As 2019 wraps up, the year holds several lessons for the private capital markets.
Notably, WeWork’s failure to launch and downward spiral, after tens of billions of dollars in investment, has likely set investors on edge at a time when several industry players are already expecting tougher fundraising conditions in the year ahead.
“Investors will be more cautious about high-growth companies with a high burn rate and without reasonable unit economics,” Yar-Ping Soo, Partner, Primary Investments team, Adams Street Partners, told DealStreetAsia, in an interaction.
While the latest Coller Capital Global Private Equity Barometer said majority of Asia-Pacific and North American limited partners saw Asia’s emerging private equity markets as offering the most attractive investment opportunities, Yar-Ping highlighted that southeast Asia had seen renewed interest from LPs, especially for the early stage/VC opportunities.
“We are selective in our exposure to the region given the depth and breadth of the market and the number of qualified managers. However, we see an increase in the number of capable managers and also an improvement in firms’ capabilities and track records. We are also seeing country-specific managers emerging, which is an encouraging trend,” she added.
Earlier this year, the Chicago-based investment management firm has closed its Global Secondary Fund 6 with about $1.05 billion in capital commitments. Prior to that, Adams Street Partners had also raised over $1 billion for its maiden private credit program.
Amidst competition and record-high levels of dry powder, Yar-Ping said there were “still opportunities to outperform the general Asia PE market.”
“We prefer early-stage managers in the venture and smaller funds in growth/buyout. They offer a better risk/return profile and have more up-sell opportunities. We are actively scouting for spinouts and new managers, as they could generate break-out returns. We like managers with specialization and differentiation, including differentiated sourcing, domain expertise, operational capabilities, and the ability to drive exits and liquidity.”
Edited excerpts of her views on the trends and shifts in the investment landscape in Asia.
In your view, what was 2019 for the PE industry, for emerging as well as developed markets in Asia? How much of it is different from the other more mature markets?
2019 was a shake-up for emerging Asia, particularly China. We saw market consolidation and bifurcation of GPs, and this trend might continue. While it might be a painful process, it should position the market better with reduced “hype”.
Developed Asia has been fairly stable in 2019 and is more similar to the other more mature markets.
What has been the biggest lesson for the year? How will it impact deal flow or decision making?
WeWork’s meltdown. Investors will be more cautious about high-growth companies with a high burn rate and without reasonable unit economics. In addition, investors should be more disciplined in terms of valuation and founders’ ethics when underwriting an investment.
Given the overhang from the WeWork fiasco, are we expecting more market discipline?
We were already seeing more market discipline in Asia even before the WeWork fiasco. This was triggered by the caution around trade war impact, and underperformance of several venture-backed IPOs in 2018 and early 2019.
Most LPs are suggesting GPs be more disciplined and cautious. We are also providing advice to our GPs on deployment pace and portfolio construction. Besides, we encourage our managers to de-risk their portfolio when they can.
What changes in the fundraising environment can we expect in the coming year? Will we see more Asia funds coming to the market?
We expect 2020 fundraising to continue to be subdued, after moderation in 2019. GPs’ fundraising pipeline is still active in 2020 and although LPs remain interested in the growing number of high-quality managers in Asia, market sentiment has become more cautious in general. The timing and amount of a few large Asia funds’ fundraising might impact the market’s total fundraising amount too.
How do you view the surge in Asia-focused funds over the last couple of years? Are there enough opportunities to deploy these billions of dollars?
The general trend of a larger Asia PE market is merited. Asia’s PE penetration is still relatively low and will continue to increase. The PE industry is also maturing and evolving.
Different fund managers might face varied opportunity sets and have different deployment situations. In general, the mega-funds (over USD 5 billion) might take a longer time to deploy, as large deals are fewer and more visible to competition. We feel mid-market or smaller funds can better deploy in the current market and they also have more “up-sell” opportunities in deal exits.
Many more GPs are emerging in the mid-market space SEA and wider Asia. What is your take on them?
It is a challenge for smaller mid-market firms to effectively cover the region, be it SEA or Asia. We feel that mid-market is best covered by local country-specific GPs for larger/deeper markets, like China, India, Korea, Japan etc. However, for SEA, a case can be made to have a regional approach given most of the markets are still not as deep and matured, and the deal flow can ebb and flow.
LP surveys have rated Southeast Asia as the most attractive investment destination over the next few years. Are you seeing that reflected in your conversations with LPs? Yet Southeast Asia’s PE market is said to lack depth. How do you see the market’s evolution so far?
Yes, we are seeing some revival of interest in SEA. Specifically, the interest is high for the early stage/VC opportunities. We are selective in our exposure to the region given the depth and breadth of the market and the number of qualified managers. However, we see an increase in the number of capable managers and also an improvement in firms’ capabilities and track records. We are also seeing country-specific managers emerging, which is an encouraging trend.
How do you see LPs’ approach towards China and India?
LPs’ general appetite for China seems to have become more cautious. Trade-tensions and the resulting sentiment is probably one of the key reasons. However, we see some interesting diverging subsector trends underneath the general appetite. Technology and venture investments still seem to be popular among LPs; offshore USD funding is robust while onshore RMB funding suffers a lot; high-quality top-tier GPs are still oversubscribed but some other managers might face more challenges. On the other hand, LP appetite for India is increasing, helped by the recent exit momentum, the performance uptick since 2012, and the maturing of early-stage ecosystem.
How have investment strategies been impacted by the events in HK, as well as the trade war and other macro events?
Investment strategies saw the minimal direct impact from the events in HK. The PE industry’s exposure to HK-based companies or businesses focusing on the HK market is very small. HK’s financial market has not been much affected as well, at least for the short term, as a key deal financing center and IPO route. However, some GPs’ operations would have implications, as we understand some of them are evaluating relocating employees and back-office infrastructure. The trade war and macro/geopolitical events have had an impact. Investors probably would focus more on domestic market-driven businesses than export businesses. They also prefer companies with a better cashflow profile and more resilience in a downturn. Import substitutes and productivity enhancements have good opportunities. In general, investors are more cautious, companies are more realistic, and valuations have become more reasonable.
PE in India has made a comeback, and exits were beginning to look up. But even as more firms were rushing back, the country is now grappling with structural issues. Does this actually offer increased opportunity for PE firms?
The Indian government enacted several structural reforms in quick succession, so some teething troubles are expected. It hasn’t helped that the liquidity crisis is causing some confidence issues. Once these things settle down, we anticipate quality growth coming back. We think that the current situation offers a good opportunity for PE to invest given the lack of risk capital, need for equity across the board, behavioral change in the business community and renewed focus on better governance.
Overall, how is the co-investment scene in Asia? Are LPs increasingly implementing private equity co-investment programmes as a means to reducing fees? Or, given the competitive environment are GPs offering co-investments to their investors without management or performance fees?
LPs are stepping up on co-investments in Asia overall. However, some would find it difficult to execute, despite their desire to do it. The challenges include unfamiliar deal type, such as more venture and growth opportunities in Asia, then the buyout deals that Western LPs are more familiar with; less due diligence comfort, including depth and language of materials and conversations, most notably in China; the lack of local team resources; and relatively short timelines. As a result, a lot of GPs look for certainty and efficiency in working with co-investors. They tend to work with LPs who really understand the Asia local markets and have prior experience of executing co-investments. Economics on co-investments sometimes is even a secondary consideration, and it is often case by case.
In 2020, do you see more LPs pursuing direct deals on a solo basis? Should GPs see this as a threat? As institutional investors look to diversify their portfolio and reduce the impact of fees and carry – does this present a challenge to the traditional GP/LP relationship?
We don’t see pursuing direct deals on a solo basis becoming a big trend and it would not be so easy for a lot of the LPs. We have seen an increasing trend of LPs doing follow-on investments or secondary purchases in GPs’ existing portfolio companies, alongside co-investing with GPs at the same time. Most of the LPs are still working with GPs and some of these activities are mutually beneficial.
In the near term, probably only the largest pension funds and sovereign wealth funds have the potential to do direct investments in Asia if they have invested in a local presence. Direct investments do require both front office capability and post-investment monitoring resources. Asia is a region with very diversified local market environments and is not easy to cover. More pension fund LPs and SWFs have opened local offices in Asia, but we understand they are still mainly partnering with their GPs on co-bidding and co-underwriting deals, instead of working on direct investments on a solo basis.
Given the steady rise in asset prices over the last few years, plus competition for assets from non-PE sources, as well as record levels of dry powder, how can firms drive higher returns?
Looking ahead, industry returns could be lower than before. However, we feel there are still opportunities to outperform the general Asia PE market – as Adams Street has consistently done in the past. We prefer early-stage managers in the venture and smaller funds in growth/buyout. They offer a better risk/return profile and have more up-sell opportunities. We are actively scouting for spinouts and new managers, as they could generate break-out returns. We like managers with specialization and differentiation, including differentiated sourcing, domain expertise, operational capabilities, and the ability to drive exits and liquidity. Building relationships with and allocating to best-in-breed managers will continue to be a driver of strong returns.
Are ticket prices going to get bigger, or can we expect a correction? What sort of consolidation can we expect in the PE industry?
We have already seen a correction in some markets in Asia, especially China. Valuation of some recent transactions could be at a 30%+ discount on what the companies asked for in 2018. On the other hand, high-quality companies are less impacted as they often outperform investors’ expectations. We expect bifurcation of portfolio companies as well as among fund managers.
How do you rate the exit markets in developed Asia versus emerging Asia?
The exit markets, in general, have been more volatile in the emerging Asia markets compared to developed Asia, but this is also dependent on GP maturity and experience. We have several emerging market GPs who have been very consistent, and it shows up in our strong realized performance. At the same time, the exit markets in Emerging Asia have matured too. This was witnessed by the expanded IPO routes for Chinese companies in both Hong Kong and the mainland’s STAR board in the past two years. In our experience, we are seeing accelerated time to liquidity in selected quality companies, like PinDuoDuo and Luckin Coffee, in Emerging Asia.
Against this backdrop, where do you see the opportunities, in emerging as well as developed Asia? In terms of sectors, types of deals, etc…
In emerging Asia, we continue to see innovation and technology transforming the economy. Lower-tier cities, which are growing faster and have more population, are another area of interest. There could be more buyout and consolidation opportunities too, as the macro economies slow down and more entrepreneurs face succession issues.
In developed Asia, we continue to see opportunities in regional expansion, family successions, and corporate carveouts.
In terms of sectors, we focus on sectors/trends that are long-term and secular in nature: (1) software and technology-enabled services (2) engineering and manufacturing (3) healthcare (4) changing consumer preferences.
For LPs investing in Asia, has it been a challenge to remain focused on the selective assets that they have invested in, keeping in mind that the market is highly heterogeneous, complex and each country is in a different place in terms of maturity? What are the lessons learnt?
It could be a challenge and there are probably two key reasons – one is related to AUM and the other is team capabilities. We saw some LPs become less selective when their own fund size, AUM, or allocation to Asia increased. At the same time, if team capabilities could not catch up, the challenge became even bigger.
We constantly remind ourselves of a few things: One, we avoid being pigeon-holed into a certain country or even the Asia market. We maintain a global platform model and frequently review our allocation to Asia markets. We want flexibility
across countries and subsectors in order to be diversified.
Two, we don’t let fundraising targets drive our investment deployment. We think this should be the other way around: our high-quality investment capacity first drives fundraising. We are an employee-owned firm and we invest the majority of our net worth alongside of clients; we have no outside pressures and can stay focused and selective.
Three, we always need to make sure we have a strong team. We have been in Asia for more than 15 years and we emphasize local presence. We also make sure our team members are all native and experienced.