Private equity (PE) investors in the Asia Pacific could face challenging times ahead as several headwinds muddy the outlook for this region, according to Bain & Co.
The challenges include an uncertain macro-economic environment, rising interest rates, and growing chasm between large and smaller funds, according to the consulting firm’s Asia-Pacific Private Equity Report 2019.
“Over the last several years, private equity in Asia Pacific seemed to be unstoppable, and 2018 reinforced that trend in terms of record-breaking deal and exit values. But we’re seeing warning signs that suggest the party may be coming to an end, at least for some investors,” said Kiki Yang, who leads Bain’s Private Equity practice in the Asia Pacific.
The warning signs are there. Fundraising focused on Asia-Pacific dropped by more than 50 per cent from 2017’s record high to $75 billion in 2018. The total was 34 per cent below the previous five-year average.
The going, in particular, might get tougher for smaller funds. In 2018, funds larger than $1 billion needed only seven months to close, while funds that raised less than $1 billion required an average of 16 months. First-time funds, in comparison, took 27 months to close.
Not all doom and gloom – 2018 was a strong year
Investors inked deals worth a record $165 billion in 2018, while exit transactions worth $142 billion were closed. That represented 48 per cent and 39 per cent increases, respectively, over the previous five years.
Asia Pacific has also been significantly moving up the global PE ranks. Now, with $883 billion in total assets under management, it constitutes 26 per cent of the global industry, up from only 9 per cent a decade ago. China and India took the lion’s share of deal-making last year, representing almost 75 per cent of the total deal value.
The total number of exits in the region declined sharply to 402, down 32 per cent from the 2013-17 period average. This was because large exits of $1 billion or more dominated, taking up almost 60 per cent of total exit value. The average exit value doubled to $353 million compared to the past five-year average.
Slowdown in fundraising
The number of funds focused on the Asia Pacific that closed in 2018 dropped to 256, a 57 per cent decline from 593 in 2017. However, the average size for funds that did close increased to a record $294 million, up 55 per cent from the 2013-17 average.
The rationale for slowing fundraise included a new record in dry powder, which had risen to $317 billion by the end of 2018, or three years of future supply at the current pace of investment.
China’s stringent policies on wealth management products were seen as another major factor curbing Asia-focused fundraising. The country’s restrictions on banks and insurers investing in non-standard asset classes, including private equity, led to a massive decline in renminbi fundraising in 2018.
Trade sales increase share of exits
A surge in exit value was led by China, India and South Korea. In contrast, exit values dipped sharply in Japan, Southeast Asia and Australia and New Zealand compared to the past five-year average.
Trade sale was the largest exit route, accounting for 63 per cent of the total deal value. Notable exits included Walmart’s $16-billion purchase of Flipkart and the $5.2-billion sale of China’s Ele.me.
The number of IPOs in 2018 fell slightly from the previous year. There was a 9 per cent drop in the value of secondary exits from 2017 but it was almost 40 per cent higher than the previous five-year average.
The amount of unrealised value in portfolios rose to $646 billion in 2018. “If multiples begin to contract, PE funds may risk building up an exit overhang,” the report cautioned.
The polarisation between large and small funds was also found in exits. In 2018, there were only 205 exits of less than $100 million, down 58 per cent compared to a year earlier. The number of exits larger than $500 million, on the contrary, rose 26 per cent to 59.
“With the risk of global recession and other macro-economic challenges, we expect the market for exits will only get tougher,” said Yang.
While such developments are adding to pressure for returns, the multiples in 2018 remained positive. Overall industry returns rose to a 12.4 per cent median net internal rate of return (IRR), over a median net IRR of less than 12 per cent for the past decade. For younger top quartile funds, the figure is forecast at 20 per cent.
However, the uptick in interest rate in the region is considered a major threat to PE returns and will test fund managers’ creativity. The Bain report said 45 per cent of its survey respondents failed to achieve their targeted margin expansion for more than half of their exits in the last two to three years.
China, India dominate
Amidst concerns over China’s new economy bubble, the country saw deal value increase by 64 per cent over the past five-year period to $94 billion across 614 transactions. Exit values jumped to $78 billion, while deal count decreased 42 per cent to 157.
“It’s important to recognize that China’s private equity consists of two markets with very different dynamics: The market for transactions in renminbi, which is hardly accessible to nondomestic PE funds, and one in foreign currencies,” the report noted.
Deal value in India in 2018 increased 79 per cent versus the five-year average to $28 billion and exit value jumped 164 per cent to $29 billion. Deal count and exit count, however, dropped 16 per cent and 25 per cent, respectively.
Southeast Asia and other markets
Southeast Asia experienced a 38 per cent increase in deal value over the past five-year average to $13 billion, and an 18 per cent rise in deal count to 76. Exit value and count dropped 48 per cent to $5 billion and 52 per cent to 16, respectively.
The Bain report noted a growing interest in Southeast Asia among both general partners and limited partners, despite a GDP slowdown. Vietnam and Indonesia, however, struggle with high price expectations.
Investment activity in other Asia Pacific markets was also higher than the 2013-17 average, except for Japan, where deal and exit values declined by 64 per cent to $4 billion and by 42 per cent to $7 billion.
Signs of a “speculative bubble” in China’s new economy
The new economy sectors of internet and technology have accounted for almost 85 per cent of private equity growth in Greater China since 2010. However, investors rushing to these sectors should tread with caution and heed the warning signs, Bain said.
“Alluring as that opportunity is, however, PE funds need to understand just how different the rules of the game are in China, the number of failures that litter the landscape, and the risk of betting on a speculative investment bubble that could burst,” the report noted.
It noted that median M&A deal multiples for Chinese internet and tech companies, at 31 times EBITDA, are twice as high as other industries in Greater China, and 2.4 times the median multiple for Asia-Pacific deals in 2016-18.
The data on recent returns further underscores the risks, it added. Median return multiples fell to less than 2 in 2016-18 from 4.7 in 2014-15 for new economy investments.