Private equity valuations are rising as managers are forced to compete more aggressively to deploy record amounts of capital, but there is better value in the small-to-mid-cap funds space, especially in emerging markets, where the pressure is less intense, say some market participants.
Globally, the amount of uninvested private equity capital hit an all-time high of $1.7 trillion in 2017, up from $1.5 trillion in 2016, management consultants Bain & Company reported in February.
The bulk of that so-called dry powder, however, is in developed markets -- with alternative assets data provider Preqin estimating the amount in emerging markets at less than $300 billion.
The challenge of capital collected for the purposes of private equity investment and waiting to be deployed is not as bad in emerging markets as it is in Europe or the US, Doug Coulter, partner and head of Asian private equity activities in Asia for LGT Capital Partners, told AsianInvestor.
And if Asia is a guide for emerging markets generally, what competition there is among private equity investors is skewed towards the bigger firms.
“If you look at where most of the dry powder is in Asia, it's really concentrated in the large and mega end of the market and less so in the small and mid cap space,” Coulter said.
About 45% of all uninvested private equity capital is held by funds with assets under management of more than $5 billion, according to the Bain report, and that opens up opportunities for the smaller funds.
“If you focus your investments and your capital on small funds, smaller companies, and you stay away from the most highly priced large companies, valuations are more reasonable,” Coulter said.
In terms of fund size, it varies across geographies, but in general small cap is anything under $500 million and mid cap goes up to about $1 billion, he said. For companies, it ranges from $200 million for small cap and $500 million for mid cap, he added.
VENTURE CAPITAL VERSUS BUYOUTS
For all that, investors should be aware that private equity in emerging markets is less focused on buyouts, a strategy that involves buying and managing a company, typically with debt financing, and then selling the company for a profit.
“On a relative basis, all portfolios are going to have more growth capital and more venture capital in Asia, in [emerging markets], than they do in the West,” Coulter said.
These strategies focus more on startups and early-stage companies, usually through minority investments. There is a higher risk in growth and venture capital as the profits track record of these companies is less established, but at the same time there is more potential for higher returns.
About 57% of emerging markets private equity funds were in venture capital as of the fourth quarter of last year, compared with 39% of developed market funds, according to a June report by fintech solutions provider eFront.
That is partly due to the shorter history of private firms in emerging markets, which limits the pool of companies that are up for sale for buyout transactions, Ku Seungha, managing partner and head of offshore private equity at CreditEase Wealth Management, said.
The emphasis on venture capital over buyouts in emerging markets is also a reflection of where the opportunities for investment are located. LGT Capital Partners, for example, has more money in venture capital in Asia relative to Europe or the US and they see opportunities in India and China in particular, Coulter said.
Emerging markets accounted for about 40% of all venture capital deals globally in the first six months of 2018, up slightly from 38.5% in 2016, data from Preqin shows.
But that doesn't tell the whole story as the aggregate value of these deals has increased to around 51% of the value of all global venture capital deals from about 42% over the same period. In this time, the average emerging market deal size has also grown at a faster pace -- by 91% compared with 61% globally, the Preqin data shows.
“We do think that you want to have a decent amount of your portfolio in venture [capital] in both China and India because this is a once in a lifetime opportunity to lock in allocation with the best venture managers in both markets,” Coulter said.
HOW TO PICK 'EM
The tricky part for investors is that in the West there are firms that have been in business for very long periods of time, with established track records, and that is much less the case in Asia.
“Here there are a lot of newer firms, spin-outs, first and second time funds, that are far less proven, so the question is how do you select? And for the [private equity] firms that have done well over longer periods of time, how do you even get access to them given high levels of over-subscription?” Coulter said.
Seven or eight years ago it would have been hard to understand the growth stage of Chinese technology companies, for example, if you were sitting in an office in London, where managers focus on metrics like cost structure, cost savings, and operations improvements, he said.
“In emerging markets, it’s mostly driven by top-line growth, so the metrics are a little bit different in terms of evaluating the companies,” he said.