Private equity in Asia
Asian Investment Market Series 3/3
By Willem le Roux, Principal Investment Consultant and Actuary
In the previous two articles, we established that when considering growth in a number of areas, Asia is leading by a long way – whether referring to population, economic, innovation, digitisation or infrastructure growth, or any other growth.
Growth in areas such as those stated above does not always translate into superior investment returns in capital markets. The issue is much more complex. For instance, we explained that although the mainland China listed equity market contains businesses showing exponential growth, there are also capital-intensive (often state-owned) companies which are not able to provide the same levels of return on capital. Nevertheless, where there is growth, there is opportunity.
The question is how to optimally convert the growth in the many areas described above into superior investment returns. The simplest step from an investor’s perspective would be to find an active asset manager who can identify companies which are allocating capital efficiently to generate a superior return on investment, rather than pursuing some form of national interest or other agenda. Remember that seeking return on capital does not imply doing so at the expense of sustainability. In fact, sustainability is very important in the crystallisation of long-term above-average returns. Such exposure would be expected to deliver returns that are substantially higher than those of the market, but skill is required to avoid the “potholes”, including those driven by ESG risks. Although this is the simplest solution, it is not easy, as it requires skill in selecting skilful asset managers who are able to make good investment decisions – there are many to choose from.
A company listed on a stock exchange often has its greatest growth trajectory behind it, proving it is successful enough to list the business. Conversely, private equity and venture capital investment opportunities identify, invest in and support smaller businesses where the runway of growth can be multiples of those of listed counterparts. Additionally, investment in these smaller, unlisted businesses, unlocks opportunities to emerging themes like healthcare technology. Many businesses in these sectors are still relatively small, but are expected to challenge and disrupt their listed counterpart behemoths. For example, as cited by Brian Lim from Pantheon, “…themes such as changing diets and an ageing population in some parts of Asia are driving niche, but fast-growing investment opportunities.” The greater upside, with greater risk, leads to higher expected returns from these private market investments, along with the diversification benefit (due to valuations not following listed equity markets’ short-term movements).
Private equity (including venture capital) needs an ecosystem of growth and capital in order to thrive. The United States (Silicon Valley is a good example) has exemplified this for many years. Conversely, Africa has not been as easy a hunting ground for these investments. However, an underappreciated fact is the extent to which the Asian ecosystem has been fruitful soil for growth and capital.
The chart below – courtesy of Pantheon, one of the global leaders in “multi-management” private equity investment – suggests that “Venture” (venture capital) is providing better returns in Asia and China than in the US, or at least comparable returns. This has been the case over the last 16 years or so. This may be considered surprising, given the US being the “poster child” for private investment. The Asian market is still developing and therefore this trend in favour of Asia may well accelerate.
Source: Pantheon presentation on co-mingled Asia PE offering: Pantheon Asia Select
There are challenges to investing in private markets. The requirement to commit capital for the long term, along with other restrictions and high costs, is well documented. However, higher returns have generally more than compensated investors who saw the opportunity and were willing to take the effort to invest in private markets.
A less publicised challenge is the inability of investors to get exposure to the best private equity and venture capital funds, which tend to offer returns substantially above those of the average peer group. After all, private markets are “private”, so access to investment opportunities is not “democratised” as is the case with listed investments. Funds only raise as much capital as the managers (called general partners, or GPs) believe can be deployed to gain exceptional performance (for which they are rewarded). Due to the skill of these top funds’ GPs, these funds tend to be oversubscribed, which means access is limited to those investors who have a long relationship with the GPs and other roleplayers in the industry.
Therefore, for a South African institutional investor wishing to invest into private markets, it often makes sense to invest via a private market “multi-manager” or “fund of funds” to access these top funds. This typically means selecting a private market multi-manager which has been “in the game” for a long time. Direct access by investors to the top underlying funds tends to be nearly impossible. Even if such an investor were able to identify the best funds that are not oversubscribed – which would take skill – it would require significant due diligence costs and time to investigate all the competent fund commitment opportunities.
For example, the current Pantheon Asia Select private equity and venture capital fund is 88% exposed to access constrained funds, which new investors in this market are unlikely to be able to access. A direct or new investor’s exposure, based on exactly the same research, would therefore have to look fundamentally different to Pantheon’s, as an example.
As much as in the private market investment world, relationships are still very important. Accessing the right “multi-manager” of private equity can bridge that gap and enable new investors to access the best private equity funds, which cannot typically be accessed without established relationships.
As for listed investment markets, and potentially even more so in private markets, skill is required for active asset managers to select businesses with the right underlying fundamentals and sustainable business models in their local and global environments. The inability to do so can lead to major value destruction, as many investors in China have experienced with the recent government crackdown. Getting this right can be very valuable to a diversified investment strategy.
Evidence of the success of private market investments leads us back to where we started the three-part series. The number of new US dollar billionaires in Asia (and China in particular) underlines the number and size of opportunities for wealth creation in that region. Private market investment in this region is probably the closest opportunity to direct investment which has allowed these individuals to see their net worth soar, that can be afforded to third-party investors.
Any investors considering private equity allocations, as well as investors seeking to capitalise on growth trends, would be well served investigating such exposure within the Asian environment.