Covid-19 has significantly disrupted the private equity (PE) industry in Asia Pacific (APAC), but it does not alter the industry’s promising long-term growth prospects. In fact, it could create opportunities for funds that understand the characteristics and trends of PE deals in the region and are willing to be bold.
Success requires a deep understanding of the region’s characteristics and typical deal patterns during the period of strong growth prior to the pandemic, as well as a clear sense of how those factors have changed as a result of Covid-19. Some new sectors and investment themes are emerging. In other instances, opportunities that were attractive before the pandemic are even more so now, due to reduced valuations, faster growth or other factors.
In the past, PE investors in APAC created value primarily through debt financing and multiple arbitrage — that is, through largely financial strategies. But to win in the future, they will need to create teams and networks that can make large-scale operational changes with the potential to unlock significant value in portfolio companies.
We are bullish about the long-term prospects for PE in APAC as we believe that firms with the right capabilities in place and willingness to be bold will capitalise on the once-in-a-generation opportunity that the next several years present.
Strong growth leading up to the crisis
The PE industry in APAC has shown robust growth over the past five years across all key metrics. Assets under management for APAC-focused funds grew at an annual rate of 31% from 2015 through 2019, versus 12% for funds focused on North America and Europe during the same time period. As a result, the region’s share of the global industry increased to 28% from about 17% (see Exhibit 1).
APAC has seen companies raise nearly US$800 billion ($1 trillion) in funds during this time frame. The average size of private equity funds in APAC grew larger, too, from approximately US$210 million in 2015 to US$630 million in 2019 (excluding VC funds, which are smaller by design).
Overall, growth-oriented funds have claimed the biggest share of PE funds raised in APAC recently, for a good reason. As governments in the region — particularly in India and China — modernise infrastructure and encourage entrepreneurship and technological innovation, the opportunities for growth funds to capitalise have increased. Buyout funds’ share of fundraising grew from about 12% of the market in 2016 to roughly 28% in 2019. For buyout funds, the more promising markets are in mature economies such as Australia, Japan and South Korea where succession deals and carve-outs present opportunities.
Technology-oriented funds have shown dramatic growth, with US$136 billion in total fundraising from 2015 to 2019, compared with US$48 billion from 2010 to 2014.
From 2015 to 2019, APAC saw more than US$850 billion in total PE investments, including a high of more than US$200 billion in 2017. At the end of that period, PE firms held nearly US$400 billion in dry powder (uninvested capital) — meaning that firms have a significant amount of pent-up demand.
Key inter-regional differences
The PE market in APAC is not homogeneous. Each country and region have its own characteristics, and each has evolved in its own way over the past several years. The most notable changes relate to types of fund classes, investment dynamics, and exit strategies (see Exhibit 2).
The first thing to note are the differences in fund classes across the region. Large pension funds have been more active in Australia and New Zealand, transitioning from a relatively passive fund-of-funds model and limited partnership positions to an approach that involves playing a more active, hands-on role with direct investments.
In Southeast Asia, state-owned investment firms such as GIC and Temasek (in Singapore) and Khazanah (in Malaysia) have been increasingly active in cross-border investments. In 2019, these investors had some level of participation in 12% of all deals across the APAC region, by value, up from 6% in 2017.
Corporate venture capital funds have been more active in China and Japan, investing heavily in start-ups and high-growth companies as the local technology ecosystem in the region evolves. For example, the venture arms of Chinese internet giants Alibaba, Baidu and Tencent have participated in about US$10 billion worth of deals over the past three years across China and India.
Finally, the contrast between two of the region’s largest markets — South Korea and India — illustrates the heterogeneous nature of the region’s investment market. In South Korea, regional funds such as Affinity, IMM, and MBK are strong and 66% of the deals by value in 2019 involved regional and domestic funds, as large regional funds increased their allocation to the country. India, on the other hand, is dominated by global funds, including large state-owned investment firms, which participated in more than 81% of deals, by value, in 2019.
But there are also differences in investment dynamics. Typically, the share of investments in mature companies tracks the maturity of the economy as a whole (see Exhibit 3).
Another factor distinct to the APAC region is the prevalence of small and medium-size enterprises (SMEs) and family-owned businesses, with a large overlap between the two. SMEs comprise over 90% of enterprises in the APAC region and employ nearly 50% of the workforce, and in some markets the numbers are even higher. In Japan, for example, SMEs make up about 99% of all companies. As Japan’s population ages and business owners there retire, many face a lack of heirs who can take over the business. As a result, investors are seeing an increasing number of buyout opportunities in the country.
At the same time, family-owned businesses in APAC are becoming more receptive to private capital. As of 2018, China, India, South Korea, and Thailand all ranked in the top 10 countries globally for number of family-owned businesses with market capitalisation of over US$250 million. In the past, owners of such businesses, especially in India, have not been inclined to accept funding from PE investors, because they typically view such investors as being more interested in generating a rapid return than in improving the company’s long-term performance. As family businesses look at growth and expansion, however, they are increasingly exploring funding through sale of minority stakes.
There are also differences in exit strategies. The exit strategy for a fund varies depending on multiple factors — most notably the maturity of a country’s public markets, strategic buyers’ appetite for M&A and prevailing macroeconomic conditions. For example, Japan, China, and South Korea have seen a higher share of IPO exits over the past three years (see Exhibit 4). Australia and New Zealand, by contrast, have had a chequered history of exits via IPO, and IPO exits therefore continue to be low.
Regulatory requirements are a factor as well. In India, strict rules limit the pool of companies that can go public (for example, companies that have yet to generate a profit are not eligible). Similarly, China has seen a decline in the number of PE-based IPOs — from 280 in 2017 to 86 in 2019 — primarily because of new regulations that aim to improve the quality of listings in order to protect investors through selective IPO approvals. In response, some funds in China have shifted to alternative exit strategies, including trade sales and IPO listings in other countries. For example, Alibaba made two public offerings — one in the US, in 2014, raising US$21.8 billion and another in Hong Kong, in 2019, raising US$12.9 billion.
There are also changes in investment opportunities due to Covid-19, which is driving changes in consumer and social behaviour as well as in purchasing patterns. For example, pressure on personal finances is reducing discretionary spending on purchases such as automobiles and luxury goods. Social distancing, driven by health concerns and government-mandated lockdowns, is turning consumers toward internet-based, at-home solutions for both work and leisure. This has accelerated adoption of digital channels such as e-commerce, digital media, and digital payments. Although many of these trends had already begun gaining momentum in APAC prior to the pandemic, Covid-19 has given them a considerable boost. As a result, new investment opportunities are emerging.
Covid-19 positively affecting previously strong sectors
Prior to the crisis, the health care sector in APAC was growing rapidly, driven by aging populations in some markets (Japan, South Korea, and Australia and New Zealand) and increased affluence leading to more spending on health care in others (India, China, and Southeast Asia). The share of health care investments in China, by value, has grown from 5% in 2017 (nearly US$5 billion) to 12% in 2019 (almost US$8 billion). However, the pandemic has sharpened the focus on the industry and spurred deals. During the first four months of this year, 69 healthcare deals were closed in the APAC region — including 47 in China alone. That is up nearly 50% over the same period in 2019.
Telehealth and online pharmacy businesses are seeing strong growth, too, as consumers require health care services while at home and governments seek to relieve pressure on strained hospitals and clinics. The convenience of these models makes them likely to stick. Baring Private Equity Asia acquired a 14.5% stake in JD Health, a telehealth and online pharmacy platform in China. Although this deal closed in May 2019 — before the pandemic — it could be a harbinger of similar transactions in the future.
Covid-19 has accelerated the rate at which consumers are adopting technology-driven solutions in everyday life, presenting new opportunities for investors. For example, education technology grew fast during the previous five years, especially in China and India, but its growth has accelerated as many parents have tried to compensate for the closure of schools during Covid-related lockdowns. Byju’s, an Indian player, is now the world’s most valuable educational technology company with a valuation of US$10 billion in its May 2020 funding round.
Meanwhile, the e-payment sector had been expanding quickly in APAC over the past five years, in part because of high smartphone penetration rates and wide 4G coverage in the region. But Covid-19 has given it further impetus, as consumers have had to make payments without using cash or having access to bank branches. Consumer studies in India indicate that 42% of consumers have increased their usage of digital payment methods since Covid-19 took hold.
A key solution applicable in virtually every industry is artificial intelligence (AI). That sector has been hot for the past few years, but it has received a further boost due to the digitisation push resulting from Covid-19. The first four months of this year saw 23 AI investments in APAC that raised a total of US$866 million, a significant increase over the preceding four months, in which 20 AI investments raised US$755 million.
There are also behavioural shifts due to Covid-19 that are creating new investment themes. For example, cybersecurity and connectivity apps and services are likely to become more important as working from home becomes more common. Previously, the trend of working from home was relatively limited in APAC. Because many APAC economies have been traditional destinations for contact-centres and business process outsourcing, shifts to working from home can impact a large proportion of employees there.
Another key way that Covid-19 is changing the investment market in APAC is by reducing industry valuations. Any sector or business model that relies on the physical movement of people, in-person transactions, or a high degree of social contact has lost significant revenue as a result of coronavirus-related lockdowns. The valuations for these sectors are all down significantly, reflecting temporary concerns that could encourage an overcorrection. Moreover, businesses that lack a strong liquidity cushion may be forced into a sale, making them attractive opportunities for investors.
Airlines have been among the worst hit companies, with share-price declines of 70% or more for carriers such as United, and bankruptcies at Avianca and Virgin Australia. The sector will recover gradually, with domestic air travel returning before international travel does.
In addition to making some sectors more attractive, Covid-19 is changing the nature of opportunities available across types of deals. As conglomerates face a cash crunch and compressed valuations, we are likely to see a trend of carve-outs, as corporations focus on their core assets to revitalise their business and counter liquidity challenges. This will create opportunities for funds that have typically preferred control deals.
Like corporations, family-owned businesses are feeling stress from Covid-19, but the effect for them is magnified because their personal wealth and their income are deeply tied to their business. Such business owners will be more open to private capital than ever before, as they look to shore up their liquidity to weather the pandemic and sustain their business. This will give investors many more opportunities than in the past to take minority stakes in such businesses.
Because family-owned businesses in APAC are often highly leveraged, the stress they experience during the crisis will be compounded. Some family-business owners may be open to relinquishing control in exchange for immediate support in managing debt obligations and charting a way through turbulence despite unfavourable valuations. Likewise, in markets with an aging population such as Japan and South Korea, Covid-19 will accelerate succession control deals, as SME owners lacking planned heirs seek external support to turn around their businesses and maintain their hard-earned legacy.
However, the divide between winners and losers will widen. Within sectors, companies that are uniquely positioned or have a robust business model will become much more attractive to investors. For example, India’s Jio Platforms, a digital services company, has attracted more than US$20 billion, nearly half of it in PE investments, over the past few months. Investors have a positive view of the company’s potential to leverage its vast telecom subscriber base and its network of physical retail outlets to transform the country’s digital ecosystem.
Funds with portfolio companies that are well positioned to navigate the crisis will try to capitalise on their advantage. They will leverage these portfolio companies to consolidate the industry through horizontal or vertical integration. By consolidating their position and expanding their theatre of operations, successful portfolio companies can help their PE investors reinforce their advantages over the competition.
Debt finance may also become scarce. The relative share of debt in the capital structure of deals is likely to fall — and where it does not, lenders will enforce stricter covenants to protect themselves. Therefore, investment theses need to be stronger to justify the higher level of equity that will be needed. As the typical value-generation route of using leverage becomes less common, funds must have a high degree of conviction about potential Ebitda improvement in their target companies. Banks are likely to direct any incremental loans toward safer recipients, as opposed to funds for buyouts. Similar trends occurred after the global financial crisis in 2008. Investors will not want to saddle their acquisitions with unsustainable levels of debt, especially when business performance is so uncertain through the Covid-19 recovery.
Meanwhile, holding periods will likely get longer, and funds will need to rethink their exit strategy. In terms of exits, the pandemic is likely to increase holding periods. Lower-than-expected valuations might persuade funds to hold on to their investments in anticipation of a post-Covid-19 recovery. Market liquidity is also likely to be lower because of the pandemic, at least in the immediate future, with funds finding fewer potential buyers in the price ranges at which they would consider selling. Yet another reason for longer holding periods is the risk of negative exchange-rate movements for emerging market currencies, as investors flock to the safer haven of the US dollar. Such a trend would further depress valuations for global investors, making the internal rate of return for a PE owner even less attractive. As funds hold on to investments for longer periods, some are likely to use operational levers more proactively to create value.
As a result of increased volatility and reduced stock market valuations worldwide, the share of IPO exits across all APAC markets is likely to decrease. Funds will need to prudently plan their exit strategy earlier in the investment life cycle and tailor their approach to the strengths of an individual holding. For example, public investors may favour a portfolio company that has a high degree of digital maturity or a unique proposition, making an IPO more likely. At the same time, in an environment with fewer IPOs overall, funds should engage with prospective buyers much more closely to capitalise on any opportunities that may arise. Regional and domestic funds may be able to exit some positions through secondary sales to global funds that are looking to increase their exposure to APAC.
The authors are all with the Boston Consulting Group. Ichiro Kaku and Kanchan Samtani are both managing directors and senior partners, Timo Schmid is a partner and associate director (corporate finance), Archit Choudhary is a partner and Roshni Rathi is a principal.