Adventures in Private Equity
Tom Lembong | December 02, 2011

In the future, 2009-2011 are likely to be remembered as the years that Indonesia's home-grown private equity (PE) industry really came into its own. However, it’s more like a jubilant exit from infancy that may soon be followed by the many awkward challenges of adolescence.

Like a fast-developing teenager, the Indonesian PE industry is currently experiencing a startling growth spurt, pimples and all. The headline event of 2011 is of course the phenomenal fund-raising success of Northstar Pacific, which raised $840 million for its third fund, an astonishing amount for an Indonesia-focused PE fund even today.

In its wake, a whole raft of Indonesia-focused PE funds has launched. And the queues of international PE investors at Jakarta airport immigration seem to get longer every week.

Private equity is one of a trio of players in a broader alternative investments arena in Indonesia that also encompasses hedge funds and mostly local “opportunistic” investors. By definition, the alternative investments sector is lightly regulated because it sources its funding from only sophisticated investors and not from innocent retail investors.

This light regulation makes data hard to come by, but it does seem that the hedge funds continue to be a larger presence than private equity, with “local opportunistic” investors in second place. Given how private equity has hogged the headlines this year, this ranking may come as a surprise to many.

The $1.35 billion margin-loan backed by shares of Bumi Plc. which is in the process of being repaid from a sale of Bumi Plc. shares to PT Borneo Lumbung is one rare glimpse into the world of hedge fund investing in Indonesia.

At such size, that single share financing dwarfs all private equity investing in Indonesia – and that’s just one single hedge fund deal.

Beyond such occasional high-profile mammoth deals, anecdotal evidence suggests that hedge fund investing in Indonesia has multiplied this year thanks both to expansion by existing players and the arrival of new ones. I believe many hedge funds have built up very meaningful positions in many Indonesian publicly listed stocks.

The godfathers of alternative capital providers are the local opportunistic funding providers, primarily wealthy local families and individuals. Often overlooked in the international media enthusiasm for hedge funds and private equity, these players are in my view actually the most potent of the trio.

Being fully self-funded and thus accountable only to themselves and not to potentially fickle third-party investors, they have the ability to muster the fastest speed and the greatest stamina in providing capital into high-risk/high-return investments.

In the meantime, the experiences of my own firm, Quvat Capital, illustrate the homegrown private equity sector’s growing pains. After flying high in 2006-2010, we stumbled last summer. We had raised $205 million for our third fund by June of last year, only to suffer a “Key Person Event” (in industry parlance) a mere two months later when one of our five founders abruptly decided to retire.

We did not realize it at the time, but in PE industry etiquette, that is a serious blunder. We thus decided earlier this year to suspend our third fund (we’re still managing our first and second funds, and will be returning to the market for our third fund at some point).

With the market left wide open by our retreat, Northstar stepped into the breach and lapped up the robust global demand for Indonesian PE exposure. Saratoga seems set to follow suit shortly. Kudos to them and congratulations. Nothing will do more to ensure the long-term health of the Indonesian PE industry than vigorous competition.

PE firms are a funny creature – like any other financial institution we depend crucially on confidence and, as such, are necessarily vulnerable to crises of confidence. Unlike banks or hedge funds, however, we benefit from relatively stable capital. While depositors can withdraw money from a bank at a day’s notice, and hedge fund investors can usually redeem their investment on three to six months’ notice, PE firms manage so-called long-term lockup money.

Once invested, investors in PE funds typically commit to having their funds locked up for seven to 10 years, which thankfully gives us a relatively stable funding base.

Nevertheless, we share with banks and hedge funds one critical weakness: public relations. By nature financial institutions tend to be horribly complex, and our competitive secrets (our “secret sauce,” if you will) are bound up inside that complexity (our trading positions, the way our investments are structured, etc.).

Thus PR can be a real challenge, and the rumor mill out there can go wildly off into the extremes. In our own experience, during an upswing, rumors of our success seem to reach near-mystical proportions. During a downturn, gossip and rumors can veer off into the truly whacky.

The reality inside, I can assure you, is much more mundane. Firms that are seen to be riding high are in truth struggling with some very serious challenges, just like everyone else. And firms which are seen to be going through a rough patch tend actually to be doing just fine.

Even after our stumble last year, we were still able to exit one pretty sizable investment in 2011, making several times our money in less than two years. Most of our remaining portfolio companies continue to deliver robust growth in revenues and cash flows.
 
In fact, now that I think of it, it’s striking how humdrum the PE business actually is most of the time, even during periods of high drama: it’s still mostly the day in and day out of helping portfolio companies with budgeting, strategy, business development, corporate finance etc., followed by “win some, lose some.”

Even a teenager going through the thrills, chills and spills of adolescence still has to grind out that good old homework in the evenings, passing some exams with flying colors and failing others.

On the other side of the homegrown firms in Indonesian PE sit the regional and global mega-funds, like TPG Capital and CVC Capital Partners, which have both arrived with a splash in recent years. Yet beyond these two, the biggest problem for the mega-funds continues to be “pulling the trigger.”

Most of the action by the mega-funds has continued to be limited to scouting trips. Several mega-funds went quite far in expending real effort and money working on deals, but those deals didn’t close in the end. That is because the Indonesian market is surprisingly difficult to crack. Thus for now, TPG and CVC remain more the exceptions than the rule.

What’s next for this hormonally turbo-charged teenager of an industry in the year ahead? Basically more startling growth. Therefore more growing pains. Hold on to your hats.

By any standard, Indonesia continues to be severely under-penetrated by private equity. China and India have literally hundreds of PE firms scouring and lubricating their economies. Investors around the world continue to be extremely under-exposed to Indonesian private equity. Yet the Indonesian market has proven itself remarkably difficult to crack, so de facto supply should remain restrained – notwithstanding the gold rush of people trying to launch new funds. So the supply-demand conditions are favorable and should remain favorable for some time to come.

The over-arching challenge for us home-grown PE firms is what I would call “the chain is only as strong as its weakest link.” To have a successful and sustainable PE firm, one needs to not only source, close and exit investments profitably, one also has to organize governance and reporting systems, formats and routines to ever more demanding standards.

And one has to do quite extraordinary investor relations (compared to what we’re used to in Indonesia), and one has to recruit, train and retain scarce and fickle talent, and one has to work with increasingly hands-on regulators, and and and… So it’s a lot more challenging than is commonly assumed – as the newly launched funds are about to find out.

The biggest challenge for everyone, both homegrown firms as well as global mega-funds, remains human capital. The depth of the talent pool is so shallow, all firms will continue to strain to fulfill their requirements. This talent shortage extends even to the ecosystem of service providers:

domestic and international lawyers, domestic and international auditors and tax consultants, and other service providers feel stretched to the bursting point by the industry’s and indeed the broader economy’s growth spurt.

Notwithstanding the many challenges, most private equity firms in Indonesia that manage to deploy capital should do reasonably well in the next two to three years. We PE firms tend to buy into our own competitive hype a bit too much, especially when we’re in fund-raising mode.

In reality, most firms should do ok. That is because conducive macro effects will likely predominate in 2012 and in fact for several years beyond.

Next year will be dominated by the next big rounds of quantitative easing (which used to be known simply as money-printing) likely to be launched by America’s Federal Reserve and by the European Central Bank (ECB) before the middle of next year.

The Fed will do it to support the American economy, which continues to be weak from the hangover of its 2008 “Lehman” financial crisis. The ECB, meanwhile, will do it to save the euro single currency from the multiple sovereign debt crises currently afflicting Europe.

Working against the Fed and the ECB will be the European banks, which will be calling in and selling down their loans from around the world (including from Asia) in a big way. They have no choice but to do so to cover their hefty losses on their holdings of European government bonds.

But I would bet that the Fed and the ECB (assisted by major Asian central banks) will successfully overpower the ill effects from the European banking sector’s credit contraction. One side-effect of the Fed’s and the ECB’s actions, at least in the short term, will be to reflate risk assets, including emerging market assets such as Indonesian private equity.

Even without all the effects from the Fed’s and the ECB’s policy actions, the likes of CLSA Securities and Credit Suisse have been forecasting Indonesia’s GDP to reach $1 trillion per year in the next several years, and then $1.5 to $2 trillion per year sometime next decade (up from $720 billion this year).

Levels of indebtedness across government, corporate, household and financial sectors, already quite low by global standards, look pretty stable. The composition of Indonesia’s GDP also appears reasonably well-balanced between consumption, savings, government spending, investment and trade. The main imbalance is that investment and government spending continue to be quite depressed – which, if anything, signals that the country is still starved for capital, a good sign for capital providers like private equity investors.

Although one should never underestimate the fragility of the gains Indonesia has made, the political, social and entrepreneurial arrangements do appear to be holding together well enough. This kind of economic development is quite an impeccable backdrop for private equity – and for the home-grown PE industry to eventually graduate from adolescence into adulthood.

Tom Lembong is the founder and president director of Quvat Capital.

Post a comment
Please login to post comment

Comments

Be the first to write your opinion!