The popularity of co-investments, among the biggest changes in the limited partner-general partner (LP-GP) dynamics in the private equity asset class in recent years, has helped LPs bring more value-add to the table, Iesan Tsai, Head of Asia, Hermes GPE, said in an interaction.
“Capital apart, what we bring to the table is co-investment – we are very heavy on co-investment and half of our capital is in co-investments. We don’t try to be a GP, but we provide guidance right when it comes to things like deal structuring, alignment, and even management,” she said.
While driving alpha in the portfolio requires LPs to actively select and manage the co-investments, Tsai was of the view that a higher risk appetite in backing first-time managers was also key to doing well in Asia.
“We have had a long history of backing first-time managers and emerging managers – we call it backing them from fund-1, up to 2 and 3. To do well in Asia, and to have that kind of alpha above your kind of average return, you do have to do that. The safest bet is to go with the well-known regionals that were established elsewhere, but I think there are some very high-quality spin outs here,” she added.
Tsai, who is based in Singapore and leads sourcing, due diligence and monitoring of Hermes GPE’s funds and co-investments in the region, acknowledged that record dry powder was an issue worldwide, and added that the excess liquidity would result in firms venturing into unknown markets and industries, driving up valuations. The end result: the returns globally for PE will decline.
“That’s inevitable. If you just look at it statistically – there is going to be a continuous increase in capital poured into the system in private equity, and there’s kind of no end in sight. The whole thesis for PE has changed. It used to be that private equity is cheaper than public markets, therefore, there is an arbitrage opportunity. This is no longer really the primary thesis anymore – it is no longer about access to capital, and it is more about having to be patient, and having the ability to hold out for a long period of time,” Tsai added.
Edited excerpts of an interview:
What percentage of your portfolio is in the Asia Pacific?
Globally, we are quite unique. We are quite heavy on Asia Pacific – about 20% of our portfolio [is in the region], which is quite high. Our investing style is a little bit more risk-seeking than other European pensions.
What does the ability to take more risks mean?
We are likely to venture into markets that people used to consider frontier – not super frontier. For example, we began looking at Southeast Asia and countries like Vietnam before others. We started looking at Vietnam about seven years ago, made our first investment there four years ago, and it was in the education space. Subsequently, our peers started pouring funds into Vietnam over the last couple of years, so I think we’re a little bit ahead of the curve there.
We are more likely to consider growth investing and tech-enabled businesses as well – it is something we have been looking at in the US and Europe for quite some time, so were a little bit ahead of the curve there. We’ve been monitoring the tech scene in Asia as well – we’ve invested in one tech-enabled business in China, but that was not pure tech.
What is your take on Vietnam? GPs and LPs have been flocking to Vietnam – are you worried about high valuations? Local PE firms say that the entry of foreign investors has pushed up valuations and made it difficult for them to enter many of the deals.
Absolutely – valuations have definitely sky-rocketed, especially on the larger end. Our first deal was about four years ago, and since then, we’ve seen a subsequent increase in multiples – we came in at a high single-digit multiple and now that same industry has gone completely up into the mid-teens – whether the growth is sustainable is a question. Overall, if you look at the first half of 2018, Vietnam is still growing at around 7%, which is one of the highest globally – so for private equity, it is finding companies that have quality earnings. If you find that business that ensures quality earnings, has a good revenue base, and is not impacted by the ongoing volatility, Vietnam is a good place to be in right now. I think it is good to be in the education sector and maybe healthcare. But, if we are looking at sectors that are more exposed to macro interest rate conditions, like real estate, or infra, that’s going to be a lot more challenging. But altogether I think there are pockets of opportunity. You do have to go bottom up and be selective. The ability to access deals is more challenging, but with the right connections, you can. It is still an inefficient market in my opinion. Many entrepreneurs are still learning exactly what it is, and then there are companies reaching a certain scale where they’re not sure what to do, succession planning issues where they are not sure whether to hold on to the asset or pass down the next generation or to another firm – so I think you can create those deals.
What are your concerns on Vietnam? Are you worried about a bubble?
I don’t really see it as a complete bubble, there are going to be small areas of bubbles – certain sectors perhaps where we are seeing valuation concerns. I think all the structural elements are there in place. Ten years ago, there was a lot of hope in Vietnam and it didn’t quite pan out. A lot of that was driven by government policy. But if you look at the private sector, it is actually quite healthy. When it comes to infrastructure, the shape of the country helps. You don’t have the massive distribution issues that Indonesia has, and it has had a stable government thus far – all these factors lend well to it leapfrogging. We’ve seen Vietnam’s ability to leapfrog in the manufacturing sector – it is an export-driven country. I think there’s a lot of secular growth trends and there are real opportunities there.
If I have major concerns, valuation definitely is one of them, but there’s still safer sectors and areas that you can invest in. I am more concerned about entrepreneur motivation and quality – the same kind of concerns we had in China and India 20 years ago – and whether the books of the companies are really clean – or will the entrepreneurs flip rapidly, or if the companies will expand at the same pace as committed. So, it is more about the entrepreneur and promoter mindset.
Have you made any tech investments in this region?
We don’t have any yet. We have one in the fintech space in China, but nothing in SEA yet. What excites me about SEA is that while people say it has a lot of parallels with China 10 years ago – it has opportunities in e-commerce and digital – it is still a more of a B2C market than a B2B. There are opportunities around the digital infrastructure space, digital payments and you can leapfrog the traditional space. I am reminded that when people first came to SEA, the primary areas for investment were infrastructure and telecom – now with digital infrastructure, there are a lot of opportunities.
But is SEA actually a 600 million-people market in terms of opportunities? We can use data to show these numbers, and that its GDP is higher than India, and that the region has high smartphone penetration and several other factors – but when LPs and GPs look at companies in this region, how many of these firms are SEA players?
I truly agree. It is more of individualised countries, because it is very challenging to get to that regional scale, it is a lot of hard work and will require rolling up your sleeves, navigating a lot of traps, knowing regulations across all the different countries, and avoiding country-specific risks. It is definitely not the same as India or China, because when it comes to the network effect, it’s not going to be as fast, but it’s still a very exciting opportunity within certain niche sectors. But taking it to the next phase or to the regional level could see potentially some Chinese players like Alibaba or Tencent come in, that’s where the opportunity is. You can get to a certain scale – whether you are at the unicorn level, that is a lot more challenging, but getting to that first level of growth – I think that’s real.
The last couple of years, we’ve have seen some of these Chinese players make big moves in SEA. Suddenly, LPs and GPs are competing with these Chinese strategics. Has this changed the dynamics?
It’s not a competitive dynamic yet – it’s actually more of a partnership. We see a lot more GPs partnering with these strategics. Sometimes, these strategics come in as a minority, or they come in together with GPs, and eventually they can offer an exit for GPs – right now it’s more synergistic, and actually if anything, it is beneficial because for most of the private equity players, the Chinese players offer an exit opportunity.
Yes, especially when exits in the region have not been great.
I actually think that exits in this region are quite good, if you know where to go – because entrepreneurs here are more likely to give up full ownership, and so there are more buyout opportunities, and it’s much more difficult to find these in China or India. Because a lot of different strategics are interested in this region – players from outside who want to come in – Japanese, Korean, Chinese maybe American and European – the exits in SEA have been quite good comparatively.
As an LP, when it comes to deploying capital, when you look at SEA versus India, which region would you prefer?
I still think SEA of over India. We’ve been out of that market (India) for quite some time. The only investments we have done in India have had some kind of a global angle – BPO businesses that have revenues in US dollars or US customers. I think SEA is easier to navigate despite all kinds of uncertainties. India is more challenging – valuations are high, equity and capital markets are all quite developed in terms of accessing capital, and entrepreneurs have more options than PE for accessing capital.
Is that why you have stayed out of India?
Yes. We see the same across a lot of LPs’ portfolios – many have stayed out because the returns have been disappointing. The latest cycle has been better. While India has been challenging over the last 10 years, the past three years have been better. LPs and GPs have learnt their lessons – they know what to look for from what is being said and how to access the risk. For us, the risk profile isn’t compelling enough – there is a lot of volatility in that market, and so in terms of returns, it is going to be safer here (in SEA) compared to there (India).
But you said the last three years have been better for the PE landscape in India. So will you reconsider investing in India? Besides, as GPs’ dry powder accumulates, and even as LPs seek returns and do more co-investments and direct deals, considering the opportunity that India offers, do you see the LPs who have traditionally skipped India go there?
They will. The LPs, especially on the large-end, have the capital and they need to deploy, and for that, they will have to seek out markets such as India. It is absolutely true that many LPs will be forced to look at India. Even for us, with the growth in our AUM, we will be looking at opportunities in India as well. While we may not have been active in India over the last 10 years, we are closely monitoring the situation, and looking to probably deploy there as well.
You talked about LPs having a lot of capital, and that brings us to the dry powder issue. Globally, we are seeing record dry powder with GPs. This comes at a time when more LPs want to venture into co-investments and directs. Will this lead to increased competition for deals? Will this force some GPs to return capital, as there may not be enough deals to deploy the capital they have raised? Will it see LPs competing with GPs?
Yes – it’s an issue here and it is an issue worldwide. The excess liquidity in the system has changed things. I would love to say that GPs will do the right thing, and if they can’t find good deals, they will return capital but I just don’t see that happening, and if it does, it is an exception. I think there have been a few mainly in Europe or the US, but I have never seen GPs in Asia return capital. The way I see it panning out is people will continue to venture into unknown markets and industries, they will drive up valuations – all of this will see the returns globally for PE decline. That’s inevitable. If you just look at it statistically – there is going to be a continuous increase in capital poured into the system in private equity, and there’s kind of no end in sight. The whole thesis for PE has changed. It used to be that private equity is cheaper than public markets, therefore, there is an arbitrage opportunity. This is no longer really the primary thesis anymore – it is no longer about access to capital, and it is more about having to be patient, and having the ability to hold out for a long period of time. But that being said, I still think that PE is a great asset class – it may become less attractive, but it will still outperform public markets – it always has and I think it is likely that it always will.
In the US, we are beginning to see some of the LPs saying that they are willing to wait longer. LPs find that when it comes to exits, many GPs are only flipping their portfolios. Eventually, do you see Asian LPs also saying that they are willing to wait a lot longer, rather than the traditional PE cycle? Also, companies are staying private longer, and therefore, exits are not easy for GPs.
It’s possible for a small segment of LPs but even in the US, only some LPs are willing to wait a lot longer. In Asia, they want it both ways – they want to mitigate the J-curve, they want distributions and they also want to tell the GPs not to flip assets. You can’t have it both ways. A select group of LPs, which may largely be the sovereigns, may be open to thinking that way – some of the pensions where you don’t have underfunded pension issues. In Asia, so far, the LP market is still focused on distribution. We may see some evergreen funds and some other innovative funds, but those won’t become the industry norm.
As an LP, when you look at GPs in SEA, are you open to taking a bigger risk by betting on first-time or relatively new managers? IFC often backs first-time managers, and their data shows that these funds – on average – do as well, or sometimes, even better than the established vehicles.
Absolutely. We have had a long history of backing first-time managers and emerging managers – we call it backing them from fund-1, up to 2 and 3. To do well in Asia, and to have that kind of alpha above your kind of average return, you do have to do that. The safest bet is to go with the well-known regionals that were established elsewhere, but I think there are some very high-quality spin outs here. We also monitor people deal-by-deal very closely and do work with them as well – their stats in the US, for example, that almost half of the capital raised were by fund-less sponsors – it is an alternative system to being on the road for two years and trying to raise.
On the IFC data, if you look at industry averages, that’s probably true. You need to be selective when backing first-time managers.
How have the LP-GP dynamics changed? What do GPs look for from LPs apart from capital?
You can bring a lot to the table in Asia as an LP, because Asian managers are still relatively new when compared to the US and Europe, where many firms are in their fund seven, eight or even ten. Fund managers here are still learning.
Capital apart, what we bring to the table is co-investment – we are very heavy on co-investment and half of our capital is in co-investments. We don’t try to be a GP, but we provide guidance right when it comes to things like deal structuring, alignment, even management. I think that being an LP, if you’ve been in this region a lot longer, compared to GPs, who have only seen one side of the market for a short period of time, you actually have a lot more collective memory, and institutional learning.
Specifically, to SEA, and big picture, how do you see the PE scene? Established funds are becoming bigger – are there enough deal flows for them? How do you see the mid-market funds – they have stuck to more or less the same fund sizes. Many of the local PE firms here have also stuck to the traditional sectors.
I think it’s going to become very challenging for the regional large-cap managers to compete and do well. That challenge will remain because there is a lot more inbound investment from the other larger regionals. Here you’ve also got Southeast Asian regional managers and I think that competitive tension will remain. In the mid-cap space, I think, people haven’t quite figured out how to make this operating model work like how you can cover so many countries in a cost-effective manner, and also try to do operations and source. It is very challenging and no one has quite gotten the model right, which is why I’m actually more keen these days on country-specific funds or first-time managers.
When you say that you are keen on country-specific country funds, which of the countries are you bullish on, say apart from Vietnam? Is it Indonesia? We’ve not seen many country funds in SEA.
Maybe country funds is more of a generalist kind of comment across all of SEA. I think that can be a couple of countries here. That’s better than trying to claim that you could cover four countries, or the whole region. Look at Northstar’s (Northstar Group) success with Indonesia – several people in the industry said it would be very challenging to invest $800 million in Indonesia, but they have been able to do so, and they have had good returns too. They are now planning to become a regional player – I like the approach, rather than saying ‘let us hire managers across SEA and see if it works’ approach. I’d rather prefer a GP that chooses two or a maximum of three countries in this region, rather than try and cover everything.
For SEA, which are the sectors that are capital starved, and which are the sectors that can take in more capital? What are the sectors that you are bullish on?
I’m not a huge fan of a lot of the healthcare sector to be honest – it sounds really cool from like a macro perspective, but being a regional healthcare player is challenging, especially in sectors like hospitals. We haven’t quite seen anyone who has made a lot of money in hospitals and nursing homes here. Those are very challenging models to figure out, and they are very expensive — people assume that they have high quality of earnings, but that’s not always the case. While I think that market is large, if you want to dip within healthcare, maybe you could look at speciality clinics and PE is crawling all over this space. I think education is still a safe asset because of higher quality of earnings – but right now, I think it’s becoming a little too competitive. There are plays around e-commerce space, but people are still figuring this sector out in SEA. I think sectors such as logistics and fintech can absorb a bit more capital. The big e-commerce players can absorb capital, but that is a different profile and may not be for traditional GPs. I think from a bottom-up perspective, there are some good businesses in the lower mid-market that could scale in a roll-up scenario – some of these businesses currently lack the platform to do so.
How aggressive are you with co-investments? Do you do a lot of directs?
Our preference is still to be a co-investor, as opposed to a direct or lead, but I think we are gravitating towards that more recently. We’ve done it in Europe and the US, and in Asia we’ve co-underwritten in a few instances, and we warehoused – in terms of going direct, it might happen over time, but not in the larger end, but in the lower mid-market – like equity check sizes of US$10-60 million.
How do you see the distress or stressed assets space? In both India and China, we are seeing a lot of PE firms – domestic and overseas funds – increasingly setting up shop independently, or as strategic partners, to invest in debt-laden firms. But, we’ve not seen much activity in this space in SEA – why is that so?
I think the opportunity set is just not big enough. There are firms that try to convince us of opportunities here – I think there are small bits of opportunity, but it’s not massive. It says something when a lot of the credit firms are looking to hire equity people because they can’t deploy.
Today, we are seeing a lot of sovereigns and pensions doing directs all over Asia – China, India and SEA. Some of them are also making huge allotments into GPs and doing joint vehicles with these PE firms. How does the PE landscape change with the entry of these players? Many of these pensions were not even active in Asia a couple of years ago, now, they are competing with GPs.
Absolutely. I think for us, it has made us more strategic in terms of staying away from the large-cap space. It has reinforced our position and has propelled us further to stay away from that space because these pensions have different return profiles – they are also going to be in funds where they have a disproportionate power as an LP. We jointly do deals with some of them globally – CPPIB is one of our partners and we have become more of a strategic partner over time.
A related question. Some GPs say they are happy having one large LP. While they may lose freedom, they are not on the road for a long time trying to raise capital. They are happy to make investments in consultation with their lead LP investor.
It depends on your risk, your view, your motivation – it is easier capital, but these GPs may be arm-wrestled into a lot of different situations – if they are okay with it, it is fine. More GPs are going toward that route – fewer LPs and larger LPs. But we are also seeing GPs that say they don’t want large LPs, or large pensions. Many GPs don’t want Korean pensions or Australian FoFs. Ultimately, it depends on the appetite of that particular GP.
As an LP, do you push the GPs that you have invested in to do tech investments?
No. But, I think it is important for GP’s to be cognisant and tech-enabled because it helps in terms of operating efficiencies. I think the whole AI sort of cost reduction of headcount is going to happen a lot faster than people think, and it is important for GPs to stay forward thinking on that. When it comes to tech investing itself, like pure tech, it is still quite early, but I think they should still continue to be aware, and for us at least we definitely are, because we’ve done that in the US and Europe.
How do you see China?
There is my personal view, and there is the firm’s view. My firm’s view is probably a bit more negative with the kind of dry powder situation. It is most severe there when it comes to RMB funds, and then China funds and then regionals, everyone is crawling there. China’s VC space is very saturated.
Personally, I am quite bullish on China. The secular trends will continue and you are at the very nascent phase in many sectors. Personally, I’m looking to ship more of our portfolio in Asia towards China. Today, we are about 30% SEA and 30% China, but I would like China to be at 40% or 50%.
Where are the rest of your Asia deployments?
We are heavily in Australia. I’m looking to kind of pull out more from Australia as valuations have crept up and want to diversify the portfolio because you can now get similar exposure in the US. Australia has good GPs, good mangers and good talent – but it does not offer that excitement for returns.
In North Asia, we are making headways in Korea. I’m quite bullish on Korea and Japan. For Korea, the mid-market offers opportunities – there are a lot of inefficiencies there. But you have to be a Korean GP to navigate these deals. Right now, we are seeing the large regional players entering Korea, so for us, it may actually be a good time to exit.
How bullish are you on sector-specific funds? We have not really seen sector-specific funds in SEA, with the exception of real estate?
Yes. But there are some GPs that do perform better in certain sectors due to their background. They are afraid to kind of make this a sector-specific fund – they are afraid whether it will sell. But over time, there should be more be sector-focused funds in SEA, because such managers will have access to better deal flows and they will probably be able to do better operational value add. We are already seeing sector-specific GPs in China.