Asia’s growth story is beginning a new chapter. Some of the central characters have fallen from grace, and there’s no happy ending in sight: deals and exits have become more challenging in China and India, hurting returns, while the latter (together with Indonesia) has proven particularly sensitive even to the suggestion that the US Federal Reserve might end its asset-buying programme.
Meanwhile other players are back in the picture: Korea, for example, is seen as a volatility safe haven and a potentially fruitful source of corporate carve-outs, while the investor mood in Japan is surprisingly buoyant.
Jean-Eric Salata, CEO and founding partner of Baring Private Equity Asia, believes that pan-regional funds like his are best-equipped to succeed in changing markets.
“I’ve always been a very strong believer in regional diversification. You realise things can change and markets are volatile in Asia. Who would’ve thought Japan would be the best-performing market in the region in 2013-2014?”
Ceiling-high windows in Salata’s office on the 38th floor of Hong Kong’s International Finance Center offer a postcard-perfect view of the ferries in Victoria Harbour and the taxis inching along the roads below – albeit through a lingering haze. It’s an apt metaphor for Salata’s outlook on the region.
“Everyone loved China when the markets were at 50x earnings a few years ago. But now that the stock market is at 8x earnings, no one likes China. It’s the old greed and fear cycle playing out. Markets are not always rational. There are fundamentals, and then there is price, which tends to overshoot in each direction. We’re in the midst of that cycle now, and it will continue for some time because of macro and political issues in some countries in the region. But valuations are attractive. For investments made today, returns should be very good.”
On India, he’s similarly upbeat – although he acknowledges that the rupee’s plunge against the US dollar has had a big impact on returns for private equity investors in the country.
“The importance of currency hedging really moved up in the minds of investors. From our standpoint, we do a lot more hedging than in the past. There are costs associated with that, but it removes an additional level of volatility from the portfolio.”
In particular, his team hunts for naturally-hedged investments. For example, Baring’s $465 million buyout last year of India-based IT services company Hexaware (the firm’s largest ever India deal), is essentially a US dollar business operating in relatively low-cost India and is therefore a natural hedge against rupee volatility.
In addition, valuations are attractive in India, he says: Hexaware had 29 percent year-on-year EBITDA growth in 2013, and Baring bought it for 6.9x EBITDA.
“We haven’t seen that level of value versus growth in a long time in India. It’s driven by the negative sentiment toward India’s macroeconomic picture. Historically the country has been very expensive.”
“Buying underlying growth at a reasonable price – that’s the core of our strategy. One of the ways of doing that is to buy when markets are bad and the outlook not so clear.”
It’s a contrarian take, not only from a market perspective (given that Asia deal value last year was the lowest it has been since 2005) but also in terms of the firm’s culture. Baring, at 17-years-old, one of the few veteran shops in Asia, has a reputation as a canny outfit with an ingrained sense of caution, sources say.
That may be because Baring Asia was born out of risk. Originally it was part of the international private equity practice at UK-based Barings Bank, which plunged into insolvency in 1995 after employee Nick Leeson, a futures trader based in Singapore, made a series of unauthorised trades that racked up $1.4 billion in losses.
Salata joined Baring in 1996, as its assets were being acquired by Dutch bank ING for £1, and launched the first Asia fund in 1997. Over the years, ING split and sold the global private equity division to the respective management teams in Asia, Russia, Europe and India.
The collapse of the venerable 233-year-old Barings Bank, tied to poor risk management controls, shocked the financial world. It also made a deep impression on Salata, then only 29, shaping his views on financial risk. Risk mitigation was the basis for its diversified pan-regional strategy, while “capital preservation” remains its guiding investment theme.
Pennsylvania Public School Employees Retirement System, an LP in three Baring funds, noted in a public document that Baring “employ[s] various financial structures such as convertible bonds, price ratchets, put options and other financial tools to further mitigate principal risk”.
Salata’s own background has also helped to shape his attitude to risk. His ancestry is actually Eastern European: his grandparents fled Europe during World War II to Chile, which at the time was the only place that would take them in. His parents were born in Chile and he lived there until about the age of five, when the family again had to flee, this time to the US, following Chile’s political revolution in the 1970s.
He grew up in Pennsylvania, and after graduating magna cum laude from the Wharton School of the University of Pennsylvania with a degree in finance and economics, he joined Bain & Co as a management consultant. In 1989, he came to Asia for a six-month posting – and ended up staying.
This background has left him with a residual wariness about perpetual change. “You always need to have back-up plans, because you never know what turn of events you’ll have to face.”
Returns have become a hot issue in emerging markets, where fund managers have largely underperformed their US counterparts across multiple time frames, according to June 2013 data from Cambridge Associates.
Salata believes Asia returns have suffered due to the two big differences between Asia and developed markets – the lack of available leverage, and the lack of value creation capability.
“US and European firms perform well due to availability of leverage, and we’re starting to see that in Asia. There’s much more availability of leverage and more focus on operational improvements. You’re no longer relying on external factors for returns; you drive returns more by what you’re doing with companies you invest in.”
To reflect this, the firm has built in-house value creation capability by adding 10 dedicated operational professionals over the past 24 months.
“The next five years, operational work will be more critical than it is now,” Salata explains. “Driving it is the fact that you have today much larger, more complex businesses. No one is running a mid-sized company by line of sight any longer. Beyond a certain size, a company needs a management team and systematic approach to running a business. Many companies are themselves interested in hearing you out. They want to meet some of the people who can help the company grow.”
Baring’s best performance has historically come from China, Salata says, highlighting the sale of confectionery company Hsu Fu Chi to Nestlé for $1.7 billion in 2011, one of China’s largest trade sales (a 4.5x multiple, a source says), and last year’s sale of Chinese beauty products maker Magic Holdings in a deal valued at $875 million.
The firm’s China exits tend to be through trade sales, though one company was affected by the 15-month freeze on new domestic listings (now unfrozen) and is in the listing queue. “Most of our Chinese investments, on the way in, have either a Hong Kong IPO or trade sale set as a primary exit route.”
Despite the caution, the firm doesn’t have an unblemished record. A $108 million take-private of China’s Ambow Education, a NYSE-listed entity, fell through last year. Baring had a 10 percent stake before it made the offer, but withdrew its proposal when three of the company’s directors and its auditor resigned at the same time. Salata would not comment on the Ambow deal, but a Reuters report at the time said the firm faced a $43 million paper loss from a $57 million investment.
In addition, Baring has not always made the best investments in India, industry sources tell PEI (though, to be fair, not many firms have).
“There’s been a few lessons learned along the away,” Salata admits, declining to talk about any specific deals.
“One is that when markets are good, don’t get greedy and take some money off the table. You learn it when you see value suddenly appear and vanish – particularly in Asia, where cycles can be deep and short. The best decisions we made were selling decisions. I can’t say we’ve gotten it 100 percent right, but it’s one reason we’re still around after 17 years. Many who started with us are not around [anymore].”
“The other lesson is the importance of the entry price. You can make up for some of that through leverage and operational improvements and good luck. But from a standpoint of a margin of safety, in case things don’t go to plan, you are in much better shape if you have the right entry price. You can make a lot of money on the way in.”
Either way, the firm intends to raise Fund VI this year – and return expectations will not be taken down, he adds.
Baring Asia’s last fundraise was impressive (it invariably gets a mention when you talk about the firm to outsiders). Fund V closed in February 2011 on its hard-cap of $2.46 billion only five months after launch. It had a $1.75 billion target, but was oversubscribed even at first close, which came just three months after launch, PEI reported at the time.
But much has changed since then. Fundraising for Asia fell 5 percent to $27.6 billion in 2013, according to PEI’s Research & Analytics division – whereas North American and European funds were up substantially, and total capital raised globally rose 20 percent to $365 billion.
In addition, two industry sources pointed out that timing played a role in Baring’s 2011 fundraise. Back then, there was little or no competition with similar pan-Asian vehicles, most of which had closed years earlier – whereas now, it’s following the likes of Navis Capital Partners, MBK Partners and Affinity Equity Partners, all of whom have closed beyond their targets in the last nine months.
“[Baring’s fundraise] could be an issue if people have already allocated to the region,” says one source. What’s more, they add, there will be further competition from two more pan-regionals, Headland Capital Partners and Unitas Capital, which are expected to raise funds this year.
Much will depend on returns from Baring’s existing funds, of course. It’s early days for Baring’s Fund V, but its one exit to date was a good one: the aforementioned sale of Magic Holdings to L’Oreal. Salata wouldn’t comment on exit multiples, but industry sources say it generated a 45 percent IRR.
Fund IV is a 2007 vintage, which has proven difficult for many firms. It was showing a 1.7x multiple and 16 percent IRR at the beginning of 2014, according to data from industry sources (Baring declined to comment) – although the February exit from Indonesia airport services company CAS to a Singapore-based corporation, which sources say yielded a 30 percent IRR, should push those numbers higher.
This is a period where Asia fundraising is seeing a flight to quality: last year, the top ten funds raised 70 percent of the total capital, and this proportion has been climbing each year. Baring has to hope that it will be among the chosen few.
Baring has beefed up over the last 36 months, adding 20 investment team members across Asia and opening an Indonesia office. It now has 100 people in seven regional offices – large for an Asia-based firm.
It has also moved into real estate: in 2011, it launched a $500 million Asia fund, which is expected to close on target mid-year.
During the recent credit squeeze in India and China, the firm started seeing real estate opportunities but didn’t have the expertise to evaluate them properly, Salata says. “We started getting reverse inquiries from property developers as well as related dealflow.”
A dedicated team of 15 was put together; they have looked at nearly 250 investments and are currently close to five advance deals. “They haven’t pulled the trigger because valuations are still coming in on real estate and in some cases starting to correct, which will make investments more attractive.”
However, the firm currently has no plans to move into more asset classes, he adds.
As a pan-regional fund, Baring has traditionally competed against country managers. Salata’s position is that a pan-regional strategy offsets risk through diversification, providing a more varied basket of deal opportunities than a country fund. Of course, country funds would counter that they don’t spread resources across a widely diverse region – and as plugged-in locals, they often have the edge on origination and financing relationships.
However, the more significant competition may come from the global firms.
As with Baring’s previous funds, Fund VI will probably be bigger than its $2.6 billion predecessor (a $3 billion target is likely, sources tell PEI). That puts it on course to compete with groups like The Carlyle Group, which is expected to close a $3.5 billion Asia fund this year, Bain Capital, which closed a $2.35 billion Asia fund last year, CVC Asia Pacific, which is near a final close on $3.5 billion and TPG, which is raising $3.5 billion.
Traditionally a growth capital investor, Baring also intends to do more buyouts, Salata says.
“We’ve reoriented our focus on finding opportunities where we can have more control and more impact. In order to do that, we needed different kinds of internal capabilities. On the origination side, too, we’ve added more skills that allow us to put debt together.”
China is experiencing a steady transition from growth capital to buyout deals, according to PwC data. Last year, buyouts numbered only 29, but they show a year-on-year increase since 2009. Meanwhile, growth capital deal volume fell about 15 percent.
And it’s not just China. The Hexaware deal in India was a buyout. A Korea buyout last year of domestic parcel service company Logen was reportedly for $146 million.
“Half of what we do is still minority investing,” stresses Salata. “That won’t change soon. But buyouts are still a very big opportunity.”
Then again, global firms in Asia have been adopting a more flexible investment strategy, completing more growth capital deals alongside buyouts. Kohlberg Kravis Roberts, for example, has often done Asia deals with a value of $200 million or less, the latest being a $200 million minority stake in Gland Pharma, an Indian pharmaceutical company.
The globals also have deep pockets and operational resources that a regional fund will find hard to match. For example, when Carlyle needed an expert to raise food safety standards at Yashili, a Chinese infant formula maker, it tapped its Washington DC network to bring in the former director of the US Food and Drug Administration.
But that doesn’t mean Baring’s offer won’t measure up. “Baring is perceived as a local firm with international governance standards, which clearly works to its advantage,” says one industry source. “And it’s on Fund VI, so it also has a longer history than many global firms.” KKR and Bain, for example, are only on Fund II in Asia.
It also can lay claim to a somewhat broader perspective than the other pan-regional funds. Of the original Baring units that were bought out by founders, Baring Asia still has close ties with Baring Vostok in Russia: they sit on each other’s investment committees and meet to share views on what’s happening in their respective regions, Salata says.
All told, competitive concerns are not at the top of Salata’s list.
“You have to have the right people, systems, process and value-added capability to be competitive with these other players. But we have been here 17 years and have market relationships and continuity of management. The people running our firm, six of us, have been together 13 years. That institutional learning is something that’s cumulative.”
He also argues that the pie is getting bigger for everyone, with an assortment of deal opportunities.
“What you’re starting to see right now is that Asia seems to be somewhat oversold. Equity capital markets and banks are unsettled, so capital is becoming more difficult for SMEs to access. More assets are being sold because the sellers have no alternative forms of financing available. The opportunities for private equity deals are increasing.”
In other words: even for the cautious, now is a great time to invest.
Fund VI target (reportedly)
Amount realised/average multiple last 24 months
Despite the slowdown, there are plenty of opportunities still up for grabs in Asia’s largest economies.
Baring separates China into two economies.
The first is dominated by heavy industry. “Cement, steel, heavy machinery are mostly state-owned and funded by state banks and as a result are suffering from a huge overcapitalisation that will result in a painful restructuring,” says Salata. “Capacity rationalisation will take place and we want to avoid the pain in those sectors.”
The second economy contains small, nimble entrepreneurial businesses – like online game developer Giant Interactive. Baring, together with Hony Capital and Giant’s founder, have agreed to take the NYSE-listed company private in a deal valued at $3 billion. It’s the second largest privatisation of a Chinese company after Focus Media.
“[Giant] is noncyclical, has no capex and has great margins,” Salata says. “It’s a service business targeting middle class entertainment dollars, and is also expanding to third and fourth tier cities through the internet.”
The firm also likes China’s food and food safety-related companies, retail-oriented businesses and healthcare.
In India, by contrast, he believes there’s still opportunity in the ‘old’ economy. Baring last year invested $236 million in ready-mix concrete business LaFarge Cement India, an affiliate of the Paris-based parent group. “Infrastructure building ground to a halt due to politics. We believe this will turn around, construction will come back and cement companies will benefit.”
Retail financial services also look cheap, he suggests, given the sector’s potential for development.
His main concern? What he calls “plant the flag investments” by global firms looking to establish themselves in the region, which could inflate valuations.
“Most of the global firms in Asia are disciplined and have raised the bar on quality investing in our region,” he says