Monday, September 23, 2013

Ontario Teachers Cautious on China?

Isabella Steger of the Wall Street Journal reports, Ontario Teachers' Pension Plan Cautious About Investing in China:
The Ontario Teachers' Pension Plan, one of the world's biggest pension funds, opened its Hong Kong office with a note of caution about investing in China, saying lack of clear information could make it difficult to invest there.

"I think we have to proceed with caution" in China, said chief executive Jim Leech, who is due to retire at the end of the year after six years in the top job.

The fund, which has about 129.5 billion Canadian dollars ($125.9 billion) in assets under management on behalf of about 300,000 teachers in Canada's most populous province, officially opened its Hong Kong office on Monday, its second major international office after London. The fund currently has about C$1.5 billion invested in the Asian-Pacific region, but faces rising competition from other investors including private-equity funds and sovereign-wealth funds that are flush with cash and rival pension funds, all of which have had footholds in the region for years.

In China, the fund's most high-profile holding is a $300 million investment in Jingdong Century Trading Co., which runs online shopping site, according to S&P Capital IQ data. The company isn't listed.

Chief investment officer Neil Petroff said that conducting due diligence in China was a big hurdle to getting deals done. "If we don't have the right information and we can't get it, it is a non-starter," he said.

In Asia-Pacific, the fund biggest deal to date is a $2.3 billion co-investment with Hastings Funds Management in a New South Wales desalination plant in May 2012, according to Dealogic data. In March, it struck a deal to buy a majority stake in the telecommunication assets of Australia's largest construction company, Leighton Holdings Ltd., for 619.5 million Australian dollars ($579.5 million).

Competition is heating up in the Asia-Pacific region for quality infrastructure assets, particularly in mature and well-regulated markets like Australia. The Ontario fund lost out on a deal to buy Port Botany and Port Kembla in New South Wales earlier this year to a consortium including Abu Dhabi Investment Authority and Industry Funds Management, which bought the assets for $5.3 billion. The Ontario fund competed against other Canadian pension funds in the process, including Alberta Investment Management Corp. and Canadian Pension Plan Investment Board. Caisse de depot et placement du Quebec has also been active in Australia.

Mr. Petroff said the fund "missed a great deal" in Port Botany and Port Kembla, with its offer price falling just $12 million short of the final sum paid.

The Ontario Teachers' Hong Kong office is also opening at a time its competitors at home are escalating their interest in the region. Canada Pension Plan Investment Board, which has had a Hong Kong office for a few years, appointed former Goldman Sachs Group Inc.'s vice chairman in Asia-Pacific excluding Japan, Mark Machin, as its Asia president last year. In China, CPPIB recently raised its investment in a logistics joint venture with Australia's Goodman Group by $400 million.

Mr. Leech said the fund sees opportunities with wealthy families in Asia. Unlike private-equity firms, who typically have a three- to five-year investment horizon, his fund "could play very well with some families in Asia" who prefer longer-term investors, he added.

"In any market that is emerging, [wealthy families] are a source of investments" when they tackle inter-generational succession issues. "We see it over and over whether in Latin America, India or Turkey," said Mr. Leech.

The fund posted a return of 13% for 2012 compared with its internal benchmark of 11%. Mr. Leech will be succeeded by Ron Mock, currently the head of fixed income and alternative investments at the pension fund.
Investing in China is not easy. There is tremendous growth but the market lacks key characteristics that are required for funds to invest properly. In particular, lack of transparency and an underdeveloped legal and regulatory system are major deterrents for Canadian pension funds that invest billions in public and private markets. That is why the focus has been in Australia which benefits from China's growth but also has the key elements found in mature, well-regulated markets.

There is another problem investing in Asia. A recent article in Asian Investor discusses how CPPIB and Singapore's Northstar Group are having a hard time sourcing private equity expertise in the region to staff their offices. The lack of private equity expertise in Asia presents serious challenges to Canadian pension funds investing in the region.

Still, Canada's largest pension funds remain undeterred and are forging ahead. Peter Guy of Investments & Pensions Asia reports, Ontario Teachers’ Pension eyes opportunities in Asia:
The Ontario Teachers’ Pension Plan (OTPP) has opened an office in Hong Kong, reflecting its proactive investment approach and the growth of Asia.

OTPP, the largest single profession pension plan in Canada with CAD130bn ($126bn) in AUM, says its presence in Hong Kong should enhance its ability to operate in the entire region. Wayne Kozun, Senior Vice President, Public Equities, says: “Today, with our Hong Kong office we can execute relationship deals in Asia.”

Working closely with external asset managers in Asia remains an important objective. According to Jane Rowe, Senior Vice-President, Teacher’s Private Capital and Infrastructure, “We take a long term view on Asia and China and intend to ride out short term cycles. We look for teams of GPs whose investment philosophy and methods are consistent with OTPP’s beliefs. Talented GPs with a sound track record also provide us with future deal flow sources and co-investment opportunities.”

Since OTPP’s inception in 1990, more than three quarters of the plan’s income has come from investments. When the plan started investing in financial markets, the fund stood at $19bn. Since then its investments have earned an average annual return of 10.1%.

Kozun adds: “Our style of relationship investing, where we become the second or third largest shareholder, is one of the ways we operate and add value. It also means that we may have a board seat and work closely with management. But, we are not an activist style, public investor. We are cooperative and supportive like our relationship with our investment in Hitachi.”

Presently, OTPP has deployed about $12bn allocated to private capital or private equity, of which $1.5bn is in Asian, regional private equity funds specialising in geographical or industrial sectors. Another $1bn is still available and committed to be drawn down by mandated PE funds. “A GP that truly adds value is paramount to us beyond financial engineering, rising multiples or access to IPO markets,” says Rowe about their standards for GPs.

OTPP has two Asian private equity mandates left for this year, Rowe adds. “We are looking for other managers with good, value adding strategies. In PE, we are looking for co-investment opportunities. OTPP adds value through its six industry specialty teams to work with Asian GPs on due diligence, governance - all to add value.”

OTPP is looking for pan-Asian opportunities, including India, but excluding frontier markets. Kozun says: “We are surprised at the abrupt sell off in emerging markets due to tapering and opportunities are out there. Our $300m QFII allocation, will be applied to A-Shares. The quota will also be used with external managers so that’s one of the reasons we have located to Asia.”

OTPP’s minimum investment size is usually $75m and aims for generating top quartile returns on its investments. They aren’t involved in fund of funds strategies; rather, they are proactive. Rowe currently favours Asia consumer themes. “This year we are focused on value creation in our investees working with them rather than putting new capital to work.”
Finding the right general partners is the key to long-term success in Asia. If Canadian funds fly solo in this region, they will get killed. As I've previously discussed, Asia is a hot market for private equity giants but even they are struggling with China's slowdown and are now pushing banks to offer more leverage:
China’s economic slowdown is prompting private equity firms to change their tactics to maintain returns in the country, with one suggestion being to push banks to provide more leverage and finance recapitalisations of portfolio companies.

“With the slowdown in economic growth, being a passive minority investor in an unlevered company is a pretty hard way to make private equity level returns,” said Stephen Peel, co-head in Asia for US private equity firm TPG, at the SuperReturn Asian 2013 conference in Hong Kong last week.

There have been very few leveraged buyouts in China and private equity firms have made most of their money taking small stakes in companies and piggybacking off economic growth spurring revenue growth. That model is now looking increasingly flawed.

“We need to find deals where we can get greater control than we have historically and where we can use more leverage to drive down the cost of capital and push up equity returns,” said Peel.

The challenge private equity firms face is that, in China, onshore acquisition finance is not permitted. Instead, funds have to find financing offshore, which is tricky when most of the companies' assets that can be used as collateral are on the mainland.

“It’s a long way off the efficient buyouts you see in North America or Europe,” said Peel.

Another method is to find a company that is already levered. TPG invested in Shenzhen Development Bank, which as a bank already has a highly geared balance sheet because it makes loans as a business. TPG still owns a leasing company called Unitrust, which is levered about 8:1 said Peel.

“We are looking more and more for businesses that inherently have leverage,” said Peel.

Carlyle’s co-head in Asia, X.D. Yang, who started in the private equity business in 1995, sees the Chinese buyout market evolving rapidly, spurred by the Chinese banks.

“I see evolution happening quickly in the next three to five years,” said Yang during the conference. “Once one or two of model deals get done then the rest of the market will follow.”

Yang was speaking after Carlyle recently completed China’s largest ever leveraged buyout, the $3.7 billion privatisation of US-listed Focus Media Holding.

Carlyle Group and China-based FountainVest Partners helped the display advertising company’s chairman Jason Jiang take the firm private and own 19.7% each.

“Lining up financing for the deal took quite a while,” said Carlyle’s Yang.

It was complicated by the fact that the financing vehicle was offshore and the cashflow from the business was onshore in China. “That took some education.”

“In the end the Chinese banks provided the majority of the financing,” said Carlyle’s Yang.

The banks providing the $1.5 billion loan included China Minsheng Bank, Industrial & Commercial Bank of China and China Development Bank, alongside Western banks. They then parceled out $1.08 billion of the loan to other banks.

“The Chinese banks clearly viewed leverage finance as a business that they have been studying for years and this was a test case,” he said.

“The next step is to educate the Chinese banks how to do a dividend recap,” said Carlyle’s Yang. “It’s a tried and true model in other markets, but Chinese banks need to be convinced that the shareholder can take capital out of the company while the banks stay put.”

A dividend recap adds more debt onto the company in order to pay its shareholders a dividend.

Ming Lu, regional head for Southeast Asia, KKR agreed that private equity’s minority investment model in China is looking increasingly flawed due to the economic slowdown. However, much as KKR would like to take control of top-tier businesses in China and lever them up, it is not always possible.

“High-quality businesses are not for sale in China, particularly for control,” said Lu.

Therefore he thinks: “Minority growth equity investment will remain the mainstay for the forseeable future .”
I agree with KKR's Lu, minority growth equity investment will remain the mainstay for the forseeable future and private equity firms looking for more leverage or eying dividend recaps to generate returns in a slowing economic environment will be disappointed.

And I'm not so sure this is a bad thing. The last thing the world needs is a leveraged buyout frenzy developing in China, exposing their banks to serious downside risks. True, Focus Media was a success and leverage finance can benefit growth, but I have a more tempered view believing China isn't ready for Western-style leveraged buyouts (eventually it will be but not now).

All this to say that Jim Leech and Neil Petroff are right to be cautious on China. There are incredible opportunities but many structural challenges that are not easily addressed.

Below,  Pantheon Private Equity's Kevin Albert and Palico CEO Antoine Drean discuss the private equity market with Pimm Fox on Bloomberg Television's "Taking Stock." And Andy Xie, a former chief Asia economist at Morgan Stanley, talks about India and China's economic outlook. He speaks in Hong Kong with Angie Lau on Bloomberg Television's "Asia Edge."