Avoiding Landmines In Asian Private Equity

The past year saw private equity buying more than double in the Asia-Pacific region, to $67 billion, but it also delivered chilling reminders of just how hard it is to invest in the region.

Lone Star Funds saw a highly profitable investment in Korea Exchange Bank explode after the South Korean government indicted the firm for stock manipulation. TPG (formerly Texas Pacific Group) and Australia’s Macquarie Bank each bid more than $7 billion for PCCW, Hong Kong’s dominant telecom company, only to have the Chinese government quash the deal after deeming the assets “strategic.”

It would be easy to conclude from those sorts of high-profile blow-ups that Asia, the land of opportunity for funds bursting at the seams with money to invest, has become a minefield for private equity investors. But that would miss a more important point: What the Lone Star debacle and others did demonstrate is that private equity firms are facing a political and social backlash in these markets that is forcing them to alter the way they do business.

Best Approach

Success in Asia often means letting go of a traditional takeover structure that private equity critics deride as a “buy it, leverage it, and flip it” approach. Increasingly, private equity firms are turning to other sorts of capital arrangements—minority stakes, venture funding, and deals based on convertible and senior debt. Capital needs to be flexible and nuanced to mesh with social, political and economic realities. In a region with some of the fastest-growing economies on earth and business sectors in the midst of massive restructuring and deregulation, business as usual doesn’t apply.

Before the Asian financial crisis in 1997, private equity was virtually unheard of in Asia. But the crisis turned the big, global equity players into heavy hitters almost overnight as they came to the rescue of Asian nations on the verge of bankruptcy. They bought up everything from banks to telecom companies to auto plants to landmark commercial properties. They negotiated with government and top business officials desperate to sell what they could to generate liquidity.

Smart, experienced private equity players have now moved on. They are focusing their energies on a new generation of deals that provide a better fit for these unique markets. Unlike the early deals, they typically involve private-sector sellers, not government-controlled or government-influenced companies. And, most important, they are done purely at the choice of the sellers. They are designed to create true win-win partnerships.

In Korea, a good example is CCMP Capital Asia’s purchase of Buy The Way, a chain of convenience stores previously run by Dongyang Orion Group, a chaebol focused on snack foods, restaurant chains and the entertainment businesses. Buy The Way was an underperforming, non-core business of Orion Group, and when top management decided to unload it, CCMP Capital Asia (formerly JP Morgan Partners Asia) carefully negotiated a deal benefiting both sides. It allowed the conglomerate to reduce its heavy debt load and gave the private equity investors a strong platform of 1,000 convenience stores that will enable Buy The Way to consolidate Korea’s fragmented food-retailing industry.

Capturing opportunities often means thinking “buy in,” not “buy out.” Consider the situation in Japan. There, debt costs virtually nothing. So why would an owner need to give up lots of equity? In parts of Southeast Asia and China, government-imposed debt caps limit the upside to a highly leveraged takeover. In many of these countries, local business people and bureaucrats are loath to give up too much control. What they often need is management expertise and access to markets. They don’t trust a blank check.

For example, world-class Indian companies are looking to acquire stakes in strategic partners beyond south Asia and are, themselves, potential merger candidates for businesses looking to expand their presence in India. By forging the right alliances, these companies can use private equity partners for introductions and access to new customers, suppliers, and the opportunity to join forces with other enterprises in the private equity firm’s portfolio.

India Opportunities

Nimbus Communications, a diversified media company based in Mumbai, is harnessing its business goals to the network connections of 3i, the big London-based private equity firm. With India’s media sector projected to nearly double to some $14 billion by 2010, Harish Thawani, the company’s founder and chief executive, acted to jump-start his company by selling 3i a 33% stake in Nimbus for $45.5 million in August 2005. Nimbus is looking to 3i for introductions to potential partners from among its portfolio of 1,500 companies across Europe, the United States and Asia, and is tapping the industry expertise of the firm’s 300 investment professionals. Thawani and 3i plan to deploy those resources to acquire broadcast rights and fund the development of new programming.

India’s ambitious start-ups and family-owned businesses also are recruiting private equity firms as strategic advisors to help supplement their team’s management skills, tap new expertise, or elevate corporate governance. Indeed, talent, transparency and independent oversight—key attributes of good corporate governance anywhere—are especially important in India, where company boards often operate through close personal ties.

It was just that need for seasoned judgment that initially drew Sunil Mittal, the founder of Bharti Tele-Ventures, to the investment offer by Warburg Pincus Managing Director Pulak Prasad, in 1999. As members of the company’s board, Prasad (who left Warburg in late 2006) and his colleague Dalip Pathak, the head of Warburg Pincus’s Indian funds, helped Bharti formulate an expansion strategy, bring aboard experienced senior managers and guide the company through an initial public stock offering in early 2002 that raised $172 million. Through successive sales, culminating in Bharti’s acquisition by cellular communications giant Vodafone for $847.5 million in 2005, Warburg Pincus has significantly reduced its stake in the company.

Private equity firms are parlaying unique skills into long term win-wins. Over time, the most successful firms will likely be those who build reputations as specialists in a distinct economic sector or who become masters at helping diverse companies solve common business problems. When Goldman Sachs’s private equity group acquired a stake in the Industrial and Commercial Bank of China (ICBC) for $2.6 billion in late 2006, the investor’s 5.75 percent holding paled compared to the size of many of its U.S. acquisitions. But that wasn’t the point. The purchase gave Goldman Sachs a foothold in a market that is just opening up to foreign competition—and one that has already earned the firm a handsome paper gain. Goldman Sachs helped facilitate an initial public offering of ICBC shares that lifted the value of the firm’s holding to some $6.5 billion, or 2.5 times its original investment.

The lack of outright control that results from “buying in” instead of “buying out” means learning to steer from the back seat. And that requires developing a deep level of trust. Korea’s Cornerstone Partners recently bought a 10 percent stake in Megastudy, the leader in Internet-based study programs for college entrance exam. Though Cornerstone will only have a minority position, Megastudy is counting on the firm to help shape its business portfolio strategy and overseas expansion plans.

High-quality local relationships pay off in other ways as well. Without an extensive web of connections, funds will find themselves cut out of the deal flow. In a reversal of how it works in the United States or Europe, the majority of the deals in these countries never go to auction. Finding out about them requires tapping into the informal business networks so important to these markets. The same holds true for navigating governments and their bureaucracies. That’s why many funds are hiring former government officials or in-country industry leaders to provide essential guidance and local knowledge. The Blackstone Group, for example, decided to put its China entry on hold until recently, when the firm was able to hire Antony Leung, ex-finance minister of Hong Kong, who has an “A-list” network in China. In May, Leung helped Blackstone Group cement its mainland connections through the sale of a 9.5% ownership stake in the private equity firm to the Chinese government for $3 billion.

Well-developed local connections can also help a fund evaluate risk and plan an exit strategy. Unlike the parade of transactions in the mature, well-oiled capital markets of the United States and Europe, deals in many Asian markets tend to have “hair” all over them—lots of complications that affect how and whether they can be liquidated. Global investment committees thousands of miles away may be able to evaluate the macro issues facing a company, but in developing markets they’ll never be able to assemble the sort of “fact base” they need to make themselves comfortable. Often the bet is on management and partners. That means the firms with the deepest local networks often have a distinct advantage.

With plenty of hot private equity money chasing relatively few investment opportunities in Asia’s hottest sectors, even seasoned private equity firms can be tempted to short-circuit their due diligence. That’s a prescription for trouble. It’s essential to look beyond the financial statements to take measure of the quality and capabilities of the management team and the company’s broader opportunities. Alert private equity investors are adept at spotting ambitious entrepreneurs who know how to navigate fast-changing markets. Warburg Pincus found both a world-class opportunity and managers with the skill to seize it at Radhakrishna Group, the food distribution company headquartered near Mumbai. It began by betting on chairman, Raju Sheté, who had piloted Radhakrishna’s growth into India’s largest food conglomerate. Investing $50 million for a 25 percent stake in Radhakrishna in mid-2003, Warburg Pincus is working with Sheté to implement a farm-to-plate reorganization of the country’s food-supply chain and to expand the company’s distribution network overseas.

As the Lone Star and PCCW episodes demonstrate, private equity investing in Asia isn’t for the timid. But avoiding those kinds of pitfalls is possible. Done right, Asia will prove to be the next great private equity frontier.

Chul-Joon Park is a partner with Bain & Company, based in Seoul, where he directs the firm’s Asia-Pacific Private Equity Practice. Boston-based Partner Hugh MacArthur directs Bain’s Global Private Equity Practice.