There is no doubt that Asia has felt the force of the global economic crisis. As credit conditions have tightened, deal flow across the region has grounded to a virtual halt. At the same time, those initial public offering windows that were previously available have been firmly shut, meaning private equity investors looking for an exit will have to rely on strategic buyers themselves in equally short supply.
A Short Story?
Given the still nascent state of the Asian leveraged buyout (LBO) market, this has left some observers to wonder whether the Asian LBO story could be over before it has properly begun. However, as LBO players in the West are beginning to count the corpses in their portfolios, it is becoming clear that the Asian buyout market is emerging from the crisis in far better shape that its European and US counterparts.
That has drawn the attention to a number of significant differences between the Asian LBO model and its Western cousin. First of all, Asian buyouts are characterised by a significantly lower level of leverage and by extension, lower valuations. In particular, the high-yield investors that flooded Western subordinated debt markets were remarkably absent from the Asian growth story in the years preceding the crisis. “Asia lacks the deep investor pool for subordinated debt as seen in the US and European markets,” explains Ming Lu, managing director at KKR in Hong Kong. “Without subordinated debt, the total level of leverage will always be limited to the amount of senior debt that banks are willing to provide. This has acted as a natural restraint on company valuations and has meant Asia has generally managed to avoid the excesses seen in other markets.”
While in the more mature buyout markets of Japan and Australia, senior debt prior to the crisis has reached a level of up to 8 or 9 times EBITDA. Market participants say the majority of deals completed were backed by a level of around 4 or 5 times EBITDA. Many mid-market buyouts included little or no leverage whatsoever.
Holding Up Well
This comparatively conservative use of leverage has shielded portfolio companies from the punitive effects of the credit crunch. “While some businesses may have suffered from reduced cashflow and profitability following the recent economic downturn, Asian portfolio companies have not suffered the immediate refinancing pressures seen in Europe and the US, mainly due to relatively lower overall leverage. As a result, they have held up comparatively well,” says Lu.
More Growth To Come
A second defining characteristic of the region is that growth figures remain comparatively strong despite a drop in exports experienced throughout the region. In June, the World Bank raised its forecast for growth in China from 6.5% to 7.2% amid signs that the economy is doing better than expected, while forecasts for India also remain comparatively strong at 5.1%. After suffering from a decline in exports, there are also signs that Korean economy has turned the corner, recording a 2.3% increase in GDP in Q2 from Q1 figures, which registered just 0.1% growth figures.
Faced with deteriorating prospects elsewhere, such figures are attractive to private equity investors. “Asia remains an extremely attractive investment proposition, by virtue of its growth projections. There is no doubt that investors are interested in the region, certainly given the reduced growth prospects elsewhere,” says Mounir Guen, founder of placing agent MVision in London.
More Asian Exposure
Indeed, despite reduced investment capacities of limited partners across the globe, figures from Swiss research firm Strategic Capital Management show Asian buyout funds in 2008 bucked a global trend by hitting a fundraising record. According to the firm, fundraising in 2008 increased by 25% to reach US$44 billion.
However, while the region as a whole may offer strong growth prospects, taking advantage of individual opportunities is a different matter altogether. “The challenge of the Asian marketplace is that it is very difficult to generalise,” says Les Fallick, founder and managing director of placement agent Principle Advisory Services in Sydney. “The region covers 20 different economies with different regulatory systems, cultures and business structures ranging from underdeveloped to highly sophisticated,” he says.
A Thin Market
Bar the few sophisticated markets, most economies remain emerging markets, offering high growth rates but an equal amount of risk and hurdles to buyout firms. For one, while there is no shortage of opportunities for growth financing, buyout targets in such markets tend to be somewhat thin on the ground.
“Most economies in the region are emerging markets, which tend to lack the type of mature, sizeable companies that make good buyout targets,” says Jeremy Hunt, partner at Allen & Overy in Hong Kong. Instead, markets such as China and India are typically considered growth equity markets and are unlikely to feature strongly as LBO markets for the foreseeable future.
“The majority of businesses in China and India register strong year-on-year growth rates and are likely to require several rounds of capital to fund that growth on an ongoing basis. For those companies, leveraged buyouts are simply not appropriate,” says Lu.
At the same time, owners of fast growing businesses are typically relatively young and not yet ready to give up control of their businesses. “Company owners can be reluctant to relinquish control to external financiers, let alone sell out of a fast growing business, making it difficult to source for appropriate buyout targets,” says Basil Hwang, Hong Kong managing partner at law firm Dechert.
If sourcing transactions is difficult, closing deals can be an even bigger challenge, as emerging markets typically lack the type of regulatory platforms that support easy deal flow. “For a leveraged buyout market to thrive, there must be a set of regulatory principles underpinning these transactions, including bankruptcy laws, accounting standards and capital market regulations. In many countries, that basic infrastructure has not yet been established and as a result, deal flow remains fragmented,” says Guen.
Protecting The Family Silver
In some instances, national protectionism also plays a role, as governments can be unwilling to see national treasures being sold off abroad. China, for example, is famously protective of its buoyant domestic industry, banning foreign investment into industries it considers of national importance and pulling up barriers hampering the transfer of assets abroad.
For example, in late-2006, the government put out a ruling to limit the use of the “red-chip” structure by foreign equity investors. Through this structure, the Chinese company owners would establish an offshore holding company that would acquire their onshore business. The founders would acquire ordinary shares in the special purpose vehicle (SPV), while the foreign private equity investor would invest in exchange for convertible preferred shares – a concept that does not exist in China. For foreign private equity funds, the structure provided a familiar investor protection framework and allowed for a future offshore IPO listing, effectively making it the most popular investment structure around.
The 2006 regulation effectively closed this exit channel for companies without prior established offshore holdings by making the establishment of the SPV subject to government approval, none of which have yet been granted.
“There is no doubt that across Asia, there are concerns about foreign investment into sensitive industries and a number of countries have put in place regulatory restrictions limiting foreign participation,” says Hwang.
In other cases, protectionism may be less institutionalised but the risks are none the lower for it. In 2008, a US$6.3 billion agreement by HSBC to buy a 51% controlling stake in Korea Exchange Bank from Lone Star fell through after the country’s financial regulator delayed approval, citing legal uncertainties over Lone Star’s acquisition of the business in 2003. Market participants say the incident, which led to the temporary imprisonment of Lone Star’s chief Paul Yoo, has led to the increased concern about the country’s openness to foreign investment. Yoo was cleared of wrongdoing in June 2008 but the credit crisis has since put a spanner in Lone Star’s intention to sell its holding in the bank.
Bringing In The Locals
Elsewhere, the Taiwanese regulator is reported to have told buyout firms that are interested in AIG’s Taiwan unit to team up with domestic players if they want a chance at securing the deal. It is understood that private equity firms Bain Capital, Carlyle Group, Primus Financial Holdings and MBK Partners have been told that they can only bid for Nan Shan Life Insurance Co if they form a partnership with either Chinatrust Financial Holding or Fubon Financial Holding. The third Taiwanese company, Cathay Financial Holding, has reportedly been allowed to bid on its own. Such cases have raised questions about the openness of Asian markets to foreign private equity players and have highlighted a number of pitfalls when investing in such markets.
Taking into account the risks inherent in individual countries and the relative lack of suitable buyout targets, pan-Asian firms are often considered the best way forward. “Given the relative lack of opportunities within most individual jurisdictions, pan-Asian buyout firms are likely to be more successful than country-specific funds,” says Fallick. “However, a local presence is critical and the ability to switch capital between markets can make or break an opportunity,” he adds.
From Strength To Strength
On balance, Asia might pose significant risks and hurdles but Asian buyout firms say the returns are worth the effort. What is more, far from predicting the death of the model, they say buyouts in the region will go from strength to strength – a prediction shared by SCM, which recommends investors to go overweight Asian buyouts.
However, it will be a story-based growth prospects, in which leverage is unlikely to play a prominent role. “Debt has never been the preferred mode of financing in Asian cultures and if anything, the credit crisis has reinforced the view that too much debt is risky,” says Hwang. “While Asian companies might borrow to acquire additional businesses and for working capital, it will be some time before they start using high levels of leverage purely as a means to improve returns.” Far from signifying the death of the Asian LBO model, the recent crisis may well have exposed a significant strength about the use of leverage and a lesson to Western investors going forward.
This article first appeared in emerging Private Equity’s September/October 2009 issue. For more information, please visit www.emergingpe.com.
