The emerging force

Author: | Published: 1 Apr 2007
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When the curtain fell on 2006, a statement was made on the status of the global economy: emerging markets are the rising stars, and will dominate the world's future economic direction. According to a December report by the Economist, at the end of 2005 the gross domestic product of emerging markets (on a purchasing power parity basis) accounted for nearly 50% of the global total. Drawing on statistics both from the International Monetary Fund and Morgan Stanley Capital International, the Economist revealed that close to 70% of the total global foreign exchange reserves are being held in emerging markets' vaults (See Figure 1). As emerging markets assume an increasingly pronounced profile on the global economic stage, Asia is the leader, accounting for more than 52% of the MSCI Emerging Markets index. The largest emerging market block on the globe, Asia's rising economic prowess has added new dimensions to the region's complex investment environment. For those seeking to establish, or further consolidate, their footholds in Asia, a new set of testing factors are arising in local markets that could be formidable hurdles to overcome.

The net of regulations

2006 evidenced one of the most revolutionary periods in the Asian private equity industry, during which regulators were mulling new measures that would harness more than just the merits of capital inflow, but provide more effective monitoring of the long-term objectives of foreign private equity investors.

The emerging economic power block

As one of the first countries to open its doors to foreign investors, and welcome them to take full control of some of the nation's most prized assets, South Korea was also one of the first Asian nations to lay down regulations to improve monitoring of foreign buyout funds. South Korea issued an edict that, when a shareholder accumulates 5% or more of equity stake in a listed company, the ultimate purpose of the holder of these shares must be publicly declared.

However, situations in which there had been no earlier defined regulations have now become extreme tests for non-domestic private equity investors. In 2006, two incidents, Lone Star's sale of Korea Exchange Bank (KEB) and The Carlyle Group's quest to assume a controlling stake of Xugong Group Construction Machinery, became sombre reminders that emerging market governments were conveying their revised positions to those who are ready to write cheques for local assets.

Bolstered by strengthened economic muscle, governments in Asia's developing economies are now emboldened to be more selective in welcoming foreign capital. In probing Lone Star's role in its 2003 acquisition of KEB, three years after the transaction had been endorsed by the government and completed, South Korea made it clear to the international investment community that its regulatory tentacles are long and resolute. The aftermath of this probe became particularly chilling when Lone Star decided to cancel the sale of KEB, effectively stalling an opportunity to reap a profit of $4 billion.

In China, Xugong has become a revealing example to all those eager to claim ownership of assets that are considered national interest. China can now afford to place the quality of an investment, as well as strategy and sensitivity, as priority factors before approving capital inflows. In December, the State Assets Supervision and Administration Commission (Sasac) identified seven industrial sectors that ought to remain under the control of the government. At the same time, the National Development and Reform Commission added further weight to Sasac's policy, urging the government to set up a unit to review mergers and acquisitions undertaken by foreign parties.

Even Taiwan, which has long welcomed foreign capital with open arms, is tightening its review of M&A funded by foreign parties, after having previously approved three large buyout transactions in the country's cable television industry. When Carlyle expressed its intent to take control of Advanced Semiconductor Engineering, the world's largest microchip packaging company and a strategic asset in Taiwan's semiconductor industry, the Ministry of Finance and Economic Affairs responded by making known its intention to scrutinize M&A undertaken by non-domestic parties.

The fact these Asian governments are declaring their positions only after the applicable transaction process has begun suggests that some are now waking up to the immense impact of foreign private equity on their domestic economic mechanisms. The search for the best regulatory framework to accommodate such inflows of capital, that could at the same time also provide an often needed overhaul of its local industrial structure, is daunting, and has only just begun.

Rich coffers

As the level of deposits in Asia's central treasuries continue to swell, domestic fund houses are benefiting from well-endowed war chests. While a US billion fund was once a fund size that could only be garnered by global private equity establishments, this is no longer the case.

In China, the recent formation of the Rmb20 billion ($2.5 billion) Bohai Industrial Fund is testimony of the level of wealth that the country has been able to attain. Bohai Industrial Fund is the first billion dollar fund that is not only renminbi-denominated, but has been able to achieve its first closing purely through commitments from local state-owned companies. Bohai Industrial Fund will primarily invest in an array of industrial enterprises in the Bohai Sea Rim region, although half of the Rmb20 billion will be designated for projects in Tianjin, an economic region south of Beijing (see Figure 2).

It will not be long before India's domestic private equity community boasts its first US billion fund. In 2006, ICICI Venture Funds Management achieved a milestone for the burgeoning Indian private equity industry when its Advantage Funds IV and V were closed, securing $810 million commitments from both domestic and international investors. ChrysCapital, an independent fund management firm that has yet to celebrate its 10th anniversary, became the first to have a fund pool under management that exceeded $1 billion.

In South Korea, after having registered the merits of private equity, and the hefty returns made by foreign buyout houses, the government has recently toiled to promote private equity in an investment community that once solely advocated venture capital disciplines. MBK Partners, which raised over $1.56 billion in 2006, is a prime example of the South Korean government's arduous efforts to create its own pool of buyout managers. Although more than half of MBK Partners' first fund pool came from foreign institutions, the investment vehicle counted a number of South Korea's domestic pension funds as its largest investors.

Profile of China funds management firms (2005-2006)

Rivalry in deals

When Affinity Equity Partners committed W800 billion ($852.1 million) to taking a controlling stake in Himart, South Korea's largest electronics retailer, in April 2005, it evidenced home-grown Asian independent fund management firms' rising ability to commit to deal sizes that were once beyond their financial capability. In October last year, MBK Partners had further underlined local Asian fund management firms' strengthened position. With a fund pool size similar to that managed by global firms, MBK Partners deployed an approximate $936 million in taking up a 60% stake in China Network Systems, the largest cable TV operator company in Taiwan. With a number of US billion funds expected to achieve their final closing during 2007, the stage is set for fierce competition in the deal sizes that are over nine digits in US dollars.

Increasingly, global private equity groups will have to raise their deal size threshold to focus on a defined segment of companies. On average, global private equity firms have increased their deal commitment size by more than 10 times. As an illustration, when Warburg Pincus first invested in China, its commitments during the late nineties were less than $20 million each. In 2006, the global private equity house has invested in six companies that aggregated to $2 billion. On average, each deal size stood at $343 million (see Figure 3).

Average deal sizes of selected global firms (2003-2006)


In the quest for deals in this increasingly competitive environment, private equity investors have accepted lofty valuations as part of the deal clinching conditions. For example, in October 2006 when MBK Partners took up a 60% equity stake in Taiwan's largest cable TV operating company, it paid NT$50,000 ($1,530) for each subscriber of the network. Of the three cable TV deals completed since the beginning of 2006, the price per subscriber paid by MBK Partners was the highest, with a 19% premium to that paid by both Carlyle and Macquarie Bank in their respective earlier deals.

In India, Hutchison Essar's valuation has risen by multiples in less than six months. When Kotak Mahindra Bank sold its 8.3% stake in Hutchison Essar in May 2006, the transaction price was $226.4 million, although the underlying value was estimated at $6 billion. A month later, when Hong Kong's Hutchison Telecommunications International raised its stake in Hutchison Essar by an additional 5.11%, it paid $450 million. Based on the reported prices that the recent consortia of bidders were prepared to pay for Hutchison Essar, its value has risen to up to $19 billion.

While focusing on larger deal sizes and paying generous entry prices are some of the realities for which global private equity firms have to be prepared when operating in the increasingly crowded Asian market, perhaps an effective deal origination plan has become a mounting priority before undertaking expeditions to Asia.