- An Executive Summary
- An overview of the company/setting or problem addressed in your case [Ray]
The case consists of a European multi-family office deciding whether to invest in private equity in Asia and if so how to do it. George Bergmann is the Senior Investment Director for one of the largest European multi-family offices, and in recent years it became clear to him and other seniors managers at the firm that they are underexposed to the growing markets in Asia as highlighted by Hong Kong becoming the largest center for IPOs in 2009. Asia was able to avoid the worst of the financial crisis in the late 2000s and was poised to continue its long-term growth.
At the last shareholders meeting, they tasked Bergmann to come up with a proposal and investment strategy to whether to invest in Asia and if so how to do it so that the returns adequately compensate for the risks involved ranging from cultural barriers to underdeveloped institutions. Bergmann had to address to the shareholders where he sees the future potential for Private Equity in Asia and whether it has gone beyond the point where it makes sense for them to invest. Furthermore, he had to determine what a reasonable return target is for the firm in order to be compensated for the risks they will be taking and develop and implement an investment strategy using the information he gathered.
- Specific responses to the assigned questions
- How do you see the future for PE in Asia? [Niannu]
- In which ways the current environment for PE is different from the mind-1990s? In your responses pls use recent research material and industry reports. [Jake]
Back in the mid-1990s, institutional investors from around the world began exploring opportunities in Asia’s growing markets to obtain returns on their investments and diversify their portfolios. Several Asian private equity funds began emerging by promising remarkable returns to institutional investors. However, macroeconomic factors within the region including low standards of corporate governance, inadequate information regarding the investments, corrupt legal system, currency swings, and inefficient exit opportunities prevented these private equity funds from successfully implementing the private equity model. Most importantly, these private equity funds were usually managed by inexperienced fund managers that were executing mediocre deals that culminated in a majority of the funds’ poor performance. In 1998, Fortune published an article called “The Great Emerging Markets Rip-Off” that stated “You can’t trust the companies, you can’t trust the governments, you can’t trust the analysts, and you can’t trust the mutual funds managers. Watch out.” Once the Asian financial crisis occurred, these macroeconomic factors were in the spotlight to the private equity community and most institutional investors ultimately withdrew from the market.
In the current environment, investors have recognized how private equity investments are driven and shaped by a region’s macroeconomic forces. Developing countries offer private equity investors with many opportunities compared to developed economies to obtain remarkable returns on their investments. Unlike the inexperienced fund managers from the mid-1990s, newly established private equity firms emerged throughout the region emphasizing a more professional style of management and increased levels of corporate governance. These new firms adopted several standards and procedures that were commonly applied in the United States and Europe to provide the private equity community with a safer environment for investing capital. Today, the private equity environment within Asia has provided investors with greater transparency of their investments and the amount of exit opportunities improved. According to Bain & Company’s “Asia-Pacific Private Equity Report 2018,” there were two key factors including “investors’ growing confidence in the region as macro climate improved, and company owners’ greater overall acceptance of private equity funding” that resulted in the growth of private equity in the region. However, investors must be aware of risks that remain present in the current environment including concerning business practices, legal issues, macroeconomic stability, and political risk.
- What should a target return for PE in Asia be? Think about PE-specific and Asia-specific risks and how investors expect to be compensated for them [Santi]
The private equity market in Asia has seen a strong growth in a span of 15 years in AUM from $30 billion to $283 USD between 1994 to 2009. Even through the financial crisis of 2008, the Private Equity Market saw a growth of 13-14% from 5-7%. However, when dealing with performance, past or future, it’s very difficult to set a benchmark or standardized return. The lack of transparency in the private equity markets along with its long-term and illiquid assets also pose a challenge in targeting returns in PE.
The risks involved can offer suggestions on what returns to expect. Some of the risks included political and macroeconomic stability, investment & tax policies, along with legal issues. Another implication is the limiting diversity many PE managers had, that came from investment banking backgrounds whereas the US and Europe had a more diverse mix. This limited diversity had many managers seek deals where the exits were IPOs.
Compared to the risk premium of 6% and 7.3% in developed markets, Coller Capital expects to see returns for Asian developing markets of around 18-23%. According to Cambridge Associates Asian PE has returned 4.65% over the last 10 years. This performance has been much worse in short term, but significantly better in the long run.
- What PE strategy do you think will be the most successful in delivering high risk-adjusted returns in developing Asia and why? [Sreekar]
- What are the similarities and differences, if any in PE transactions for Asia vs. United States? [Clara]
In the United States the nature of the securities or interests held by managers is more varied, with managers typically holding either options exercisable into ordinary equity, profits interests or, occasionally, leveraged common equity, with vesting of these interests subject to continued service and the overall performance of the business or investment. The choice between these different interests is driven by tax considerations and the negotiating strength of management: options giving rise to ordinary income treatment but a compensation deduction benefit in the hands of the company, and profits interests and equity giving rise to capital gains treatment for the managers, but no compensation deduction for the company
The position across Asia is also more varied, and in general there is no settled market standard for management equity incentive arrangements, although it is more common for management in transactions in China to be given equity incentive awards that vest purely over time with no performance requirements, whereas in the Hong Kong market managers are commonly issued with a mix of ordinary equity as well as options exercisable into ordinary equity and which are linked to future business performance.