Private equity in Asia is changing rapidly. A fast-growing middle class, urbanization and rising competition are causing investors to increasingly look at more specialized sector- and country-based investments, said Pamela Fung, a principal for the Morgan Stanley Alternate Investment Partners’ Private Markets team. And competition is intensifying. “We see a lot of managers who have very strong early track records but appear to be struggling to maintain their performance.” Nevertheless, Asia’s size, rate of growth and a relatively high degree of business inefficiency in small and mid-sized companies make it an ongoing investment target, Fung noted, in this Knowledge at Wharton interview at the recent Wharton Global Forum in Hong Kong.

An edited transcript of the conversation follows.

Knowledge at Wharton: To start, please tell us about your chief responsibilities.

Fung: First, I’ll explain what Alternative Investment Partners (AIP) is, and then I’ll explain my role. Alternative Investment Partners is a group within Morgan Stanley Investment Management that focuses on providing innovative private markets solutions to a global client base. AIP manages approximately $10.5 billion in assets [as of June 30, 2017]. We invest in funds, in co-investments that we make alongside private equity (PE) funds, and in secondary interests. We invest across the entire spectrum of the global private equity universe, from buyout, to growth, to venture, to special situations.

In terms of my role, I cover our Asia-Pacific investments for the group. I am located in Hong Kong.

Knowledge at Wharton: You’ve been involved in identifying good companies to invest in for quite a while now in Asia. What do you look for in a good company, especially in Asia, versus what someone might look for in another region?

Fung: Our starting point is actually the fund, so I will begin there. In terms of looking for a good private equity fund, you look obviously at the manager’s past track record. Are the returns good? Are they mediocre or not performing very well? However, we believe it’s not just about having strong performance. When selecting a fund, we look to understand the teams that are managing the fund, what their strategy is and how that explains their past performance. We believe these qualitative factors are an integral part of the decision-making process.

If you look at a lot of the Asian funds, Asia private equity is generally pretty cyclical. In the pre-2005 era, many funds did very well. After that, the industry became a lot more crowded and as a result, I think, returns have reverted to the norm.

“We see a lot of managers who have very strong early track records but appear to be struggling to maintain their performance.”

Knowledge at Wharton: So, in Asia, growth was so strong that you could surf on top of the wave, without a lot of competition?

Fung: Exactly. Now, however, the Asian private equity space is not so easy to navigate. We see a lot of managers who have very strong early track records but appear to be struggling to maintain their performance. It requires strong diligence skills to really understand how these managers are generating their returns.

Knowledge at Wharton: Your background has been also actually in choosing companies — working to evaluate companies. You worked on mergers and acquisitions, and that kind of thing.

Fung: Right. Before Morgan Stanley Investment Management, I was in management consulting with McKinsey, and before that, with Monitor. Some of the projects I worked on at McKinsey and Monitor were about helping private equity firms or investors assess what industries they should go after, identifying targets that they should pursue. I was also involved in screening some of the targets they had already identified through commercial due diligence, assessing whether they were good or bad investments. One of the responsibilities in my current role is to assess co-investments alongside general partners (GPs) we have backed.

Knowledge at Wharton: When it comes to looking at a fund now, are they sometimes more specialized in a particular industry or sector? You’re looking for the strong ones, obviously. What are the best areas for people to be looking at now?

Fung: Something I should mention first … is how Asia differs from the U.S. and Europe. In particular, there are a lot of differences in sector specialization. In the U.S., you’ll find a lot of private equity firms specializing in one sector only. For example, we’ve invested with a group that only focuses on helping companies with their branding in the consumer space. This is very specialized.

We view Europe as halfway between the U.S. and Asia, where specialization is still emerging. In Asia right now, you’ll see funds focused on health care, you’ll also see a lot of consumer-focused funds. But there aren’t a lot of true specialists, in the sense that you get in the U.S.

“We’re now seeing a lot of country-specific funds. Before, the view was that being country-specific might be too risky.”

Knowledge at Wharton: What about specializing in countries? For example, China, versus the rest of Asia.

Fung: That’s a very interesting point. I was alluding to the 2005 era earlier. Back then, you didn’t really have country-specific funds. I would say the emergence of country funds really started in the 2009-onward era. We’re now seeing a lot of country-specific funds. Before, the view was that being country-specific might be too risky. There is a great deal of country risk, especially in certain countries in Southeast Asia, which some are considered frontier countries. But now the pool of talent in each country is fairly deep, so it is possible to build a portfolio of country-specific funds.

Knowledge at Wharton: Which countries look most interesting?

Fung: China, of course, is the obvious one. It’s a very attractive country in terms of growth potential and opportunities — but it’s also an over-capitalized market. There’s already a lot of private equity money in China, and  many investors, strategic investors, corporates, who are also looking to invest in private equity deals. As a result, valuations in China are pretty high compared to the rest of the region.

The concern in China is also that many of these deals are minority-stake deals, where you have to exit through an IPO. In China, the IPO window is open and shut continuously. So, you really need to be careful that you’re backing a general partner who has thought about the exit potential of each deal.

Knowledge at Wharton: When you say “open and shut,” it’s not in the sense that — let’s say in the U.S., the market’s just not good, and so it’s not a good time to float something. In China, it’s the government’s heavy hand opening and shutting the door.

Fung: The government has been trying to move for years from an approval-based system to a registration-based system, with varying degrees of success. When I say “open and shut,” this is in part due to the regulator and in part due to market volatility. You may have seen the surge two or three years ago followed by the very large dip we experienced right after. This is reflective of both market forces and regulatory impact, which you don’t have in the U.S.

Knowledge at Wharton: Tell us why is it interesting to invest in Asia-specific companies today?

Fung: As a private equity investor, I think the opportunity is that Asia so far is a sizable, fast-growing region. There’s also a lot of inefficiency in the system. Each country has its own idiosyncrasies. In China, there are still many state-owned companies, not efficiently run. In the broader Southeast Asia region, you have a large number of family-owned companies that are going through succession issues. They’re also being run as a family holding company, as opposed to professional managers running the company.

Some markets are more transparent than others, so you may be able to get into deals that are more attractively priced compared to the private and public markets.

When we’re looking at co-investments, what we’re really looking for is — is there a good growth potential in this company? Are there attractive market tail winds? Is there room for the GP [general partner] to come in and help the company to improve efficiency and operations, thereby improving margins? Are they getting the deal at an attractive valuation, because they have some kind of angle or they have some kind of proprietary situation?

“Valuations in China are pretty high compared to the rest of the region.”

Knowledge at Wharton: In the U.S., typically, the private equity companies want to take a majority position. Is that different in Asia, with these family-owned businesses?

Fung: Yes, I think the ability to get majority stakes is a key difference between Asian private equity and the U.S. and Europe. In certain Asian countries it is difficult to obtain control. India and China are minority-focused markets. Southeast Asia is a bit of a mix of both. You can get control in certain countries and certain situations. Japan and Korea are more established buyout markets.

With respect to families, it depends on the family situation. In China, for example, there are still a lot of first-generation entrepreneurs. As a result, unless they’re ready to retire, the owner is generally not willing to give up control of the business. Accordingly, in a buyout situation, you need to proceed very carefully. For example, it is often the case that owners are willing to sell control because they don’t have a positive view of the outlook of their company.

Knowledge at Wharton:  The other difference between China and the rest of Asia is demographics. China is aging. The rest of Asia is so young.

Fung: This is an interesting point. Yes, China is aging but certain pockets in Southeast Asia are also aging. For example, Thailand’s population is not as young as you might think.

Knowledge at Wharton: How does that change your investment view? You mentioned health care. I’m assuming there’s some connection there, for example.

Fung:  Right. The reason why there are a lot of health care funds in China is because it is an attractive opportunity. The aging population is obviously a driver but, additionally, you also have a growing middle class, which is a very attractive growth driver for most Asian countries. This is why investors have found health care private equity to be so interesting, and many people are moving into that space.

Knowledge at Wharton: What are some of the other interesting sectors — because of this growing middle class, which is changing everything? And also, I think another big theme is urbanization.

Fung: Exactly. I’d say the consumer sector. Again, the growing middle class and an increase in consumption — the switch from an unorganized, informal sector, to a more organized one. The transition from unbranded goods to branded goods. Many groups may tap into that as well.

Other themes that are interesting: Education is an important one. With growing household incomes, you see an increasing number of families able to pay for their children’s educations. These are themes where we see substantial market tail winds. Obviously, everybody sees the same trends, so a lot of money is rushing into these few sectors.

Knowledge at Wharton: How does private equity invest in private companies for education?

Fung: This is something that’s very localized. We’ve seen a lot of education deals perform well. However, the regulations in each country, and even within China, in each province, differ greatly so it is very important that you are aware of this and understand the regulations specific to each jurisdiction.

Knowledge at Wharton: What is the size of the private equity market in Asia?

Fung: Asia represents approximately 10% of global private equity investment [based on Morgan Stanley AIP data, August, 2017]. If you think of private equity investment as a percentage of GDP — what we call PE penetration — more developed countries are typically at 1%-2%. In Asia, you’re looking at, I would say, approximately 0.5%. India’s a little bit higher. China’s a little bit lower. Japan is very under-penetrated.

“The average life cycle of a deal in Asia is probably slightly longer.”

Knowledge at Wharton: That suggests there are more opportunities.

Fung: There will definitely be growth in the Asian private equity markets going forward. It will come and go. You’ll see a lot of money rushing into the sector, and then a lot of money pulling out of the sector. I think the overall trend, however, is definitely growth. I would say that the other key trend I think we’ll see is increasing specialization. You’re starting to see the emergence of that with health care and consumer-focused funds. Maybe a few years from now we’ll start to see specialization in different industries.

Knowledge at Wharton: If you have a family-owned business and they work with a private equity partner who has a minority stake, it sounds like it could be messy at times. Because you’ve got to agree on when to sell, and that sort of thing. What are the major challenges?

Fung: One of the main challenges lies in the ability to implement the changes the private equity firm wishes to make. Another challenge, a few years down the line, would be if the private equity firm cannot sell its stake, or convince the other side to sell the company. You should note, though, it’s not just a problem with minority-stake deals. It can be a problem with control deals as well, where the original founder has sold the majority or even all of the company, but still maintains a very heavy influence on the company. So, I would say relationship management in private equity in Asia is pretty key.

Knowledge at Wharton: We’ve had this major development with the U.S. walking away from the Trans-Pacific Partnership. What will be the effect on PE?

Fung: It depends what kind of businesses you’re talking about. Obviously, you will see more impact on companies that export a large share of their production compared to local companies focusing more on domestic markets. The good thing about private equity I would say is that it is typically a bottom-up industry. So, while there will be some impact, the key driver is more the bottom-up approach as opposed to larger macro-events.

Knowledge at Wharton: One other thing is the life cycle of the project. So, a company is taken over, or invested in. And typically, there’s a certain amount of time before a company is sold – perhaps five years in the U.S. Is it similar in Asia?

Fung: The average life cycle of a deal in Asia is probably slightly longer. That said, the standard deviation is likely to be wider than in the U.S. Deals with short life cycle are typically PE firms investing in private companies and then quickly trying to take them public, taking advantage of the valuation arbitrage. This is not private equity in the western sense, but it happens frequently in Asia.

Deals with longer life cycle are also those involving IPOs. As we discussed earlier, the windows for IPOs in China historically have fluctuated greatly. We have also seen this in India, where exiting investments has been difficult. So a longer life cycle is often a consequence of fewer exit windows than what we may have in, say, the U.S.

Knowledge at Wharton: What is the difference between investing in a private equity fund, versus a fund of funds?

Fung: There are two ways to invest in private equity. You can either invest directly in a private equity fund, which in turn invests in companies, or you can invest via a fund of funds. Investing in a fund of funds, as opposed to investing in a private equity fund, can bring a number of advantages. The first one is diversification (though that does not eliminate the risk of loss). If you don’t have a large amount of money to invest in private equity, investing in a fund of funds may provide you with broad diversification that cannot be achieved by investing in a single private equity fund. Diversification will be in terms of type of strategy (buyout, venture, distressed, etc.), geography, industry sectors, technique (investment in funds, co-investments, and secondary interests). A more diversified portfolio may provide you with downside protection and can help take your money further.

The second benefit is investment expertise. We constantly meet with and evaluate managers, scanning systematically the private equity landscape. This, we believe, allows us to select for our investors the best investment opportunities available at any time in the marketplace.

The third advantage relates to portfolio management, which can be extremely complicated and cumbersome, for example, dealing with the reporting, administrative and operational work, understanding tax issues, etc.  Having a third-party provider that is able to manage that for you is definitely a bonus.

The main drawbacks of investing in a fund of funds versus directly into a PE fund are the additional layer of fees and carry that the fund of funds investor needs to pay, the longer fund duration and the investor’s visibility into the portfolio – since fund of funds are highly diversified, it is harder to keep track of the underlying exposures.

Knowledge at Wharton: Is it fair to think of this [a fund of funds] as a mutual fund made up of private equity companies — not unlike a mutual fund of stocks, where you’re diversified so you’re reducing risks, and you’re working with someone who’s got expertise in many areas?

Fung: You could say that, yes. It’s a fund made up of private equity funds and private equity companies, though unlike mutual funds, private equity fund of funds are generally privately placed and are dealing with private companies and funds where information flow is less transparent.