Asia, driven by the giant economies of China and India, continues to attract new private equity players and money. Despite the uncertainties that rattled public markets in mid-2006, the fundamentals that have driven Asian private equity for the past five years remain as solid as ever. In the midst of this, Hong Kong is enhancing its status as the preferred base for private equity operating across Asia, outside Japan.

Growth has been over the past five years even though Asia was hit by catastrophic events such as SARs, terrorist activities and natural disasters. In 2002, USD 1.1 billion was committed to new Asian (ex-Japan) private equity funds.* However by 2005, the amount committed was USD 14.7 billion, a CAGR of 137%, encouraged by much publicized success stories of investment in Asia. Private equity backed Asian companies flourished and emerged as global players.

Up until June 2006 equity markets were at new highs producing ideal exit conditions. But continued interest rate hikes by the Fed, increases in oil prices, overheating of the Chinese economy and overall political uncertainty combined to dampen market sentiment. As the values in developed and emerging public markets shrunk, investors reacted to the tightening of liquidity and the potential slowdown in global economy. For private equity in Asia the biggest impact has been on realizations. 2004 and 2005 provided extraordinarily benign conditions for exits. Currently many firms planning IPOs are waiting for conditions to improve.

The real question is whether the more volatile market environment has changed the fundamental attractiveness of Asia for private equity investment. The answer is clearly no. Many players see the correction as providing better priced opportunities for the growing private equity pool. The fundamentals for Asia are strong and private equity is well placed to profit from the opportunities by partnering with good management teams

The recent close out of Asian focus funds also showed that even with liquidity being tightened, there is still plenty of cash seeking investment vehicles with good returns. Many Asian funds are announcing final closes well in excess of the original target figures.

As the cost of capital- both debt and equity- increases under the more bearish market conditions, the attractiveness of private equity to companies increases. As a result, the trend for PIPE deals is likely to grow at an even faster pace. Asia registered a 200% increase in PIPE deals in 2005 alone. India saw 35 capital injections into public listed companies by private equity investors, representing 79% of total PIPE deals in 2005. The current market valuations for many public listed companies make PIPE deals increasingly attractive to private equity investors. Asian private equity groups have been able to show significant value add in PIPE deals in areas such as corporate governance and strategic input.

The higher cost of capital is also likely to increase opportunities for private equity funds to participate in industry consolidation. Backing management teams, either as minority or controlling investor to buy other companies in a similar industry and consolidating rather than creating additional capacity is a good strategy at this stage of the capital cycle.

Buyouts funds are gaining momentum in Asia given the greater awareness of availability of the large funds pool and the recognition by controlling shareholders of privatization as an attractive option and that higher value that can be derived from private equity than the public market. Since 2005, 10 out of the 15 private equity firms recorded as setting up in Asia were buyout firms. The biggest of them together with 4 other new arrivals have chosen Hong Kong as their Asian base. Funds seeking opportunities in control situations accounted for USD 7.3 billion of funds committed in 2005, about 49% of total raised (source: APER) representing 17 times that of 2004.

Funds investing in infrastructure and technology have also started to make up a substantial part of the total private equity investment pool, attracting 26% and 9.24% of the new funds respectively. Western venture capitalists are looking for promising technology start ups in China, a scene not too dissimilar to India a few years ago. Among them are Sequoia Capital's USD 200 mil China fund, and the USD 290 mil fund JV between Accel Partners and IDG Technology Investment.

Overall, private equity in Asia enjoys healthy prospects. The two main markets in Asia ex Japan-China and India are still expecting a strongGDP growth rates of 9.6% and 8.9% respectively in 2006. Together they constitute almost half of the world population with a young productive demographic profile. Companies in China are starting to move away from low cost manufacturing to economic activities higher up in the value chain - more services orientated and technology driven, and to acquiring companies outside of their own market. The Lenovo-IBM deal, Nanjing Auto acquisition of MG Rover, and the failed bid for UNOCAL by CNOOC clearly demonstrate Chinese companies' global ambition. India is just beginning to open up its economy to foreign investment and allowing more liberal trade. With more corporate transparency and industry deregulation, China and India offer the prospect of excellent returns to their investors. Of the 57 deals reported divested in 2005 with IRRs of 100% and above, China and India captured 30 and 16 respectively. While current economic condition may not look as positive as a year ago, the fundamentals remain strong, with many companies in India and China backed by solid management track record and excellent value proposition looking for funds to grow and emerge as the next Baidu or Infosys. In addition, the Asian collapse of '97 taught Asian government's fiscal prudence. The government balance sheets are stronger now and more prepared to face the volatile market conditions

Challenges remain in government regulatory and tax environment, particularly in markets like PRC and Korea which may impact the execution of large buyouts. Examples are setbacks in Carlyle's quest to buy controlling stake of Xugong Construction Machinery and the failed buyout bid of Shandong Chenming Paper Holdings by CVC AsiaPacific. Funds operating in Asia have to navigate a complicated legal and tax environment. And with more firms arriving in Asia, there is increased pressure on professional resources creating a high management turnover. But these are growing pains and should not seriously affect confidence or ultimate returns.

Hong Kong's private equity industry is in the centre of this exciting area and has historically been the gateway to China. Hong Kong bourse remains the clear favorite for Chinese companies and the main exit route for private equity investors in China. In 2005, 58% of Chinese companies backed by private equity divested via Hong Kong stock exchange. Hong Kong is in pole position to benefit from opportunities that come with continued deregulation in China and potential buyouts of major state owned enterprises. At the same time, Hong Kong finance industry also has a strong connection with India in their common colonial history and legal system. Hong Kong has a competitive advantage in Asia for servicing private equity firms with its excellent infrastructure and skilled finance manpower. This, combined with the strong government support, clarity in terms of legal and fiscal operating environment ensures that Hong Kong will continue to play a leading role in Asian private equity.

* Source AVCJ