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Winna Brown

Hello and welcome. Thanks for tuning in to part two of two-part series on private equity (PE) in Asia-Pacific. In part one, we had a really enlightening conversation about the market landscape, relevant cultural factors and ways of working, as well as, value creation in the region. In this episode, we will shift gears and focus on how new legislation in Hong Kong is impacting the PE ecosystem in the region.

So, joining me from Hong Kong is my colleague Josh Lewsey, EY-Parthenon Partner, Strategy & Transactions, Ernst & Young Limited, and the practice leader for value creation in Hong Kong. I’m also really pleased to welcome John Levack to the podcast. John is the Vice Chairman of the Hong Kong Venture Capital and Private Equity Association (HKVCA) and has a distinguished career, having established operations in Hong Kong for the UK-based PE firm, Electra Partners, in 1995. And before that, he spent 12 years with 3i Group in the UK and India.

So, between the pandemic, protests and evolving US-China relations, the region is certainly endured some rather disruptive events over the last few years. Of course, all of this is culminated in the passing of the national security law. In your view, what impact will the national security law have on the appetite of PE to invest in the region? Do you think it’s disrupting business?

John Levack

To put a question to us that mixes politics and forecasting is really tough. 

Brown

I had to ask.

Levack

But you have to ask and actually it does open up a whole bunch of interesting answers to that general question. In terms of forecasting, it’s a really brave person who puts their name to what is going to happen in economics and trade over the next year or two. But ducking that responsibility and calling on the Organisation for Economic Co-operation and Development (OECD) numbers, OECD is predicting that 2020 will see a 4% contraction in gross domestic product (GDP) across the world. And as of the G20 countries, only one country will be having a positive GDP this year and that is China. And if you then take the two least bad second and third countries that make the smallest decline in GDP, it is Indonesia and South Korea. And so immediately that is showing that this part of the world has a certain amount of resilience to it that investors have to sit up and pay attention to. The GDP and investment returns are not perfectly correlated by any means but they are an indication of where there is opportunity and growth.

I think the other thing that is a bit concerning at the moment is a market and product bifurcation where there may be a US and European market for certain products and an Asian market, and that may be driven more by politics than consumer requirements. But it means that there are going to be different performances the day that one company would have a global market share, may be a bit restricted and you may have big market share in Asia and small market share elsewhere or you may find your American operations get taken away from you and sold to someone else. So, you’re getting to a situation where the performance of Asia can potentially be stronger than the more developed economies and very different.

And so from a global allocation perspective, if you are allocating a pension fund or an endowment, you might be looking at your allocation percentages and saying: you know if we had 10% in Asia before we should have more than that now because it is going to be different and maybe less correlated with some of the issues we have at home and to miss out on that could be potentially problematic. So, I think overall the importance of Asia will probably be stronger when we come out of this disruption than it was before, so that’s a very macro thing rather than talking about the political.

John Lewsey

I think also, irrespective of the politics, and we obviously won’t touch on that, but just from a business lens, I think some of the statements from the multinational inbound funds who’ve been here now for quite a long time and the commitment to stay in this region and invest in this region based on the opportunity, for me throws up a really interesting point and that’s really around how does that impact and are people aware of that from an LP perspective and pension houses in terms of M&A and P&A investors back in UK or the US, etc., and therefore the bigger thing here and the more interesting thing for me is around the perception, or indeed misperception, sometimes played out in terms of this part of the world vs. elsewhere. I’ll tell you a little story. My parents are in their late 70s; mum grew up in a small mining village in South Wales and she’s a history teacher.

Obviously she’s studied, lived through her perception of the cultural revolution. And when she came over to visit this part of the world last year, she was surprised just seeing some of the opulence and development. And I think sometimes people perceive certain parts of Asia as some sort of Lowry painting or industrial landscape. But the reality is you can jump on the fast train here and in 10 minutes you’ll be in Shenzhen, one of the most technically advanced cities in the world, which is really clean. There is VC consistent to same kind of size as Silicon Valley and therefore, the difference between the reality vs. perception I think is very, very significant. So, I think that do I see politics playing through who knows, we’re not crystal ball gazers. But certainly from a business perspective, if that geopolitical aspect continues, you’ll probably see allocations of capital to more distinct areas where we’ll see that probably play through. We’ve talked a lot about the inbound capital, Western capital planes and China in this part of the world; but what we haven’t touched on yet is kind of the growth of Chinese-based funds, who have CITIC, etc., and their dominance and how they’re looking for opportunities abroad, not just in Europe or the US, but in other parts of the world as well.

And I think that where we’re going to see that growth and that allocation of capital is probably across the Belt and Road Initiative infrastructure and indeed into Africa as well. And I think that in 20 years’ time, we’ll probably look back at this moment and think of it as a real interesting time to be sitting right here in Hong Kong, which is kind of obviously on the border between East and West.

Levack

Picking up on Josh’s point on Hong Kong, one of my responsibilities is to try to represent the PE and VC industry in Hong Kong, and clearly there’s been a lot of issues and a lot of concerns about changes here, and the national security law is the most prominent of it, and so I’ve been talking to many of the firms. The general reaction to that is that for most PE firms based in Hong Kong, whether they are a multinational firm that has its Asian headquarters here or a firm that has grown up as an Asian firm or a Chinese firm that uses Hong Kong as a stepping stone to its external investment, for a lot of those businesses, they are looking at China as one of their major investment markets already and China has consistently over the last 10 years, probably, taken 50% of all of the capital invested in Asian PE, so China is a really important market.

And because they’re investing in China, they are already subject to the Chinese national security law, which is very similar to the Hong Kong one, so they see no real change to their business process. There’s never been any great benefit for a PE firm to wade in on political issues because we’re about doing business and making investment returns by backing good companies. And therefore, for a lot of those firms, the issue of a national security law in Hong Kong doesn’t change very much. As Josh said earlier, when you look at Hong Kong, it has a proximity to the places where deals emerge, China being the biggest, but Southeast Asia and Korea and other markets, even India, are easily accessed from Hong Kong and it has been a terrifically easy place to live. It has had a really fundamentally strong law that you could rely on if you have commercial disputes. If you did get into a dispute, it is resolved properly here. And therefore, it has already become the biggest cross-border center for PE within Asia. And in addition to having that sort of lead in cross-border finance, the industry has been asking the Government in Hong Kong to make a few changes to some of the rules and regulations surrounding PE, which in the past never really had any need or asked for anything. And it has resulted in a year where there’s been an awful lot of distractions for the Government as three landmark new laws were being introduced.

In April, we had a unified fund regime that made its tax clearer for the management companies that operated out of Hong Kong. And then at the beginning of this month, the Government introduced a new limited partnership fund law, which allows, for the first time, for you to set up a limited partnership in Hong Kong. So you can actually have your fund vehicle here, which makes a lot of sense for some of the tax treaty rules. And in addition to that, the Government has announced that it will come out with a concessionary tax rate, which will apply from this year for the tax of carried interest. And those three things taken together will really help solidify Hong Kong’s position as a great place to base your PE operations. I mentioned just incidentally, EY played a really important role in the discussion of those partnership funds and carried interest tax rules, but it has really helped Hong Kong be positioned for the future.

Brown

Gentlemen, it sounds very clearly that you’re both very passionate about Hong Kong and the place that it has in the business world, and that smart business, in fact, will continue to invest in Hong Kong and in Asia more generally. Any other predictions about where you see PE going in the next 30 years in the region?

Lewsey

I think it will move to a more value-add model. There is so much try. If you look at the growth and focus and allocation of capital, the lack of options of yield elsewhere in the world, you’ll still see record amounts of dry powder and then it hitting a tipping point in this part of the world. I think funds are generally bifurcating, so kind of the ones that had the size and the scale to work with the underlying companies to drive value, they’re the ones that are succeeding.

And we have to look at some of the previous downturns. There’s a real bifurcation in terms of that performance, which we saw elsewhere. And some of the smaller funds then become niche and really effective but stuck in that middle ground and it’s a bit of no man’s land and we’ve seen that development across the asset management industry, we’ve seen bifurcation in the banking industry and I do think that, particularly with fee pressures, with low yields and low returns in bonds elsewhere, I think we’re going to see a polarization continue and be accentuated. And therefore, that leaves the haves and have-nots and I think that then the very best funds will be able to firstly, drive sustainable returns and it’s not just about sort of leveraging the balance sheet and as we’ve touched earlier on sort of drive operational value, but secondly, it’s around through the governance and sustainability of organizations that they choose to invest in.

For me that throws up massive opportunity in this part of the world, particularly, as John has highlighted, there is a small and medium-sized enterprise (SME)-dominated market here. It’s a minority state but increasingly we see that starting to change, particularly as some of the people that originated and founded companies, 20, 30, 40, 50, 60 years ago, some of those family ownerships start to change and maybe the grandson or granddaughter doesn’t want to take on the ownership and run that company in the same way it has done previously. So I think that creates real opportunity in this part of the world, but ultimately it’s around, if you’re going to be in the funds space, you’ve got to demonstrate and also, you touched on earlier Winna, on how you measure that value both from an economic perspective through the investment lens, but also in some of those intangible aspects around your impact to society more broadly, because that is how investing is moving. You only have to see the shift and focus toward environmental, social and corporate governance (ESG), long-term value and for me being part of that journey is really exciting.

Lewsey

I agree fully with Josh on those issues and I think it’s either you’re a financial conglomerate or you’re a specialist fund and that specialist fund may have a sectoral or a country focus, but you need to bring real value to the table when you’re investing and increasingly the investee companies will choose the investor for what they bring, not just the size of the check that they deliver when they come into the company. So, I think that trend is very strong and our clients, which are effectively the pension funds and other long-term investors are going to increasingly have green investment, impact investment requirements attached to the expected returns that they make. I think PE has gone down a bit of a rabbit hole on justifying its existence based on internal rate of return (IRR), which is a manipulatable issue of value and we’ll have to look at a broader set of return criteria, which would include multiples of capital invested as well as nonfinancial benefits that are being delivered.

And if we can do that and if we can keep providing the value creation. I find it really difficult to look 30 years ahead, three years is quite a long way for me. But if you ask me to think about what would be one of the significant impacts 30 years down the track, one of the concerns I have is that if we do everything right, I think it’s measurable that the financial returns that PE has delivered over the past 10 to 15 years have been significantly better than stock market returns. And as getting decent returns has become harder and harder across all sectors, more capital will be allocated toward the areas where you can get higher returns, which means you started off by talking about the trillions of allocations and the large amounts of dry powder, I think those numbers are going to get bigger. There is a whole issue about pension funds and the fact that PE sources a huge amount of its total capital from defined benefit pension funds, which are shrinking. And the real growth is in defined contribution.

And at the moment defined contribution entering PE is really difficult. There’s a mismatch on time and flexibility and tradability. If a solution can be found to that, then a whole pile of new capital could come in, which then would make our industry look subscale in terms of our ability to deliver and manage those increased amounts. And I think it will put a lot of strain on firms not to drop standards in becoming much bigger and looking for lower returns and therefore squandering the advantage that you have of holding money for a three to eight year period and being able to implement real change in your business, not just being a temporary shareholder, who when things get difficult you sell your shares and you disappear. That is not the mentality that PE uses and I think it can help justify better returns until it becomes overused or overwhelmed by the amount of capital that it is trying to deploy, but that’s real long-term stuff.

Brown

Well gentlemen, look thank you so much for your time today. Your insights and your knowledge of the Asia-Pacific market and of the history and its journey has been absolutely fascinating and I know that our audience will really appreciate hearing about the uniqueness of the market and a lot of the untapped opportunity that still resides in the Asia-Pacific market. For those PE firms that are brave enough to tackle it and to take the head-on challenge of the cultural differences and the way you do business being different from the US and Europe, but it sounds like the rewards are there for those who want to come. So, thank you again, both of you, really appreciate your time today.

 

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