Highly leveraged deals may dry up, warns investor

Richard Pyvis of CLSA Capital Partners predicts riskier private equity deals will become unfeasible as the cost of financing rises.
Chairman and CEO of CLSA Capital Partners, Richard Pyvis, is a big believer in the Asian growth story, but says riskier buyouts will become harder to finance. He also says the success of recently completed large-scale deals will only be proven when these investments are exited and profits tallied. FinanceAsia speaks to Pyvis about the fallout from the liquidity crunch sparked by the US subprime crisis.

How do you view the opportunity for private equity in Asia?
We have a range of funds which in total aggregate around $2 billion under management. We are believers in the emerging Asian story. We strongly believe in our underlying investment hypothesis: there are a billion baby boomers emerging with growing per capita GDP, purchasing power and consumption demand which in turn will lead to growth in investment, and demand for capital.

What is your view on the subprime fallout on Asian economies?
We recognise that Asia is still part of the global economy, even though growing domestic demand is very significant. Issues in the US subprime mortgage sector will have some impact û it is the degree of materiality with which we are all wrestling.

I donÆt see any country in Asia being singled out to suffer or do better than any other but we do have economies in the region with different degrees of maturity and inter-dependence.

What is the degree to which there is contagion?
We donÆt know the answer yet. But broadly we donÆt think there are any countries in Asia where we have invested which are going to be unduly disadvantaged. In general, we remain positive and, what we have found in Asia over past decades, is that there are almost always times you can invest in one country or sector or another, which is why our funds tend not to be country or sector specific.

Is raising debt to finance private equity deals becoming more difficult?
Debt will more accurately reflect risk in the future which means riskier deals will become more expensive. So, some highly leveraged deals may no longer be financially feasible. The price for credit for some deals will not change where credit risk has been accurately assessed. Some could even benefit as they were being lumped with riskier deals and were not being sufficiently delineated. Some will suffer as risk and rates are better assessed.

It is healthy for markets for risk to be differentiated and properly priced because otherwise capital is mis-allocated and goes into the wrong deals. Returns will otherwise not accurately reflect the underlying risks inherent in the deal.

Will mega-deals dry up in the current financing environment?
In Japan impediments to large foreign deals have little to do with credit availability or pricing issues but have to do with institutional obstacles. However, we have seen heightened concern by Japanese banks for their exposure to senior and mezzanine debt.

Through Asia ex-Japan there have been maybe 10 high-profile deals done over recent times, predominantly in the financial services sector. We have not seen too many exits. If you go into a jumbo deal you want to be confident the exit is feasible. The track record thus far does not give you that comfort. That could be another reason large deals are falling out of favour.

The reasons for large deals falling out of favour are myriad û changing regulatory environments, institutional, credit availability, cultural issues among them, but where there is a demand for capital and that capital is sensibly priced, deals will occur.

Do you see rising nationalism becoming an obstacle for private equity deals in the region?
In unclear regulatory environments and jurisdictions, capital allocation is unlikely to be optimised. Inefficient capital allocation is not the right thing for any economy. We sometimes see short term nationalistic concern affect deal completion, but over time see the market economy philosophy prevail in favour of capital efficiency and deal completion û but some times we have to wait quite a while.

Having said that, I have a great deal of empathy for countries which want to protect strategic sectors and preserve jobs for their own people. As long as private equity is transparent, it will not face problems. We are a non-adversarial firm and donÆt use our capital in a hostile way, as in the long term it is likely to be sub-optimal in the Asian sphere. We have had a few situations where constructive dialogue has not resolved issues, and have not proceeded with those investments.

Asian currencies are appreciating in real terms vis-a-vis the dollar. How will this play out?
I am a great advocate of flexible exchange rates. It gives central bankers the interest rate as a tool to manage inflationary expectations and price stability. Without flexible exchange rates you cannot achieve sustainable price stability and manage inflationary expectations other than by fiscal policy, which inevitably leads to policy decisions in favour of certain sectors and individuals, distorting an economy, and not desirable as this fiscal interference distorts capital allocation decisions.

From a private equity standpoint it is important because we do want to unnecessarily focus on the currency of our investment and form a long-term view on the exchange rate vis-a-vis political uncertainty, over the drivers of the underlying investment decision.

I have empathy for countries that are subject to massive bets against their currencies where some of the players have resources that dwarf the country in particular. I donÆt have the answers on how to moderate international capital flows and I donÆt advocate pegged currencies, but appreciate the frustrations some must experience.

How would you characterise the development of AsiaÆs private equity market?
I think the development of the asset class and its sub-sectors has been really positive. It varies by country and sector but I think the asset class development has been a positive for the region. A whole new source of capital has been unveiled for entrepreneurs, enabling growth and wealth creation.

Mezzanine financing is very interesting. If there is going to be one standout beneficiary of the re-assessment of risk in the region, it will be mezzanine financing, which bridges the widening gap between equity and senior debt. Overall, the asset class is developing rather well û but it is never fast enough.

Is too much private equity money chasing too few opportunities in Asia?
A massive amount of money has been raised over the last three to four years but we probably have to wait until the end of the cycle - maybe 2010 - to see how much has earned a living.

æAdequateÆ capital in the alternative asset sector is enabling opportunity. This is where differentiation will become key, and over time we will see returns correlate with the quality of managers. Good managers will continue to find investment opportunities, and capital.

There is a risk that this is becoming a sellerÆs market which may see some markets favoured over others at different points in time, which is why we favour pan-Asian funds over country-specific funds.

Dangers exist û but we insist on discipline: stick to your knitting; stay focused on sensible entry and exit multiples; donÆt look for multiple expansion as a way of making a quick return; and add value on the way through. Given all this we believe there is money to be made and value created for the foreseeable future in the alternative asset class investment sector.
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