Business service sectors ripe for platform roll-up play: Pantheon’s Jie Gong

Jie Gong, Partner, Pantheon Ventures

Business service as a sector remains underinvested by private equity and venture capital firms, Jie Gong, Partner, Pantheon Ventures, and a member of the Asia Regional Investment Committee and Global Coinvestment Committee, said in an interaction.

With companies in Asia, especially China, witnessing substantial growth, it will be more efficient to outsource some services, and as the complexity of their operations may require more sophisticated solutions, these firms will need to access best practice in specialist areas, she noted.

Beyond just outsourcing, for the investors’ community, there is an opportunity in the consolidation theme for a platform roll-up play as the business service sectors tend to be very fragmented with a large number of sub-scale firms with uneven quality, Jie added.

“If you look at the portion of business service deals in Chinese PE, it is a much smaller slice compared with the US.  On the VC side we are also seeing early evidence of SaaS companies getting traction among enterprise customers,” she said.

Jie is of the view that this space remains underinvested as it has a long tail of small-sized participants: “This lack of scale has contained deal flow in this area,” she said.

On PE’s outlook towards the traditional industries, Jie said digitalization has blurred the distinct delineation between the technology and traditional sectors.

“Instead, the distinction has become more focused on the stage of the business, i.e. early stage or mature stage.  We’ve seen a number of GPs sponsor businesses in traditional industry sectors that have been able to demonstrate forward-thinking and integrated capabilities to adapt and capitalize upon disruption in their sectors and industries,” she added.

Edited Excerpts:-

A year ago you mentioned that China continues to throw up sectors that are underinvested by PE. And you added that business service was such an area. Has it changed since then?

I had highlighted outsourcing as a theme for business services and commented that the sector has in general not attracted a large amount of PE capital. These businesses provide services in specialist areas that are typically not core to a business and offer solutions to reduce cost and improve efficiency. When you think of the development in China over the last several decades, company sizes have grown substantially. It is typically the case that small businesses, at the start of their growth cycle, will cover everything in-house; but as they grow in size, it is often more efficient to outsource some services. By way of example, the complexity of operations can require more sophisticated solutions, and business may need to access best practice in specialist areas.

In addition to the outsourcing theme, there is, in my view, also a large consolidation theme for a platform roll-up play as the business service sectors tend to be very fragmented with a large number of sub-scale firms with uneven quality. Those are all enabling factors for business service companies to flourish today. If you look at the portion of business service deals in Chinese PE, it is a much smaller slice compared with the US. On the VC side we are also seeing early evidence of SaaS companies getting traction among enterprise customers.

Why haven’t GPs done more in this area?

The business service space tends to have a long tail of small-sized participants. This lack of scale has contained deal flow in this area. Only in recent years have a number of companies reaching scale that put them on the radar of GPs. We are also seeing examples of a US- or Europe-headquartered company seeking to expand its Asian operation, an initiative which could benefit from PE’s local knowledge and network. Expansion such as this requires some heavy-lifting by GPs to open doors, help with recruitment, advise on organizational structure and strategies that adapt the business to the Asian local environment.

All GPs say they add value. How many really have the capability to do that?

I think there is a very large spectrum as to what value-add can amount to. Generally, the more knowledge and prior experience a GP has in a given sector, the more value they can add. We are seeing a much higher percentage of Chinese GPs developing sector specialization. The hunting ground for fund opportunities is much more diverse and interesting today compared with 6-7 years ago when the pool of managers was pretty homogenous.

Of late, we are seeing a trend where some of the LPs who typically don’t do early stage VC are putting capital into such firms as they want to get into deals early – your thoughts?

Two reasons for the phenomenon you describe – late stage valuations have risen, especially in 2017 and early 2018, though these have come down quite a bit since. Also, there has been very strong performance coming from a few leading early-stage venture funds that catalyzed more LPs to deploy capital to this sector. In early stage venture there are many GPs and therefore selectivity is extremely important. To access in-demand GPs, it’s essential to have built an investment relationship before their funds become oversubscribed.

How about more traditional industry sectors? Have GPs started looking at this space more over the last 12 months?

Clearly, we are living in an increasingly digitalized age, which has blurred the historically distinct delineation between the technology and traditional sectors. Instead, the distinction has become more focused on the stage of the business, i.e. early stage or mature stage. We’ve seen a number of GPs sponsor businesses in traditional industry sectors that have been able to demonstrate forward-thinking and integrated capabilities to adapt and capitalize upon disruption in their sectors and industries. It is actually the case that there is ample scope within traditional industries to optimize their supply chains or create omni-channel distribution through digitization.

What about the consumer sector? In particular how about consumer internet?

The consumer sector is broad – deal volume varies depending on which sub-sector. I see consumer internet as a tool; it is not an end in itself. It is a capability within a company whose customer reach is empowered by the ubiquity of smartphone and internet, as well, these days, as a company’s use of artificial intelligence and big-data analytics.

Interesting. How have IPO exits been? The number dropped off late last year, and so far this year, we are seeing a pickup in IPOs.

Exiting through the public market remains an important route. What has perhaps been less visible is the number of strategic acquisitions in PE/VC backed companies. We have seen strong appetite from strategic buyers, being leading technology companies on the venture side, and industry leaders & conglomerates on the PE side. In addition, there are also intra-regional acquisitions – Indian firms acquiring Southeast Asian assets, Chinese firms acquiring assets in India and Southeast Asia, Korean firms buying Chinese assets, and so forth. Strategic sales are a big component of PE realization.

In reference to your question on IPO realizations, despite the market correction in the second half of last year, 2018 saw a higher number of PE/VC-backed IPOs in Hong Kong and the US compared with 2017. The proceeds from these IPOs were also larger owing to a number of marquee names that listed. This reflects the expanding pool of PE/VC-backed companies, which have reached a scale ready for the public market. In 2018, public markets were depressed by the threatened trade war and the cumulative effects of governments’ de-leveraging policies, which created some attractive valuations in both the listed and private markets.

The recently opened Science and Technology Innovation Board on the Shanghai Stock Exchange, dubbed China’s NASDAQ, merits mention. Besides being an additional IPO destination for venture companies, this Board is the first to adopt the registration-based IPO system as opposed to the approval-based system, which is a positive market-oriented development.

Ultimately, of course, it’s business fundamentals that drive investment outcomes. Given the long term nature of the PE/VC asset class, a GP has the ability to determine when and through which route to exit, picking what they perceive to be a favourable window rather than trying to second-guess market volatility to plan exits.

We’ve not seen many distressed funds in China.

There are quite a number of special situation funds but very few with a purist distressed mandate. The special situation funds typically target value-oriented entries into a company where they see opportunities to fix its balance sheet or replace an incumbent shareholder. The complex structuring often associated with situational financing is typically not something that a local bank can fulfil.

What do you make of the dry powder built up from the large fundraises which have kept setting records?

The pan-Asian funds are a one-stop solution for many LPs that may not have the access and resources to explore the large GP pool in Asia, or that like the perceived quality reassurance of well-recognized global names. This has driven dry powder at the larger end of the Asia market. What we find more exciting are what we determine to be higher-octane single-country funds in the mid- and smaller end of market managed by experienced GPs operating in a less competitive environment, and where outperformance may be easier to achieve. Even though the middle market has increased in absolute size in Asia, the level of competition and supply of dry power remain very differentiated.