be limited in their financial capacity and ability to garner resources to expand, putting a drag on their valuation.
The lack of sophistication and disparate data sets in valuing Asia’s mid-market can sometimes lead to high valuation expectations by business owners. Over the past 10 years, median deal multiples have nearly doubled from 7.8x EBITDA in 2008 to 14.5x EBITDA in 2018. Even with this phenomenon, investors believe that this will drive more innovative and constructive ways to further enhance and create value in their portfolio companies.
“They view us not as money, it’s often not competitive. It’s a relationship that we cultivate over many years, and it’s the trust. Our first fund’s entry valuation across the portfolio is actually less than 5x EBITDA. The value we create with these founders and the journey we take is the important step.” – Loke Wai San, Novo Tellus Capital Partners
Wai San believes an important part of equation here is to identify and invest in the targets with an appropriate valuation. Companies in the midst of a leadership transition tend to be more welcoming of investors who are able to contribute fresh business ideas to the table. For these companies, valuation becomes secondary to the ability to cultivate trust and good working relationships over the longer term.
Even with apparently high valuations, Tak Wai sees this as a challenge for investors to be more innovative in creating further value for these companies.
Is there a need to specialize?
The diverse pocket of economies and size of markets in different Southeast Asia countries can make specialization a challenge at times.
For Tak Wai, specialization works in their favor as it allows EQT to sift out proprietary transactions. The fund has a six-sector focus, in which tons of research are ploughed into finding attractive sectors in the region, which eventually trickles down to identifying proprietary deals in each sub-segment.
In the mid-market, you would see opportunities for proprietary transactions. We are very much a sector driven investment firm…There is a lot of research and work being done on a global basis to identify attractive sub-segments. – Chung Tak Wai, EQT Partners
Florian Marquis, Senior Vice President at Partners Group, also agrees with a sector-driven approach to sourcing deals. He uses a ‘top-down’ approach, where a fund narrows its industry exposure to a particular sector, before going deep and reaching out to the companies operating in these industries.
Rather than having that investment banking mentality about doing the next deal (and clapping when you’re doing a transaction), it is about what makes sense in the long run, and what you are able to invest in. We spend a lot of time, rather than going bottom-up per individual transaction, (we go from) top down, what are the sectors that we would like to be exposed to, and what are the companies that are active in these segments. – Florian Marquis, Partners Group
In both cases above, specialization works as a strategic tool for effective deal sourcing. In the case of Olympus Capital, sector specialization becomes a critical aspect that cannot be ignored for “winning”. The funds monitor their deal pipeline and investment portfolio closely, observing them as they evolve from small enterprises to larger companies. This also allows the team to groom operational teams with first-hand knowledge of the industry, which can be subsequently re-deployed to other transactions to smooth the learning curve.
‘There's a lot of capital in today's world, and as a consequence you can't do everything and anything. You have to follow specific themes and have specific ideas on value creation. With all of these self -reinforcing themes, the sector evolution has become a very natural part of what we do today.” - Edan Lee, Olympus Capital
For Novo Tellus, industry specialization comes naturally to the fund as most of key team members were former engineers. In addition to the team’s background and expertise in technology, they were also able to leverage their relationships with investors and companies in Silicon Valley to create value in their portfolio companies.
For funds operating in the PE secondaries space, specialization is a tricky prospect. Secondary funds, by nature, are looking at deals in sectors that primary funds have selected a number of years ago. Due to the nature of secondaries, choice is limited. Rather than a top-down approach to specialization, a bottom-up one considering value-add strategies may be more appropriate. Darren says that funds, especially those that participate in the secondaries space must be selective about the industries they choose to participate in, so as to ensure they have the ability to add value to those companies.
How to create value?
Wai San believes in putting on the owner’s cap when it comes to value creation. He contrasts his approach to that of a stereotypical leveraged buyout. Rather than placing his focus on trimming the bottom line, his focus is on driving top line growth by pivoting his portfolio companies into more lucrative target markets. A company can achieve much higher revenues by operating in larger and more attractive markets. Pivots are a very powerful method for driving top line growth, and also creates significant value in the process.
“We take the approach as owners; we think about terminal value creation. That is often not a quarterly cash flow free-up exercise, it is more about which end markets you serve and which addressable markets you look at… When you make successful pivots, you’ve actually fundamentally changed the terminal value of that investment.” – Loke Wai San, Novo Tellus Capital Partners
GPs have also been successful in augmenting their internal expertise with external industry experts to assist in both pre-deal due diligence and post-deal operations management. Florian likened Partners Group’s investment philosophy to that of General Electric in the 80s.
“Our approach is that we want to be the GE of the 80s, and have an industrial approach to investing. Very focused on how we own businesses, how we think about value creation, and how we like to surround ourselves with advisers who know much better about companies and sectors than we do.” – Florian Marquis, Partners Group
The fund works closely with external advisors who are sector experts, tapping on their experience and knowledge to implement the best practices for corporate governance after the acquisition. This has been attested by many of its portfolio companies that have later evolved into larger regional players through bolt-on acquisitions, which they also believe is a significant part of the value creation process.
Tak Wai also believes that it is important for fund investors to demonstrate ‘skin-in-the-game’. The advisors and industry experts approached by EQT are often invited to participate and co-invest in selected transactions alongside the fund.
“You do have a bigger pool of such talents in places like Europe or the US, where you have more retired CEOs. A lot of CEOs are still very busy making money here in Asia, but I think the trend is definitely there.” – Chung Tak Wai, EQT Partners
Keeping sector experts on a GP’s retainer is a rather popular strategy to drive value creation strategies. US and EU-based GPs generally find joy in tapping on such experts due to the deep talent pool available in such regions. In contrast, Asia’s pool of retired experts may not be as extensive. This does not mean that such strategies become out of reach for Asian-based GPs. With some creativity and extensive usage of networking opportunities, Asian-based GPs are also able to capitalize on expert knowledge.
One example cited by Edan is Olympus Capital’s co-investment into an Indonesian-based e-commerce business, with Ant Financial. As part of the deal, Ant Financial was able to mobilize its operational know-how to drive value creation, subsequently transforming the company into a unicorn. Another example was an investment into a Vietnam-based integrated logistics business, whereby Olympus was able to engage a retired General Manager from China based logistics firm SF Express to assist with due diligence and post-investment execution.
Keep Southeast Asia in your radar.
Many headline trends have already hinted at Southeast Asia’s growth potential – strong macroeconomic fundamentals, a rising middle class and the recent emergence of many high-profile unicorns such as Grab, Gojek and Carousell. With increasing interest from the market, the region’s under-served middle market may offer investors an opportunity to ride on its next wave of growth.
This article is curated from the Singapore Summit of the Asia Investment Conference 2019