As the COVID-19 pandemic takes a heavy toll on the global economy, Morgan Stanley Private Equity Asia (MSPEA) believes that the Asia-Pacific will outshine North America and Europe in both market liquidity and exit performance in 2020.
“Asia’s secular long-term growth over the past 25 years has been characterised by dramatic volatility. There were different events that were significant to the growth trajectory of Asia,” said Chin Chou, CEO of MSPEA and a Hong Kong-based managing director of Morgan Stanley, in an interview with DealStreetAsia.
Chou continued: “Given what we’ve lived through in the past, I think it ensures that the investments we make will always have some level of risk mitigation. In other words, Asian managers are more experienced in terms of managing through crises.”
His optimism on Asia comes as the region, where the novel coronavirus started, has fared better overall than North America and Europe since the first case was reported in the central Chinese city of Wuhan in December 2019.
At 10.8 million cases as of October 3, Asia takes up nearly one-third of global cases, compared with 15.3 per cent for Europe and 49 per cent for North America.
Countries like China, South Korea, Singapore, and to a lesser extent Japan, have effectively flattened the curve. China, in particular – where MSPEA earmarks about two-thirds of its capital and professionals – has recorded a largely two-digit daily growth of new COVID cases since March, while the country’s GDP rose 3.2 per cent in Q2 2020 from a year earlier.
Currently, MSPEA invests in China through its second RMB fund, which raised 2.9 billion yuan ($427 million) and started investing in 2016; and the $1.7-billion Asia Fund IV, an Asia-Pacific US dollar fund that is also 50-60 per cent focused on China. The firm also sources deals in India, Thailand, and South Korea.
“One of the reasons we like investing in China is because for almost every investment we have made, e-commerce aside, we’ve made the investment at a price below what we would pay for a similar business in the US,” said Chou, who leads the firm to primarily invest in consumer-oriented products and services in China. “Price is a big mitigant of risk.”
Established in 1993, MSPEA mainly invests in highly-structured minority investments and control buyouts in growth-oriented companies. As of June 2020, Morgan Stanley Investment Management had $665 billion in total assets under management (AUM), of which $17 billion were allocated to private credit & equity, per its website.
In Greater China, some of its portfolio companies include Hong Kong-based financial institution AMTD, Beijing-based baby formula firm China Feihe, fintech giant CreditEase, and women’s shoe retailer Belle International.
The firm also backed companies like non-banking finance firm Kogta Financial, education services provider Nspira, and food firm Southern Health Foods in India; and hire purchase loan provider Ratchthani Leasing, retail bank Thai Credit Retail Bank (TCRB), and assisted reproductive technology business SAFE Fertility Center in Thailand, as well as several other firms across Taiwan, South Korea, and Singapore.
Chou, who joined Morgan Stanley in 1987, has led MSPEA’s four private equity funds, including the $330 million MSGEM Fund (1999), the $525 million Asia Fund II (2005), the $1.5 billion Asia Fund III (2007), and the current $1.7 billion Asia Fund IV.
Chou also oversees MSPEA’s private equity business in China, where the firm had launched its debut 1.7-billion-yuan ($250 million) RMB fund in 2013 and the second 2.9-billion-yuan ($427 million) RMB fund in 2016.
The firm is in the market raising its fifth Asia PE fund and has so far secured $398.33 million for the new vehicle, according to its latest filing with the SEC in late September. Chou declined to comment on the fifth fund.
In Thailand, MSPEA had launched a $440-million country-focused fund in October 2018 and has deployed about 30 per cent of the fund to six deals.
What is your view on SPACs and how they’ve taken off in the US? Do you see SPACs gaining traction in Asia?
In Southeast Asia, one of the key limitations will be an expectation that the SPAC will ultimately get invested in a control position and turned into an operating business at some point in time. There are some markets within the PE world in Asia where we see quite a bit of control activity, like South Korea, Australia and other developed markets. We have not seen that as much in emerging markets such as China, India, Southeast Asia, so it will be interesting to follow the development of SPACs.
The traditional LP-GP model has worked quite well. The incentives seem reasonably well-aligned. The proliferation of alternatives and PE in Asia and globally has been beyond expectation. It seems to me that clients are comfortable with the structure of GP-LP funds. Although we’re always interested in what clients are saying and new technologies, I think our current focus is on more traditional GP-LP funds.
In Asia, especially in Southeast Asia, PEs have been struggling for exits. Do you think that SPACs have the potential to create exits in markets where they are hard to come by?
With control investments, I don’t think there’s been an issue with exits in Asia. If you own a nice business in the Asia Pacific market and it sells domestically or even exports, by and large, managers like ourselves can find a buyer. The question, of course, is the right price. But I don’t think there is an exit problem.
I think the bigger issue has to do with the growth of minority investments. The reality is that there have been so many deals done on a growth minority basis. Yet, the natural exit market for growth minority deals is not a strategic sale because the manager doesn’t have the ability to affect that sale. So, the natural exit methodology is clearly [an IPO on] the public market. Still, the public markets are largely reserved for best-in-class businesses within a given industry. That’s not surprising, to be honest.
If many GPs made minority investments in a business with an expectation that the business would transform into a size that would be listable [viable for a listing] but it didn’t – Is that an exit problem? Or is that just the manager invested in a business that didn’t perform as expected? That’s been one of the single biggest mistakes made in the Asia Pacific region, which is too many minority investments where it’s not clear that the businesses have a home in a listed market.
I think that exit liquidity in Asia has not been a risk factor. Actually, I found that one of the key developments over the last 20 years has been the scaling of both M&A and capital markets and that managers like ourselves have been rewarded for taking those risks 20 years ago. In 2020, one of the areas where the Asia Pacific will shine, versus our North American and European peers, is in liquidity.
When we started this business 25 years ago, the Asian stock markets were a fraction of North America and a fraction of Europe in terms of total market cap. Today, the US is the biggest stock market in the world at $30 trillion [in total market cap]. Asia is 10 per cent smaller than the US – almost the same size in combination – driven largely by China, India and a few other countries. Europe now is one-third the size of both Asia and the US. So, I kind of look at that exit disappointment as a disappointment with respect to investment strategy, rather than the lack of exit markets.
Has the COVID compounded the exit issue in Asia? What impact has the COVID crisis had in terms of portfolio companies’ businesses, valuations, expected performance, and risk-adjusted returns? How has it changed the way you look at new deals?
I do believe that relatively speaking, Asia this year will perform better than North America and Europe with respect to exits.
Getting to the heart of your question in terms of how COVID has changed things, I think you have to look at it in context. Asia’s secular long-term growth over the past 25 years has been characterised by dramatic volatility. There were different events that were significant to the growth trajectory of Asia, including the Tequila crisis in Mexico (1994), the Asian financial crisis (1997), which was the most debilitating situation I’ve ever lived through, the dot-com bubble (late 1990s), the 9-11 attacks (2001), the global financial crisis (2007-2008), and the Greek crisis in 2012 or so. Given what we’ve lived through in the past, I think it ensures that the investments we make will always have some level of risk mitigation. In other words, Asian managers are more experienced in terms of managing through crises.
When we think about risk mitigation, we think about really simple issues. For example, we’ve always said that it’s better to invest in businesses that make money today versus businesses where incomes are all on the come. Meanwhile, you should not compound emerging market risk with indebtedness, which means that you need to be mindful about having too much debt in Asia, as compared to some of the capital structures you see in the US and Europe.
Price discovery has been very important for us. I’ve always thought that a good business should have a big income statement and a small balance sheet. Fund managers need to be mindful of investing in businesses that require tremendous amounts of capital.
COVID is clearly a humanitarian tragedy, as well as an economic tragedy throughout the world. But at least till now, COVID hasn’t manifested itself into a financial crisis in what we’ve seen in prior situations like GFC. There are two main mitigants this time around: One is the fact that, with China being so large and India becoming larger as well, I think there’s more ballast in Asia than there was previously. The amount of GDP in Asia has increased by leaps and bounds, which brings a little bit more counterbalance to any volatility. Secondly, some of the Asian countries that lived through SARS learned a lot from that experience.
I always think about how the crisis impacts all aspects of our businesses, including portfolio monitoring, management & exit, and new investments. On the portfolio management side, what we’ve seen is that starting in February, March and April – depending on what country they’re in – every GP was doing triaging to understand the situation of our portfolio of about 70 companies across three different strategies. Luckily, the number of companies that required additional care as a result of COVID was few, at less than 5 per cent.
In terms of new deals, I think the deal flow will be much lower [in 2020] than in prior years across the board. There are active markets like China, South Korea, and even India, so I think the deal flow will definitely continue. But I would be surprised if there isn’t an aggregate reduction in overall deal volume.
We heard from many GPs, especially those in Southeast Asia and India, that the mid-market is becoming extremely competitive. What is your take on this?
I noted earlier that Asia grew from $10-20 billion to half a trillion US dollars. I would estimate that much of that increase in AUM has gone to two strategies over the last 10 years, e-commerce and large-cap PE. In contrast, I’ve seen less capital come to what I would call “traditional mid-market PE.” To be very clear, traditional mid-cap PE was what everyone was doing 12-13 years ago. Then in the mid-2000s, a few established buyout shops launched and successfully raised very large funds (multiple billions) and subsequently we just witnessed an Asia fund exceeding $10 billion, which is quite impressive.”
However, I think it’s fair to say my observation that because all that money has gone to e-commerce and large-cap PE, you’ve seen price escalation in those two markets. My sense is that e-commerce and large-cap PE markets are now very expensive and competitive.
Now we’re in the midst of a pandemic and at least an economic dislocation, not yet financial. Firstly, I would be more concerned about strategies that have historically paid very high prices for assets. Secondly, with respect to e-commerce, I would be very concerned about owning portfolios of businesses that don’t generate positive EBITDA today, for sure.
And then with respect to large-cap PE, two issues are concerning to me. First would be the level of indebtedness that’s required when you pay 12 to 18-times EBITDA, compared to the 8 to 9-times EBITDA that we pay in the mid-cap PE market. So, there’s a lot of debt heading into a pandemic, which isn’t positive. Secondly, large-cap PE tends to be focused on those buyout markets that are by its nature slower-growth, including South Korea, Australia, Japan and other markets. Today, I’d rather own a portfolio that sees a little bit of near-term growth.
Moreover, there should have been a tremendous value that these large-cap GPs can bring to large, complicated businesses. However, with the prices they pay and the amount of indebtedness they take on, they are not participating so strongly in what is clearly the big so what in Asia – China. The country has added $10 trillion of GDP over the last 15-20 years, but unfortunately, it’s not the best market for large-cap PE. And what I think about mid-cap PE is that it’s free from much of the competition because we don’t look at the same deals anymore.
You said that you prefer to invest in profitable companies. Does that rule out most tech deals?
Yes. But on the tech side, we are very aware of what has been going on in China over the years. Because we are a consumer-oriented organisation, we need to be quite thoughtful and cognizant of developments with respect to channels and the like. The country transformed from a product and manufacturing-oriented economy to a services-driven economy, which is in the heart of what e-commerce develops. We have investments that are leveraged to those themes.
We bought an IDC business a few years ago, and that business is clearly leveraged to the massive growth in data. But the day we bought that business, we were buying positive EBITDA and we were paying what we think is a more traditional PE price rather than what’s going on now.
To be very clear with the definition of mid-cap, I would describe it as a market of equity cheques ranging from $20-150 million and EBITDA from $5-75 million.
In markets like mainland China, South Korea, and Taiwan, it’s more opaque in terms of deal sourcing and that opaqueness is positive. I would estimate that by capital, probably 80 per cent of the deals we’ve completed have been in situations where there wasn’t a direct auction process. That’s really helpful in terms of price discovery. The earlier you are in an industry that is hopefully promising, the more rewarded you’ll be in terms of paying a lower price and being a first mover. That’s the case with China, in particular.
Have your focus areas changed in the last couple of years as some sectors may have gained more prominence in Asia?
One of the themes that we’ve been pursuing for many years is child-care spending in India, China, and Southeast Asia. As incomes rise, an increasingly disproportionate amount of that income goes to children, which makes sense in the Asian culture.
You said that the firm has been focused on the consumer-oriented sector, yet we are seeing the increasing popularity of B2B or B2B2C businesses, especially in China. What do you think of the trend?
When we first started investing 25 years ago, China was a country of $1,000 GDP per capita, which was similar to America in 1950 post-war. Back then, we looked at the US as a template for China and we thought consumer-oriented products offered by firms like P&G and Sears would be an interesting play. As the economy went from $1,000 to about $6,000-$7,000 per capita income, we started to invest in slightly more sophisticated products. That was when we did our first and second pharmaceutical investments.
And now, China’s per capita income crossed $10,000, although there’s a bit of a bifurcation between the large metropolitan areas and the rest. But that’s not unlike America in the early 80s, when the country shifted to a services-oriented economy. And today, services still dominate America’s consumers and corporates. Around five to seven years ago, we started to look at service-oriented businesses in China, including healthcare, education, vocational education and the like. At the same time, we spent time on the corporate space as well.
By and large, it’s fair to say that the corporate space is an outsourcing theme. Previously, Chinese companies, particularly SOEs (state-owned enterprises) and the like, did a lot of ancillary functions in-house. But nowadays, led by really amazing businesses like Alibaba and Tencent, there’s a focus more on core competence and outsourcing the other non-priority services.
Outsourcing has been strong in the past 2-3 years in terms of revenue. Even into the first half of this year with the COVID impact, we’re not seeing a let-down at all. However, as much as we love servicing large, sophisticated corporations in China and elsewhere, they are very tough in terms of generating better margins. For us, our emphasis is still more on the consumer side than on the corporate side.
What is your take on the Greater China market in the context of geopolitical tensions? How much do you take into account that geopolitical risk while assessing new investments?
Investing in China today, even with the geopolitical risk and the like, is a much less risky proposition than when we first started investing in the country around 25 years ago. There was no exit market and barely a corporate structure. The private sector was still reasonably small. The currency is frankly more liquid today and has strengthened, and we can hedge the currency. Back then, we couldn’t.
One of the reasons we like investing in China is because for almost every investment we’ve made, e-commerce aside, we’ve made the investment at a price below what we would pay for a similar business in the US. Price is a big mitigant of risk.
We’ve always focused on domestic businesses, instead of cross-border businesses as a whole. First and foremost, I still think the biggest returns have been generated by Chinese businesses serving the domestic market – a theme that I don’t think is being directly impacted by the geopolitical risk. Morgan Stanley’s research group did a survey of all the listed businesses throughout Asia. Only about 6 per cent of all revenues generated by Mainland’s listed businesses are estimated to be directed to the US compared to 25 per cent in Taiwan, which had the greatest exposure to the export market, presumably selling motherboards and semiconductors.
Geographically, how much capital have you deployed to different markets across Asia?
We have three strategies: A Thailand fund that’s focused on Thailand and contiguous countries adjacent to Thailand; an RMB fund which is 100 per cent focused on China; an Asia-Pacific US dollar multi-country fund that is still 50-60 per cent focused on China, with the other focus areas equally concentrated across India and South Korea. So, in aggregate across Morgan Stanley Private Equity Asia, about two-thirds of our capital is earmarked for China, as are our professionals. Besides China, we invest in India, Thailand, and South Korea. It’s pretty much equally weighted among the three countries in terms of both capital and people deployed.
Are you planning to increase your emphasis on China in the coming three to five years?
There’s no plan for material changes in proportion. This proportion has been reasonably consistent over the past 5-7 years and I would expect it to be reasonably consistent going forward.
How much of the Thailand fund has been deployed and to which sectors?
The Thailand fund had $440 million. Over the past year and a half, we’ve deployed about 30 per cent of the fund to six deals, including two deals in the consumer field (of which one is a child diaper business), two deals in finance, one in healthcare, and one deal in media.
We’ve been very pleased with the team’s ability to source opportunities in a country where there is not a lot of deal flow. The key question going forward is whether there will be a continuing deal flow. Hopefully, over time, we’ll see an increase in deal sizes as well. We believe Thailand is the centre of increasing trade between Southeast Asia and the hinterland countries of Cambodia, Laos, Myanmar and Vietnam. We are seeing this theme playing out and we expect to see more of that.
Do you see an opportunity to launch another country-focused fund in Southeast Asia?
We’re probably not looking for a new fund in Southeast Asia. As a GP, Asia is complicated from the get-go because there are so many countries. Even 25 years after we started here, I believe there are very few GPs that can say that they have really strong competence and expertise in more than a handful of countries. It’s very important for managers to be comfortable with their focus areas and not spread ourselves too thin.
Back to the philosophy of why we did the Thailand fund: When you look at our past geographic template, we invested in China, South Korea and India. But the one big hole geographically was Southeast Asia.
We did a deep dive in Southeast Asia and came to a couple of key conclusions. Thailand was an overlooked and underserved [by PE] market with inherent traits that made it attractive from a PE point of view. Firstly, Thailand has the strongest, the most robust, and the most liquid capital market in terms of both debt and equity in Southeast Asia. Second is Thailand’s consumer base. Although the country is not as populous as Indonesia, it has a much higher per capita income. Its consumer sector, in which we have confidence, is the same size as Indonesia’s in terms of GDP.
Thirdly, the Thai baht has been incredibly stable and can be hedged. The volatility around currency is a reasonable reflection of the risk that is inherent in an underlying economy. Lastly, and most importantly, we had seasoned executives who are exceptionally skilled and very well-known in Thailand who initiated the idea of a Thailand fund and bridged our cooperation with Bangkok Bank.
We had a combination of all key points. To start a fund business is a decade-long commitment, so you have to be comfortable in these 3-4 premises.
India has seen extreme opposite reactions of GP attitudes. Some of them are bullish and confidently raising money to invest in India, while others have lost money and they’re bitter about it. Given a market of its size and potential, what is your take on the Indian market?
We’re cautiously optimistic about India. In the early 2000s when we were investing in China, there were GPs and LPs who started their focus on India. If you look at the history of emerging markets – anywhere around the world – you don’t see the scaling of businesses until a country has $2,000-$3,000 per capita income. India’s income level was still a bit low until around 2015.
Managers have been less tough and disciplined on terms in India. I’ve seen a trend to give way on price and terms in order to compete against one another. What’s been so wonderful about the PE market in China is that these terms that we first set 20 years ago have continued to sustain themselves. We still get earnings guarantees and the like. Whereas in America and India if you did a private deal as a minority investor, no one would ever guarantee you two-year net incomes.
Meanwhile, India has the so-called promoter who often arbitrages away much of the value in a deal. In China, we’re directly investing with an industrial management team or a hospital management team who are original entrepreneurs. There isn’t a financially-savvy promoter standing in between. Frankly speaking, there’s a better deal dynamics in the kind of relationship in China versus the relationship in India.
India returns have not been as good as China returns. Anyone who made that decision in 2000 to choose India over China would have been hit very badly because that was a mistake.
Where we have optimism in India is as follows: First and foremost, India has hit a level of per capita income of between $2,000-$3,000, which is more consistent with what we saw in China in 2005 when the economy started to take off. Secondly, India does have strong liquid capital markets, which in some ways is actually more liquid than China’s.
You said when you started investing in China, some businesses were far cheaper than their counterparts in the US. Do you see the same learnings applicable to the comparison between businesses in India and, for example, businesses in China nowadays?
No. The price discovery is dependent on a number of factors, but ultimately it’s the nature of deal dynamics. Even today, we still find deals in China that are very reasonably priced because the deal dynamics enables us to have one-on-one dialogues without the presence of intermediate advisors. And our reputation in China attracts people to select us as their counterparty.