At Willis Towers Watson, we believe Asian institutional investors with long-term and patient capital can take advantage of many opportunities via private markets to access a different kind of equity market exposure not available in the public equity market.
Private markets help to complete the portfolio
Typically the listed equity market represents a small proportion of the total equity in an economy. The amount of listed equity tends to be a function of economic development for that country, the underlying market structures or systems, as well as cultural norms. Differences can be accounted for by different ownership structures, extent of entrepreneurial activity and need for third-party capital as well as the banking framework and access to other third-party capital. Companies need to reach reasonably mature stages of development to meet the various criteria for a market listing, while owners need to be convinced that third-party capital is the most effective form of financing.
As a consequence of this, public market indices cannot provide full exposure to the underlying dynamics of an economy. With this in mind, private equity can therefore be a useful portfolio-completion tool to help institutional investors more effectively target sectors that are not well represented, and provide exposure to companies at different stages in their economic development.
More representative exposure
In addition, Asian private equity provides exposure to parts of the economy that are not well represented in Asian public equity market indices
We have noted that conventional Asian benchmarks do not reflect the underlying growth drivers of the regional economy very well, resulting in a number of gaps in the underlying economic exposure. There are a number of reasons for this. Firstly, capital markets in Asia are at different stages of development. In certain countries this has resulted in a very small or even non-existent public equity market (such as Cambodia, Laos and Myanmar).
Some countries are quite dominated by market regulations and state-run investment, with many industries and sectors closed to international investors, or with restrictions on the level of investment. This can inhibit the development and growth of public equity markets.
Secondly, when compared to Western markets, a different investment culture tends to permeate Asia. A large number of enterprises are family owned and controlled. Oftentimes these owners do not want to dilute their control by having third-party investors involved in their company. Subsequently, when business owners look to expand, they generally look to do so with retained earnings and/or bank financing. In the US, on the other hand, it is very common for entrepreneurs to cash in on their investment, list their company and sell equity to outside investors.
Finally, many sectors and industries are still at an early stage of development, and the constituent companies tend to be rather small so may not qualify for market listings.
The above factors can ultimately result in many businesses not being listed on public equity market exchanges in Asia compared to more developed regions and can result in key economic sectors not being properly represented in common indices, and if they are, they may be dramatically underrepresented vis a vis their impact on the underlying economy.
Asian private equity can provide exposure to attractive themes
In our view Asian private equity can provide good access to sectors and themes that have attractive long-term fundamentals, which are potentially hard to access in public equity. Skilful asset managers can look to target structural, thematic growth drivers within the region and look to identify appropriate companies from the vast pool of small and mid-sized privately held companies operating in Asia (whether in consumption-related sectors, healthcare, sectors exposed to young or aging demographics, education and entertainment, etcetera).
Which is the best implementation route?
When the assets to be deployed are small, coupled with limited internal capability, there is a greater need to delegate private equity investment to an external manager. Typically the first port of call for many investors in this category is a private equity fund-of-funds manager, which will select a number of private equity managers and strategies and build a suitable portfolio on behalf of their clients.
As size increases, some institutions may look to benefit from economies of scale, reduce costs and manage a greater proportion of assets in-house. They may look to take more control over the underlying portfolio construction and subsequent selection of private equity managers. Certain investors with more internal resources and private equity investment skill may also look to deploy private equity capital via co-investment deals, where they partner with private equity managers and other strategic investors.
When asset size exceeds a certain threshold, the internal team might reach the maximum capacity in terms of relationship management and their ability to effectively deploy capital. Consequently the investor will need to re-examine the appropriate implementation approach, which may mean a return to some kind of fund-of-funds models.
We note that as the market has evolved in recent years, and there are some ‘hybrid’ implementation options that fall between the headline categories, often with participants such as consultants or fund-of-funds managers playing an active role in supporting asset owners. Such examples include separate accounts with consultants or fund-of-funds managers focused on specialist implementation approaches like co-investments or strategic partnerships with direct fund managers.
In the past, a common route for investing into Asia was through a fund-of-funds approach, as such managers were regarded as specialists in this unknown territory. However, more and more investors have now been able to invest directly into Asian private equity managers, bypassing funds of funds, as investors became more knowledgeable about the private equity industry in this region and the direct fund managers become better known and/or have a stronger marketing presence. It is still not very common to see co-investments in the region, unless the investor has a very good relationship with the underlying private equity manager and internal capability. Direct deals are done by larger investors with specialist teams that can effectively manage such transactions.
In summary, depending on their size, internal capabilities, capacity and skillset, asset owners can find themselves located at either end of this spectrum. All investors will naturally gravitate to points of equilibrium that balance all these forces, often adjusting the investment model through time, either in reaction to a past event (good or bad), or as their strategic preferences and ultimate aspirations for investment in the asset class evolve, or as part of a considered re-allocation of resources (higher or lower) as perceptions shift on the extent of reward for effort.
Complexity and governance are often cited as constraints on the extent to which investors can access private equity. That being said, we believe the governance budget is not fixed but should be considered a variable factor. Indeed, the governance budget can be expanded through careful and appropriate use of delegation.
A professional advisory company such as Willis Towers Watson can offer a number of solutions in this space to assist investors overcome their implementation challenges. In this way asset owners can move closer towards best-in-class portfolio construction, and ultimately more efficient and robust portfolios.
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The contents of this article are for general interest. No action should be taken on the basis of this article without seeking specific advice.
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