Why now is the time for Asian private equity

Investor interest in Asia, particularly in Asian private equity, appears to have waned in recent years, with many developed markets globally trading at or around all-time market highs while various Asia-Pacific markets continue to languish.

However, a look at the data on the region's economic strength and valuations shows that now might be cyclically the optimal time to be investing in Asia, and the best route for capturing this opportunity might be through small- and midsize private equity funds that can access the dynamic fast-growing businesses — notably those in consumer-related sectors — that are driving growth, and which have generated, and might continue to generate, the strongest investment returns.

Underlying rates of GDP growth continue to be strong across the major economies of the Asia-Pacific region, resulting in the region progressively accounting for a greater proportion of the overall global economy, as well as offering investors the prospect of higher financial returns.

The emerging Asia markets continue to grow at solid mid- to high-single-digit rates, driven by increasing urbanization, growing middle classes and a resultant rise in disposable income, and beneficial economic and structural reforms. Ongoing policy reforms might also enhance prospects. For example, governmental policies in China are driving state-owned enterprise reform, privatizations, and a general deregulation in certain sectors, which should promote competition and improve efficiency.

Additionally, the developed Asia markets are generally faster-growing than their global counterparts, partly as a function of their proximity to emerging Asia markets and their ability to benefit from the trade and capital flow linkages with these economies.

Despite Asia-Pacific GDP growth remaining strong by global standards, valuations have been affected by capital outflows from emerging markets, with public-market indexes in general remaining broadly flat in the past several years, in contrast to the runup in developed markets' public indexes during the same period.

As a result of the cyclical flow of capital away from emerging market equities, many Asia-Pacific markets now offer attractive entry valuations for investors. The MSCI World index now trades at a price-earnings multiple of 16x, whereas the MSCI Asia Pacific ex-Japan index has a lower P/E multiple of 11x.

Notably, our view is that valuations in China are now particularly attractive, with Chinese public equity markets typically trading at high-single-digit P/E multiples despite the higher expected growth of many constituent companies. While there are valid concerns over the potential implications of the shadow banking system and the real estate sector, these risks appear already to be largely priced into the market, and in any case it is the public market rather than private equity that is more exposed to these risks, given the latter's relatively underweight position in the financial and real estate sectors.

Finally, in the longer-term, there is potential for additional upside through foreign exchange gains, given that the monetary and capital control policies within the region are arguably causing an artificial undervaluation of particular local currencies.

Capturing value

While structural drivers continue to propel outsized relative economic growth rates in much of the Asia-Pacific region, and while valuations in many of these markets appear attractive compared with developed markets worldwide, public markets have not sufficiently reflected the rate of economic development of the Asia-Pacific region. Between 1990 and 2012, the nominal GDP of the major Asia-Pacific economies expanded more than 400%, but the public markets — as represented by the MSCI Asia Pacific index — rose only 45%.

We believe investor access to certain companies within these dynamic growing sectors such as consumer discretionary, specialist industrials, information technology and health care will be important in maximizing the potential for higher returns that are better correlated to long-term growth, and that private equity offers a superior vehicle for investing in Asia-Pacific growth trends and investment themes than the public markets. Long-term empirical data support the view that private equity returns in the Asia-Pacific region as a whole significantly outperform public equities.

One structural explanation for the public equity markets' failure to reflect the growth of the Asia-Pacific economies is that the stock markets in many of these countries still generally are dominated by the financial and utilities-related sectors, rather than the fast-growing small and midsized consumer and services-focused enterprises that are developing rapidly to fulfill an increasing demand for goods and services.

In the vintages prior to the global financial crisis as well as the 2010 to 2012 vintages post-global financial crisis, there was significant interest from investors globally in Asia-Pacific private equity. Accordingly, the amount of capital raised and deployed by private equity funds in many sub-segments of the Asia-Pacific private equity markets resulted in a combination of higher entry valuations and reduced downside protections. In turn, these might have been contributory factors to the relatively weak median Asia-Pacific performance record for these vintages.

Conversely, current weaker investor sentiment toward Asia can create a significantly more attractive investment environment for forthcoming vintages, particularly in the small- and midcap private equity space. There has been a material reduction in Asia-Pacific private equity fundraising in recent years, with the smaller end of the market bearing the brunt of this while larger funds benefit from both a “flight to brand names” as well as the increasing participation of larger, less nimble investors, who are only able to deploy sufficiently meaningful check sizes in large-cap funds.

This cooling of the smaller end of the market is anecdotally leading to lower entry valuations and superior non-price terms, with the potential to benefit from a cyclical upswing in valuations between entry and future exits. The outperformance of small- and midcap funds in the Asia-Pacific region is not a new phenomenon, but an ongoing historical trend that many investors seem to ignore in a headlong rush toward larger funds. Cambridge Associates' data suggests that, as of March 31, 2014, sub-$750 million funds in Asia outperform their larger counterparts by more than 0.25x in total value to paid-in multiple terms and more than 250 basis points in internal rate of return terms.

Based on FLAG Capital's benchmarking analysis of the broader universe of Asia-Pacific private equity funds over vintage years 2004 through 2013, a disproportionate number of top performers — those generating a total value to paid-in multiple of 2.25x or higher — are sub-$250 million funds. Conversely, no fund over $750 million in size has reached the top performers' list.

These trends might continue to persist, given smaller private equity funds' ability to access faster-growing small-cap investments while benefiting from a less efficient market with higher arbitrage potential, as well as better alignment of interests between general partners and limited partners.

Clearly, exposure to the Asia-Pacific region is an important element in many global investors' portfolios, from both a portfolio diversification perspective as well as potential returns generation. Moreover, certain emerging Asia markets — notably China — are now at cyclically low valuations, trading at significant discounts to developed markets.

These factors lead us to conclude that the Asia-Pacific private equity investment environment — particularly with regard to smaller funds — is cyclically and structurally more attractive than at any time over the past decade. Smart investors should take advantage.

Wen Tan and Myron Zhu are partners at FLAG Capital Management.