With strong economic growth, surging middle class populations and a hunger for capital and business expertise, emerging markets in Asia look like rich hunting grounds for private equity (PE) firms. But there are hurdles: slowing growth rates in some areas, political uncertainty, unfamiliar business cultures and today's tighter lending standards.

Private equity investments in Asia, while often profitable and still promising, are not easy pickings. "Today, no discussion on private equity is considered comprehensive without touching upon PE in emerging markets," say the authors of a research report, SME Private Equity 2.0: GDPs, Accounting Deficits, Proprietary Sourcing and Operations.

The authors of the study are Saumil Annegiri, a recent Wharton graduate who has worked on private equity deals in India and the U.S. and now works as an investment banker; Suhas Kulkarni, former executive director of UBS Investment Bank and CEO of Hydrolines Group in India, who now is a dealmaker in industries such as natural resources, energy and technology products; and Stephen M. Sammut, a senior fellow and lecturer at Wharton who has long studied private equity in emerging markets. They find that small- and medium-sized enterprises (SMEs) are the sweet spot for PE investments in Asia. The PE firms that succeed, they say, will be those best able to develop good personal relationships with potential target firms and other industry players, along with skills for providing portfolio companies with significant operational upgrades, not just financial engineering.

Emphasizing the unfamiliar characteristics of many Asian markets, the authors observe that: "Amidst a constantly adapting and dynamic landscape, most [general partners], even successful ones, are relegated to learning along the way, or to practicing a trial-and-error approach…. As the industry evolved in these geographies, SMEs have now become the flavor of the month, given smaller deal sizes available, a robust deal pipeline of family-owned businesses and the lack of leverage for large [leveraged buyouts]."

That doesn't mean profits will come easily. PE and venture capital firms reported a plunge in returns in Asia for the year ended in September 2011, from 30.9% to 10.9%, closely matching results of PE and VC funds in emerging markets worldwide. Overall, conditions in Asia were sobering in 2011, the authors write, noting that some Asian currencies lost value, some countries experienced deficits, and even powerhouses like China and India are displaying some economic weaknesses.

"While concerns of investing in the 'East' had been well documented, this was the first time that investor bullishness saw a re-evaluation," the authors say, observing that "not even 2008 really shook the emerging markets story as much."

Asia's Appeal

Still, Asia remains appealing. Asia-oriented funds drew more fundraising in 2011 than any region except the United States, with surveys showing that the chief attraction was the potential for high returns rather than issues like portfolio diversification. A November 2011 survey of PE investors by Ernst & Young found that 70% expected to significantly or slightly expand holdings targeted to the Asia/Pacific region, while only 1% said they would cut back significantly. The survey showed that "Asia bullishness will sustain in the medium term," the authors write, noting that China and India continue to get the lion's share of PE allocations to Asia.

Each of the major economies in the region offers a unique mix of opportunities and risks:


Though still enviable by Western standards, economic growth is slowing in China, with gross domestic product expected to increase by 7.5 % in 2012 and 7.1% in 2013 compared to 9.1% in 2011.

Among the concerns: Domestic consumption still remains only 40% of GDP, low compared to developed nations, and the country's heavy reliance on exports makes it susceptible to "export shocks" from factors like lower demand in Europe, the authors write.

"Moreover, beyond concerns over a questionable growth model, with more money going in (investment) than coming out (consumption), a weakening currency, manufacturing and services output, [and a] stressed banking sector all are serving to be a drag on the overall economy. If this wasn't sufficient, possibly [for] the first time since China started its March toward double-digit growth, the country is starting to feel rumblings of dissatisfaction politically."

Nonetheless, there are positive features, such as an expected rise in per capita income and lending rates in the low single digits. The migration of the rural population to cities remains strong, privatization of state-owned firms creates a demand for PE capital, and the government has been easing regulations to attract PE firms.

China, the authors note, "still has a treasure chest of foreign reserves to protect against external shocks and is still the fastest growing economy with a massive trade surplus. Moreover, we have still not seen global brands emerge consistently from China, and this may just keep the aspiration of the next big wave alive. Despite the concerns, possibly dangerously, investors have not backed down in part because the country still offers them one of the best risk-adjusted returns relative to any part of the world…. With over $10 billion deployed just in 2011 and local LPs starting to emerge, this [PE demand] is bound to keep growing."


GDP growth is expected to slow in China and may also slow in India, to less than 6.5% in 2013 compared to 7.3% in 2012 and 6.8% in 2011. Lending rates are higher, however — 6.0% in 2012 and projected for 2013 — and the stock market has fallen by more than 25% since November 2010, while the rupee has depreciated about 20% since summer 2011. Government deficits are growing.

"Inflation rates and interest rates have held at a steady high, agricultural efficiencies are low and, although domestic consumption was supposed to be the big story behind growth, it is not near the level of exports-based growth, with per capita income oscillating around a dismal $1,500," the authors write. "To worsen matters, not dissimilar to China, political instability/competence is a prominent investor concern. The lure of a deregulated retail sector vanished when political factions blocked the way."

PE investments have recovered somewhat from 2009 levels of about $4 billion, but at $6.17 billion in 2011 they were actually behind the 2010 level of $6.22 billion. Nonetheless, PE firms find promise in India, with more than 250 opening shop in the past five years.


Once again, growth is strong compared to developed countries, though wavering, with GDP up 6.5% in 2011 and expected to be 5.8% in 2012 and 6.2% in 2013. Per capita income is relatively high, at about $3,500 in 2011 compared to about $5,300 in China and $1,500 in India. Unfortunately, lending rates are sky-high, at 14.8% in 2011, 14.4% in 2012 and an expected 14.9% in 2013.

"One of the better geographies to weather the storm during the financial crises, Indonesia, along with Singapore and Malaysia, is increasingly catching investors' fancy," the authors say. "Although issues with physical infrastructure, high unemployment and [a] slower growth rate bog [down] the country, investors are finding appeal in the strategic location between the Indian and Pacific Ocean and its resource richness…."

A rise in Islamic financing and strong performance by the equity markets and economy during the financial crisis make Indonesia an attractive PE location.


Here, economic growth has been weaker than in the big Asian powerhouses, with GDP up 4.8% in 2011 and expected to fall to only 2.6% in 2012 and 3.5% in 2013. An inflation rate near 5% and loss of exports are key factors.

Still, there are significant positives: a strong account surplus, the government's power to manage the currency, and the potential for economic diversification. "Diversification opportunities exist in developing and expanding high tech, biotech and pharmaceuticals with supportive policies from the government and make-it-happen partnerships from local funds, corporations and universities," the authors say. Per capita income is very high, topping $51,000 in 2011 and expected to keep growing.


GDP growth is similar to Singapore's, at 4.5% in 2011 and projected to be 3.2% for 2012 and 4.6% in 2013. Per capita income is not as stunning as in Singapore, but still robust, at about $9,100 in 2011. Malaysia is transforming from a commodities-based economy to a computer and electronics producer.

Despite a decline in the growth rate, there are numerous positive features, the authors say, including "a high level of foreign reserves, a strong account surplus, proactive policies by the government to handle inflation, and moderate and stable politics." According to the authors, Malaysia has an "opportunity to develop and expand high tech, biotech, IT solutions and Islamic financial products with make-it-happen partnerships with local corporations and financial institutions."


Growth trails that of China and India, but is strong by Western standards, at 5.9% in 2011 and projected to be 5.8% in 2012 and 6.5% in 2013. Incomes, however, remain very low, at about $1,350 in 2011.

Vietnam, the authors say, is on the upswing. "In the last 20 years, Vietnam's poverty rate has fallen from 58% to 10% and it has earned its place as one of the top five fastest-growing economies in Asia," the authors point out, cautioning, however, that "account and trade deficits and an overall weak currency inhibit some of the country's potential."

Nonetheless, Vietnam benefits from political stability and membership in the World Trade Organization, which gives it access to foreign capital and financial markets. PE investors are also attracted by the country's urbanization, demographic features and pace of privatization.


How can PE firms insure the best chance of success in Asia? The authors identify two key strategies.

First is to develop "proprietary sourcing" of PE acquisitions, to get the lowest purchase prices possible. This requires developing an "insider network to get better terms on the deal," thus allowing the PE firm to avoid the bidding wars that often accompany auction-based purchases.

To improve their information and gain an inside track, the PE firm should nurture personal relationships with a range of knowledgeable sources: accountants, lawyers, credit rating officers, tax inspectors, executive coaches, personal wealth mangers and journalists.

The PE firm should also realize that the owners of a small or mid-sized target may have a range of interests aside from earnings, making personal relationships essential. "Creativity, empathy and an inherent interest in people are necessary to build such relationships," the authors explain. "To invest in an SME, an investor must first appreciate the personal needs of the founder and those who are in his circle of trust. Is it succession planning that worries him? Does he wish his children were more involved in the business? Can you push forward the aspirations of those in his circle of trust somehow?"

The second key to success is "operational involvement," as the owners of SMEs are typically wary of PE firms that simply hope to provide capital and then ride the company's coattails as it grows. SMEs that make attractive acquisitions often do not need PE capital, "but can see the lure of growing business to the next level, either with a higher profile or a larger-scale customer," the authors write.

"However, to get to the next level, you don't just need capital and business development but also a retooling of the organization to ensure you don't feel like a fish out of water while meeting with such a potential customer. PE firms that appreciate such nuances are attractive…."

Clearly, deals vary, and it is not possible to establish a universal formula for allocating resources to strategies like generating proprietary networks and developing operational improvements. But the authors say PE firms should keep on top of distinctions between the deals won with a proprietary advantage and those done without it. Among the measures to watch: the price paid, the stake acquired versus the stake sought, and the time and money spent during the process of originating the deal to closing the purchase.

In addition, PE firms should study the contrasts between the deals and funds that emphasize operational improvements with ones that do not. That should involve looking at the composition of teams of professionals used, tracking the time and money spent on internal and external operations, and measuring factors like numbers of factory visits, calls handled and potential acquisitions researched, and the revenues and margins achieved.

The best opportunities, the authors emphasize, will continue to be among small and medium-sized firms. Operational improvements are especially important to such firms, which are abundant in most Asian countries. "The lure of SMEs for PE firms started once [PE firms] came to terms with the reality that neither large targets nor significant leverage was available for deals, and that SMEs offered high growth, quickly." That has been the case in recent years, and is likely to be so for some time to come — as long as investors go about things the right way.