Tuesday, March 12, 2013

Asian Conglomerates As PE Replacements?

I've heard from several sources that returns from private equity (PE) funds investing in Asia, and their fund-of-funds equivalents, have had poor returns.

At the same time, many family owned and controlled conglomerates in Asia are criticized for 'asset-trading', which sounds like PE-type investment strategy.

My question is the following: what if one viewed, invested and valued Asian conglomerates like a PE alternative rather than an operating company?

This would involve not just looking at current business lines but also the conglomerate's investment track record.  Instead of evaluating the CEO/Chairman as an operator, perhaps look at the group's long-term investment returns and prospects, and how much of this is distributed to minority investors.  As compared with PE investments investors in listed companies have a timing advantage and an information advantage as the investor can buy when shares overshoot on the downside (late 1998/early 1999), and company insiders need to disclose when they buy and sell shares. 

Conglomerates retain optionality. A key advantage for conglomerates is retaining the option of when to sell. Unlike PE funds, conglomerates are not subject to exiting their investments in a predetermined time period, which is typically 7-10 years for PE funds.

Thus the PE fund is giving up the option to hold its investments past the life of the fund. To raise the next fund, there is a powerful incentive for managers to realize capital gains quickly rather than holding on for a higher value.  Forced, or pressured selling, is not a very good way to get top dollar.  (This is not my thinking but rather from reading a study on the subject as part of the CAIA program.  But logically this makes sense).

Asian markets tend to be more volatile than those in the US so putting a time-frame on selling could lead to additional diminished returns for Asian PE investors.

Options have value and PE fund managers are under pressure - internally and externally - to give up this option.

People like Li Ka-shing and his Cheung Kong Holdings, as well as many other family-run conglomerates, have done very well by retaining and acting on this 'option' at the right time.  (It has also been written that Li Ka-shing very rarely losses money when he buys shares in companies he controls.  I suspect, but don't know, that this is the case for similar insiders).   

Operating Knowledge.  Another advantage is inside operating knowledge.  Most Asian conglomerates focus on one or two key business lines with a healthy dose of property somewhere in the mix.  This likely means they have insiders' knowledge when investing in a competing or complimentary business. This may give them an advantage over a PE fund which are more than likely more interested in the financial returns only rather than strategic, longer-term returns.

This can be is different then Silicon Valley and the US where many funds are started by ex-entrepreneurs and/or businessmen.  In Asia, most PE funds are started and staffed by bankers and financial types, rather than operators.  This puts them at a disadvantage in many instances.  Conglomerates thus may have an edge in buying and building businesses.

There are a lot of risks to investing in Asia-based conglomerates.  Taking money out of the listco via negative transfer pricing; long-term operational pump-and-dumps; selling and buying assets from the parent; valuation difficulties from multiple business lines, lack of business line concentration, replication of fund manager's diversification, etc.

But at the same time, there could be several unrecognized - and therefore likely undervalued - embedded options in the conglomerate that investors can ultimately benefit from. 

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