Private equity Asia û the market today

This article takes a look at the rise of sovereign wealth funds, among other things, and seeks to make a few predictions for likely trends in private equity over the next 12 months.
Asia has been an area of focus for a number of global and local private equity players for many years. The credit crunch has prompted an even larger number of financial sponsors from the US and Europe, and the advisers who look to work with them, to ramp up their Asian presence and make it a key market for their business. Of course, simply increasing presence and capital available in Asia will not be enough for private equity players to succeed in the region.

Asia continues to present some formidable challenges to private equity investment. While these vary from country to country, generally speaking they include a combination of cultural, commercial and regulatory factors that get in the way of successfully investing and successfully exiting in a time honoured fashion. In many markets, and in particular in the two markets which dominate Asian investing - China and India - this means that even the basic LBO deal model that has served private equity so well in the US and Europe often cannot be used. Having said that, certain innovative (and highly structured) solutions have been developed to overcome this issue in India.

This article highlights some of the recent trends and developments that our lawyers, working across Asia, have observed during the past 12 months. It draws some comparisons with markets and market practice in Europe and the US. It also takes a look in more detail at one key trend, the rise of sovereign wealth funds and the global reaction to them. Finally, we seek to hazard a few predictions for the likely trends and developments over next 12 months.

M&A markets in Asia - an overview
The M&A market in Asia is still active, with levels of activity for the year to date being similar to or greater than 2007 (although precise levels vary depending on how data is reported, the broad trend is clear). The Financial Times has measured Asian M&A at around $189 billion in the year to date, with Australia, China and India being by far the biggest markets. This represents an increase of 10% on previous levels, contrasting with a drop in the US and Europe of around one-third to one-half.

The available data suggests that private equity in Asia continues to form a smaller proportion of M&A activity than in Europe or the US. The Asian Venture Capital Journal reports private equity in Asia represented 17.9% of M&A in 2007, with $87.3 billion of transactions, compared to an historic 30%-40% in Europe and the US. Mergermarket reports this increasing to 23% in Q1 2008, which would be a significant upward trend if it continues. Of course, such figures have to be treated with caution given that many deals go unannounced and the general desire of players in the industry to avoid publicity in connection with their investment activities.

The suggested figures for private equity M&A stand in stark contrast to the amount of capital being raised for deployment in the region. On any measure, this capital represents a multiple of the numbers for private equity M&A deals done. Data compiled by the Centre for Asia Private Equity Research supports this and indicates that since 2006, north of $75 billion have been raised for Asia but only $20 billion have been spent. This demonstrates the point, although it is difficult to measure given the ability of many private equity funds to invest only a portion of their commitments in any geography.

Outside Australia, China and India, other markets have also been active. Japan continues to generate significant amounts of mostly domestic corporate M&A, but with less success for private equity relative to the size of its market. Singapore and Hong Kong have seen an increase in activity in the past two years, particularly with P2P transactions, and Thailand is very much the flavour of the month at the moment, with a number of interesting assets going to auction. Both Korea and Taiwan, particularly after recent elections, may also present an increase in buying opportunities, especially (in the case of Taiwan at least) in the P2P/LBO market.

There are a number of ôhotö sectors, but the hottest one û especially for investment into China and India û is infrastructure (power and utilities in particular). Activity in this sector has been further enhanced by the emergence of an increasing number of infrastructure focused funds seeking more stable, longer term investments in line with pension fund type liabilities. They are also seeking to capitalise on the opportunities afforded by what has been, historically, low levels of infrastructure investment outside developed markets.

Deals not yet seen in Asia are the debt buy-backs by sponsors from lenders to their portfolio companies û backed in some cases by newly raised debt funds û or significant levels of distressed M&A. This is symptomatic of the fact that the credit crunch has not had the same impact on an Asian market that has been far less reliant on leverage.

Key recent trends
Asia is a rapidly developing market for M&A, and is still subject to a high degree of fragmentation and regional variation. However, some common themes are prevalent across the region, and the following section highlights some of these in more detail.

The macro-economic factors at play (above all, sustained growth in Asia as the already vast markets of China and India continue to integrate into the world economy) mean that financial investors û like it or not û need to have (or claim to have) an ôAsia strategyö. This ôpullö has been accentuated by a ôpushö as the credit crunch has hit deal execution in the more established markets of Europe and the US.

The combination of a pull and push into Asia has resulted in financial sponsors, and the advisers who work with them, gearing up their presence in Asia. The local market has seen sponsors increase team sizes and/or open new offices in Asia, and financial advisers send heavy-hitting bankers into the region (such announcements from investment banks have been emerging on what seems like a weekly basis during 2008). Lawyers have also recognised the need to provide focused financial sponsor coverage in Asia, and Linklaters for one has materially increased its sponsor and leveraged finance coverage in the region with eight partners and over 20 associates now specialising in private equity.

As well as ramping up in terms of personnel, new Asia-focused funds are being announced on a regular basis (such as the $1 billion Macquarie India Infrastructure Opportunities Fund, or the new Hopu fund of $2.1 billion). Many of the largest US and European private equity players are launching Asia specific funds (either in succession to previous funds or as a new departure), thus further expanding the pool of funds seeking Asian opportunities.
Local private equity funds
Another key development in the private equity market is the rapid growth of funds headquartered or raised in Asia. There have historically been some local funds, but the majority of the significant players in Asia (with Asia-specific funds) have generally been global players. Now, however, local funds are raising significant sums, particularly in China and India.

In addition to the funds mentioned above, Bohai, a Bank of China fund, has raised $10 billion onshore in China; in India, IDFC plans to raise 5 billion and ICICI $3 billion. Funds such as these are likely to become key players in markets where it is more difficult to deploy offshore money, where onshore money abounds and where there are local currency appreciation trends. They are also likely to become key players in those sectors where foreign investment is heavily regulated. The availability of this onshore private equity finance is likely to grow ChinaÆs share of the Asian private equity M&A market.

The extent to which offshore funds can access deals in competition with, or perhaps as a co-investor alongside, such locally raised and headquartered funds is likely to be a key driver of success (or lack of it) in generating deal-flow and, therefore, returns. In China in particular, the regulatory approvals needed for foreign investment load the dice in favour of local funds (who can deliver quicker and more certain deals). This may lead to attempts by global players to raise local funds with the intention of getting on to a level playing field for onshore deals.

Sovereign wealth funds
There is no question that one of the most significant developments in the financial sponsor space in recent years has been the entry into the market of sovereign wealth funds (SWFs). SWFs have developed rapidly from passive investors as members of lending syndicates to becoming players at every level of the capital structure (including as lead investors on LBOs).

The sheer size of sovereign wealth is well documented. Although SWFs have been around for a long time (France formed one in the 19th century and NorwayÆs petroleum fund has been in existence since North Sea oil was discovered), what is new is the sheer size of Middle Eastern and Asian SWFs. Whilst much of sovereign wealth will not compete with private equity, as a number of SWFs operate partially or wholly in other spheres (for example, managing foreign exchange reserves on behalf of the government), private equity cannot ignore the firepower of SWFs.

A key issue for Asian-based SWFs is the extent to which they face foreign regulation. The US have recently amended legislation aimed at vetting SWF investment (with the CFIUS approval process), and others such as Germany are considering doing so. The EU and OECD/IMF proposals to establish voluntary guidelines on these issues are likely to become something of a standard to which SWFs are held if they are looking to make outbound M&A investments. Canada and Australia have had foreign investment legislation on the statute books for some time, but only rarely has it been invoked to prevent foreign investment outside of certain sensitive sectors (e.g. defence and uranium mining).

However, the legislative machinery is there and whether it continues to be rarely invoked in practice remains to be seen. Political and media reaction to SWFs has not been favourable in all circumstances, and the pressure for transparency and an explanation of investment strategy, in particular demonstrating an armsÆ length relationship with sponsoring governments, is likely to become increasingly important, not just in Asia but throughout Asia (as we have already seen in Europe and the US).

There are many challenges to executing private equity deals in Asia, and particularly the classic LBO control transaction. Historically, this explains the low proportion of M&A which private equity enjoys in the region. There are a number of existing key factors still at work. Culturally across the region, owner-entrepreneurs have historically been reluctant to cede control of their businesses; and an IPO (often of a minority stake only) has been the traditional route to crystallising value (and generating prestige). Getting foreign bank debt directly lent (on a secured basis) into key markets is rendered difficult to impossible by regulation. Regulatory uncertainty (both for entry and exit) can also deter investment in some Asian markets.

New factors emerging post the credit crunch in 2008 include falling asset prices and resultant (temporary?) gaps in pricing expectations as buyers and sellers alike struggle to reach agreement on the pricing of assets in current financing market conditions. The pricing gap has narrowed more quickly with listed assets as stock prices have adjusted to prevailing market conditions. This has driven a greater interest in public to private transactions (P2Ps), although volatility remains and this has proven an impediment to pricing even on these deals, especially where the stock is trading below net asset value of the listed entity. Key jurisdictions for P2Ps have recently been Singapore, Taiwan and Hong Kong, due to relative ease of execution (particularly in Singapore) and the ability to leverage.

Bringing more than just capital to a deal will also allow financial sponsors to overcome challenges to deal execution, particularly where capital is plentiful and offered to sellers by more than one source. Financial sponsors with recognised global reach in particular sectors will be able to use that knowhow as leverage to win auctions and funding processes. Funds with a strong sector focus will continue to find this a powerful differentiating factor. In addition, partnering with local funds may open the door to more deal opportunities. Macquarie, for example, has recently announced that it and overnment-controlled State Bank of India (SBI) will jointly raise a $2 billion private equity fund with an infrastructure focus.
Deal types
Despite all of the challenges, investors have generally found ways to deploy capital in the key markets of India and China, often by adapting the type of deal those investors will accept to fit the environment. Markets in the region that allow control LBOs (i.e. with ability to close control deals) with the use of leverage, have also attracted increased attention. The newest such market to take off is Taiwan, which offers an ability to do control deals and generally provide operational exposure to Greater China. In addition, investors perceive that management teams in Taiwan are of high quality in certain sectors (especially technology and electronics), which is a key consideration for financial sponsors.

Growth capital deals, whether pre-IPO financings, private investments in public entities (PIPEs) or minority equity stakes, continue to be far more prevalent in Asia than elsewhere. Private equity players entertain these deals as they allow the deployment of capital whilst avoiding control issues and they do not need to be leveraged (at least onshore). These deals are often structured as equity-linked instruments. This is driven by a number of factors, the key one being that commercially having a hybrid position between equity and debt mitigates the lack of control over an investment a minority equity stake would imply, and it gives some downside protection to entry value. PIPEs have been particularly common in Japan and Hong Kong and pre-IPO financings in India and China (using similar techniques) are prevalent. These are shorter-term investments with exits built in.

Deal techniques/execution
Unsurprisingly for a regional market that is fluid, fragmented and at an earlier stage in its development, Asia market practice in terms of deal execution is much more varied than in Europe and the US. This is true both in terms of approach and adviser sophistication. There are comparatively fewer specialist financial sponsor-only advisers, whether as corporate or finance counsel, available in the region.

On acquisitions, there is a mix of US style and European (which is to say English law/London standard) purchase agreements. The key variations are essentially in the area of risk allocation and the approach to warranties and indemnities (to the extent agreed). A key issue is to marry the correct commercial approach to the governing law being used: the meaning of a US style indemnity under Hong Kong law, for example, is not the same as a New York law-governed indemnity. ôLocked boxö structures (fixed pricing based on historic balance sheets) are becoming more common, although these need to be used with an eye on the robustness of the locked box accounts.

One European deal technique already taking hold is the practice of sellers expecting ôcertain fundsö (essentially, unconditional committed financing û possibly pre-funded into escrow) to be in place at signing. As well as being seller-driven, financial sponsors should also be looking to use these techniques (whether private equity-style equity and debt commitments, or infrastructure style-escrowed funds/letters of credit) to level the playing field between financial sponsors and cash-rich trade buyers.

On equity financings, management deals vary considerably. Some could even be described as aggressive, possibly to the extent of being counter-productive on deals where management is also the principal seller. This is largely due to the reluctance of sellers (especially founding shareholders and MBO teams) to pay for competent advice early enough in the process. It is not uncommon, for example, for a binding term sheet to be signed before the seller retains international counsel. This has often proved to be a false economy as there is only so much the newly appointed advisor can do to unpick the deal between the parties. Time will tell who the winners and losers are in this process. It is highly likely that, over time, deal terms will standardise along the lines of US/European market practice.

Financing products will develop new levels of sophistication as the market in Asia grows with increasingly elaborate capital structures becoming a feature. As well as single-tranche senior debt structures, we are starting to see subordinated and high-yield components on Asia deals. PIPEs, or quasi-equity, are converging with traditional debt structures in this regard, as convertible bonds are used as quasi-equity to take minority stakes. We have also seen certain investors looking, for confidentiality reasons, to take ôshadow equityö positions û essentially sitting behind an equity investment taken by a bank but replicating the equity risk and return by a series of derivative products. Private equity players are increasingly utilising such structures, and in doing so, the range of expertise required for executing transactions is moving further beyond that needed for a traditional M&A transaction. In this respect we are seeing a convergence of M&A, finance and capital markets deal techniques. Islamic finance techniques, driven by the emergence of Middle Eastern capital, are also growing in prominence and all advisers are now also needing this expertise as part of their offering.

One prediction that is relatively easy to make with confidence is that market practice in execution will continue to develop rapidly, and the arrival of advisers and financial sponsor principals from other jurisdictions û the globalisation of teams and institutions û will lead to the adoption and adaptation of European and US approaches in many areas. The end result will be a globalisation of deal practice.

M&A in general, alongside private equity M&A, will continue to grow in the region. By some measures, M&A is underweight in Asian economies, representing only 4% of GDP, as opposed to 11% in the US, according to the Asian Venture Capital Journal. This would suggest growth is assured.

On the other hand, key challenges to private equity M&A in Asia will remain. Sourcing and agreeing prices for deals will continue to be a fundamental challenge; and regulatory constraints and cultural factors will drive a greater variety of deal types. Private equity players who succeed will have mastered the art of applying skills on a global scale to a local business with on-the-ground connections. Using the right advisers will also be key as deals become more complex and global market practice converges. Offering more than just capital will be a key differentiating factor for financial sponsors.

If you would like to discuss any of the issues raised in this article, please contact:

Christopher Kelly
Partner, Linklaters (Hong Kong)
Tel: +852 2842 4184
email: [email protected]

Jonathan Woolf
Managing Associate, Linklaters (Hong Kong)
Tel: +852 2901 5351
email: [email protected]