Private Equity - Implications For Economic Growth in Asia Pacific

p r i vat e e q u i t y
Private Equity: Implications for Economic Growth in Asia Pacific

a d v i s o ry
Contents
introduction
2 4 8 14
executive summary
inside private equity in asia pacific
Criticisms of private equity and regulatory responses Excessive leverage Lack of transparency Potential conflicts of interest Tax leakage Negative impact on employment Other issues
the growing reach of sovereign Wealth Funds
29 30
private equity performance analysis Case studies Little Sheep in China Austar in Australia the way forward
40
2007 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis--vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved.
Introduction
The lure of Asia Pacific for private equity houses has increased dramatically over the last few years and showed no signs of abating during the first six months of 2007. Last year, private equity (PE) companies in Asia Pacific raised USD 32.9 billion in new capital, up 39 percent from 2005 and five times the total just four years ago. Deal volumes jumped 79 percent in 2006, with a total of 1,495 transactions completed and average deal size up by 8 percent to USD 41.3 million.1 According to the Asian Venture Capital Journal, private equity houses invested USD 61.8 billion of new funds during the year and total private equity funds under management across the region rose by almost 30 percent to USD 158.5 billion, from USD 122 billion in 2005.Initial figures for the first six months on 2007 indicated that these trends have all continued.2 This sudden growth has caused excitement, but also some alarm. To a degree, this reflects a lack of understanding about this industry and its somewhat brash image when seen against the quiet dedication of Asian businesses and financial institutions. Media opinion pieces have cautioned against the PE houses excessive and lightly-taxed profits and their use of high levels of debt to fund buyouts. In turn, this is influencing a wider political and regulatory debate. In Australia, these sentiments have been voiced by several prominent politicians. If private equity funds broaden their market activity substantially they can affect our whole economy, Senator Andrew Murray recently warned. If as a consequence the market as a whole is exposed to too much higher risk, then so is Australia exposed to much higher risk.3 Although a Senate inquiry found no case for further regulation at present, it did note and recommend the ongoing vigilance of the corporate and taxation authorities. The anxiety is by no means confined to Asia Pacific. In the United States, congressional hearings are being held to examine the risks of hedge funds and private equity funds, and whether the tax rates these funds pay should be sharply raised. The US Securities and Exchange Commission recently adopted a new anti-fraud rule for hedge funds and private equity funds, which are technically not covered by the Investment Advisers Act of 1940.4 In the United Kingdom, the Walker Commission into private equity has now handed down its report, recommending a variety of measures designed to enhance the transparency of private equity funds to their stakeholders and the community at large.
1 Asian Venture Capital Database, 24 September 2007 2 Data provided by AVCJ Research show that private equity houses made new investments of USD 37.4 billion in the first half of 2007, up 24.7 percent from the same period in 2006, while total private equity funds under management across Asia Pacific topped USD 171 billion, from USD 138.5 billion in the first half of 2006. 3 Private Equity: Higher risk, higher return, higher danger, online opinion by Senator Andrew Murray in Australian Democrats, 6 February 2007 www.democrats.org.au. 4 On 11 July 2007 commissioners of the US Securities and Exchange Commission (SEC) voted 5-0 to adopt a new rule that will make it a fraudulent, deceptive, or manipulative act, practice, or course of business for an investment adviser to a pooled investment vehicle to make false or misleading statements to, or otherwise defraud, investors or prospective investors in that pool. In a media statement, SEC Chairman Christopher Cox said the rule applies to investment advisers not only of hedge funds, but also of private equity funds, venture capital funds, and mutual funds. Source: SEC Votes to Adopt Antifraud Rule Under Investment Advisers Act, media release by the US Securities and Exchange Commission, 11 July 2007.
Private equity investments in Asia Pacific are quite modest by international standards. In Australia, a major destination for private equity investment, the value of all businesses purchased by private equity funds in 2006 amounted to less than 1.4 percent of the market capitalisation of all companies listed on the Australian Securities Exchange.5 At the regional level, USD 61.8 billion of private equity deals were announced in 2006,6 coming to a minuscule 0.5 percent of market capitalisation.7 Nevertheless, these complaints and criticism have swayed opinion among the wider public, many of whom would have barely heard of private equity more than a year ago. Private equity has now been made very public. The turmoil in the debt and equity markets over July and August 2007 has further focused the spotlight on private equity, particularly the large leveraged buy-outs with their substantial covenant-lite debt packages. While it is still too early to call just how markets in the region will react over the next year as the debt crisis in the sub-prime US home loan market works it way through the global financial system, it is fair to say that, at least over July and August 2007, there seems to have been minimal impact on announced deals in this region where the focus is on growth capital rather than leveraged buy-outs. The speculation about how the industry may fare in this new world where risk has been re-priced has illustrated how little is known about private equitys core investment rationale. This report presents some basic facts about private equity funds in the region, including their size, their deals, their investment approach, exit strategies and plans for the future. By assembling information directly from the ground, we hope to inject a measure of objectivity into the emotional debate on private equity in Asia.
David Nott Regional Leader KPMG's Private Equity Group
5 Private Equity in Australia, submission by the Australian Private Equity & Venture Capital Association Limited (AVCAL) to the Senate Standing Committee on Economics, May 2007. 6 Asian Venture Capital Journal database. According to the World Federation of Exchanges, the combined market capitalisation of 17 Asian stock markets, including those in Japan, Hong Kong, Australia, China, India and South Korea, topped USD 12 trillion as of the end of 2006. 7 WFE Annual Report and Statistics 2006, annual report by the World Federation of Exchanges.
Executive summary
In March 2007, KPMG member firms in Asia Pacific commissioned a survey of 119 private equity funds across the region. The following are the key findings:
Generalist, venture and growth capital are likely to remain as private equitys bread and butter. Only one-tenth of respondents describe their fund as a buyout fund, meaning that their strategy is to acquire other businesses, usually by borrowing against the target companys assets (10 percent). The vast majority of those polled describe their fund as generalist, meaning it invests in all stages of a companys development (44 percent), provides venture capital to start-up enterprises (27 percent), acts as a fund-of-funds that finances other private equity funds (11 percent), or injects growth capital into later-stage companies in need of expansion support (8 percent). This indicates that while high profile buyouts may dominate the headlines, most private equity funds will continue to take stakes in private companies and work with existing management to build more profitable and competitive enterprises. While public to private (P2P) transactions are comparatively rare in the region, they look set to become more of a focus. Only 39 percent of the respondents say they conduct P2P deals. Looking forward, another 47 percent say that, while their fund currently does not engage in P2P, they may consider doing so in the future. A key determinant of the reluctance to participate in P2P deals is the high execution risk, as Australian PE funds have found in recent times. There also needs to be a degree of maturity in the capital markets and a regulatory acceptance of this type of takeover activity. Whatever the investment approach, the respondents describe their company as an active participant in the task of growing businesses. The vast majority, 90 percent, say their company is a hands-on investor. They agree strongly with statements that say private equity companies supply the capital needed to expand businesses, provide management guidance at the board level and improve corporate governance. In terms of their impact on economies, the respondents say their main contributions lie in improving the ability of regional businesses to compete globally (India, Korea, Japan and Oceania), helping a country attract external investment (China, India), and growing small businesses (Southeast Asia). This reflects the core thesis of private equity funds that, while they may bring some debt to a deal, there must be a core growth of earnings proposition. At the very least this should increase value based on a current multiples and it should also create the possibility for a multiple shift as the underlying quality of earnings is raised. Mezzanine finance will increasingly be used to help structure private equity investments. Slightly more than half of respondents expect increased borrowings from Asia Pacific banks (55 percent), local banks (53 percent) and international banks (48 percent). In addition, the majority (70 percent) see increased levels of borrowing from mezzanine funds or providers.
Future investments are likely to diversify risks because they will be pan-regional rather than focused on a single country. Six out of ten respondents (66 percent) say the next fund they raise will have a pan-regional focus, with only 34 percent saying their next fund will concentrate on a single market. This investment mandate gives the fund managers flexibility in applying the funds to work, reduces overall fund risk and reflects a view of the region, or segments of it, as an integrated economic whole rather than as a collection of disparate countries. The one exception to this is likely to be Japan. Most likely due to the size of its economy and M&A market, it is expected that pure Japan focussed funds will continue to attract much interest. Going forward, private equity investment is likely to continue growing strongly across the region. Asked the primary reason for investing in the Asia Pacific, the overwhelming majority (94 percent) cite economic growth, a trend that looks set to continue particularly in China and India in the foreseeable future; 83 percent expect to see deal sizes increase in the next two years, with only 15 percent forecasting no change. In the next five years, the top two target markets will be China 74 percent of respondents say their company will remain or put in new money there and India (63 percent). More than one-third each say they will be in Taiwan (38 percent), Australia (37 percent) and Vietnam (36 percent). They expect to be investing in consumer markets, healthcare, environment, services and renewable/alternative energy.
The growth of private equity in Asia appears to be having a positive effect in driving economic gains across the region. The findings of this report suggest that private equity is fulfilling an important development function in mentoring entrepreneurs and mid- and late-stage managements about operational best practices, transparency and corporate governance, and achieving regional and global competitiveness. Private equity houses have also pursued "roll-up" strategies, building economies of scale and creating companies that have the potential to expand out of their Asian roots and become more serious global players. Both advocates and antagonists have noted, however, that the industry can do more to communicate its contributions. To do this, it has been suggested that the industry needs to engage with the media and the investment community, and disclose its results not only to its shareholders but also to the larger market. Some proponents suggest that at the very least it needs to clearly explain to outsiders why and when certain information cannot be shared publicly. Private equity firms could also consider adopting a code of practice and code of ethics, and pursue more self-regulation to pre-empt more heavy-handed regulatory oversight.
About the study

This report is based on a survey of 119 general partners (65 percent), investment directors (19 percent), investment executives (13 percent), and fundraising/investment relations executives (3 percent) in the Asia Pacifics private equity industry. The respondents were based in Greater China (29 percent), Oceania (19 percent), Southeast Asia (18 percent), India/Pakistan (11 percent), and Japan/Korea (10 percent). The 13 percent who came from the rest of the world were making investments in the region. The anonymous online survey was conducted in March 2007 by i.e. consulting on behalf of KPMG.
Respondent Job Function

3% 13%
Respondent Location
10% 11%
19% 13% 19%
29% 65%
18%
n Partner/equivalent n Investment Director n Investment Executive n Fundraising/Investor Relations
n Greater China n Oceania n Southeast Asia
n Rest of World n India/Pakistan n Japan/Korea
Current Investment Profile

China India Australia Singapore Taiwan Korea Japan Malaysia New Zealand Thailand Indonesia Vietnam Philippines 0% 61% 37% 29% 29% 28% 26% 21% 18% 18% 18% 14% 10% 8% 10% 20% 30% 40% 50% 60% 70% 80%
We would like to thank all the executives from private equity houses and private equity organisations that were interviewed in the course of this research.
Private Equity 101

Private equity is long-term, committed share capital that helps companies to grow and succeed. Whereas debt financing entails a legal right to interest on a loan and repayment of the capital, irrespective of success or failure, private equity is invested in exchange for a stake in the company and, as shareholders, the investors returns are dependent on the growth and profitability of the business. The entity that makes the investments is usually structured as a limited partnership and is known as a private equity fund. The investors in this fund, known as limited partners, primarily include pension funds, insurance companies and wealthy individuals. A private equity fund is managed by a general partner, who is tasked with deciding where and how to invest the funds money, in accordance with the focus defined in the funds terms of reference. Different private equity funds have different objectives, such as backing start-up companies (venture capital funds) or investing in mid-stage/mature enterprises that need expansion support (growth capital funds). A third focus of many international funds is the buy-out of existing equity holders, in a public to private deal, a privatisation of government owned assets, a takeover of a division of a larger company or the acquisition of a private company from retiring shareholders. Whatever the objective, they have a medium to long-term investment horizon, typically three to five years, during which they provide management with guidance, experience and expertise on the board and operations levels. Private equity funds make money (or cut their losses) by exiting their investments through an initial public offering or sale of their stake to another company (a trade or secondary sale, where the latter is a sale to another private equity fund). In the emerging markets of Asia, private equity investment has predominantly been growth capital, even when conducted by the larger buyout private equity houses. Private equity funds are often mistaken for hedge funds, but these two investment classes are fundamentally different. While private equity funds have a long-term investment horizon and add value to their holdings by playing an active role in strategy and operations, hedge funds concentrate on company and industry hedging strategies, short-term performance and returns. Whereas private equity funds typically focus on long-term valuation methodologies, hedge funds frequently mark their investment to market (or model), and utilise this valuation methodology in decisions concerning exit strategies. While the differences in approach are significant, a convergence between private equity funds and hedge funds may occur in one of three ways: Hedge funds have been involved in private equity deals, such as building stakes in potential public-to-private deals (for example, Airline Partners failed USD 10.95 billion bid in 2006 for Qantas Airways), buying leveraged loans in the debt markets or coinvesting with private equity funds in target companies. Hedge funds have participated in private equity-type investing, as illustrated by the rise of activist hedge funds in the US. Private equity funds and hedge funds are sometimes owned and managed by the same entity, as is the case with Blackstone, the US global alternative investment company.
Inside private equity in Asia Pacific

Private equity funds are rapidly growing in size in the Asia Pacific. As tracked by the Asian Venture Capital Journal, total private equity funds under management across the region were valued at USD 158 billion last year, up nearly 30 percent from 2005.8
exhibit 1 Value, volume and new fund-raising by private equity funds

Value of deals and funds raised, USDbn 70 60 50 40 30 20 10 0 2002 Value of deals
Source: Asian Venture Capital Journal database
1600 1400 1200 Volume of deals 1000 800 600 400 200 2003 2004 2005 2006 0
Funds Raised
Volume of deals
The regions private equity funds have large volumes of capital to invest. Last year, they raised USD 32.9 billion in new money, an increase of 39 percent from 2005 and five times new fund-raising in 2002. They are now aggressively putting that money to work. The number of private equity deals last year jumped 79 percent to 1,495 transactions, from 834 in 2005 and just 532 in 2002. The value of the 2006 deals topped USD 61 billion, up 94 percent from 2005 and over five times the value of 2002 transactions. A key driver in this growth has been a move up the transaction value chain between 2003 and 2005 there were on average eight deals a year in excess of USD 500 million; in 2006, there were 24 completed deals. Similarly, the average deal size has grown from just USD 18.5 million in 2002 to USD 41.3 million in 2006. Asked about deal size in the next two years, the vast majority of our respondents (83 percent) expect this trend to continue.
8 These figures and other data in this section were extracted from the database of the Asian Venture Capital Journal, on 24 September 2007, unless otherwise stated.
exhibit 2 How do you expect deal sizes to change over the next two years?
2% 15%
n Increase n Decrease n Stay the same
83%
Source: KPMG survey of 119 private equity firms in Asia Pacific, 2007
Markets of choice
The key factor that makes the Asia Pacific region so compelling for private equity fund managers is the economic growth of the region 94 percent of our respondents singled this out (Exhibit 3). It is not surprising, therefore, to find that the market receiving the most interest from private equity funds is China. Economic growth eclipsed other considerations such as pricing, deal flow and competition. The upward pressure on the pricing of deals in Europe and the US has also made the region more interesting, with very few respondents mentioning low labour costs as a factor.
exhibit 3 What are your key reasons to invest in Asia Pacific?

Economic growth Pricing Dealflow/Investment opportunities Demographics Less competition Market size Quality of management/entrepreneurs Local knowledge/networks Skilled workforce Market inefficencies Stability Sophisticated capital markets Technology Regulation Labour costs Exit opportunities Manufacturing capabilities Debt markets 0% 94% 26% 23% 15% 13% 8% 8% 7% 7% 6% 6% 5% 5% 4% 4% 3% 2% 2% 20% 40% 60% 80% 100%
Six out of ten respondents say their private equity fund has assets in China. India is in a distant second (37 percent), followed by Australia (29 percent), Singapore (29 percent) Taiwan (28 percent) and Japan (21 percent). Of our sample set, the least penetrated markets are Vietnam (10 percent), the Philippines (8 percent), and Mongolia (3 percent).
10 Private Equity: Implications for Economic Growth in Asia Pacific
When asked to project five years out, respondents still choose China as the prime target market (74 percent, see exhibit 4). India becomes far more popular (63 percent), however, whilst Taiwan (38 percent), Australia (37 percent) and Singapore (34 percent) remain attractive. The biggest mover is Vietnam, which vaults from near bottom to fifth place (36 percent). In terms of growth over time, the number of funds that expect to invest in Vietnam in the next five years represents an increase of 258 percent, though admittedly from a low base. Other big movers include the Philippines (130 percent), Indonesia (100 percent), India (70 percent), and Malaysia (68 percent). exhibit 4 Which countries do you think you will be targeting in five years time? China 74% India 63% Taiwan 38% Australia 37% Vietnam 36% Singapore 34% Korea 34% Japan 31% Malaysia 31% Indonesia 29% Thailand 25% New Zealand 23% Philippines 19% Mekong Delta (ex-Vietnam) 17%
The future make-up of private equity investments could be a force for continued stability. Future investments are likely to diversify risks because they will be pan-regional rather than focused on a single country (Exhibit 5); 66 percent of the respondents said the next fund they will raise will have a pan-regional focus, with only 34 percent saying their next fund will concentrate on a single market. This should help bring more stability to Asias private equity industry, and thus to financial markets and economies as a whole, since the ability to hold assets in multiple markets should lower overall risk. A wide investment mandate gives the fund managers flexibility in putting the funds to work, reduces overall fund risk and reflects an investors view the region, or segments of it, as an integrated economic whole rather than as a collection of disparate countries. exhibit 5 What will the geographical focus of your next fund be?
34%
n Pan-regional n Single country focus

66%
Private Equity: Implications for Economic Growth in Asia Pacific 11
target sectors
exhibit 6 Top private equity investment by value, USD million, with volume of deals in brackets
2002 Financial services Telecommunications Media Travel/Hospitality Retail/Wholesale Consumer products/services Medical Transportation/Distribution Manufacturing - Heavy Computer related Electronics Information technology Ecology Mining and metals Non-Financial Services Construction Infrastructure Utilities Manufacturing - Light Textiles and clothing Agriculture/Fisheries Leisure/Entertainment Total
2003 3,419 (34) 3,637 (33) 205 (9) 1,185 (10) 338 (20) 250 (20) 960 (42) 928 (37) 1,055 (36) 1,199 (72) 547 (35) 585 (37) 61 (5) 176 (15) 243 (31) 311 (8) 263 (3) 1544 (18) 132 (19) 138 (4) 30 (6) 754 (11) 17,960 (505)
2004 1,867 (40) 2,739 (19) 36 (6) 571 (8) 1,229 (26) 383 (21) 943 (64) 3,314 (36) 480 (57) 2,061 (89) 443 (56) 262 (79) 17 (3) 125 (18) 456 (38) 158 (8) 283 (7) 764 (18) 276 (19) 81 (10) 0 (1) 58 (17) 18,919 (640)
2005 8,634 (70) 304 (21) 237 (7) 2,130 (26) 2,328 (37) 1,078 (28) 2,044 (93) 2,368 (47) 1,089 (61) 3,730 (99) 2,801 (42) 890 (116) 103 (6) 708 (26) 293 (36) 1034 (7) 177 (3) 200 (19) 491 (40) 841 (24) 7 (5) 374 (21) 31,800 (834)
2006 10,318 (115) 8,201 (33) 7,059 (24) 4,295 (48) 4,095 (74) 3,888 (69) 3,687 (127) 3,306 (75) 2,771 (116) 2,265 (158) 2,033 (89) 1,874 (221) 1,709 (7) 1,645 (43) 1,469 (97) 849 (30) 748 (23) 472 (34) 460 (36) 307 (27) 220 (15) 110 (34) 61,782 (1,495)
2,715 (45) 1,899 (53) 100 (8) 77 (11) 388 (20) 393 (21) 250 (45) 502 (15) 505 (25) 663 (107) 255 (41) 272 (57) 14 (3) 146 (8) 232 (23) 1 (5) 449 (1) 27 (5) 345 (17) 19 (3) 310 (4) 273 (15) 9,836 (532)
In 2002, private equity funds in Asia most often invested in computer hardware and information technology companies (Exhibit 6). By 2005 and 2006, these remained the most popular sectors, but others were catching up fast. Average deal size has grown steadily from USD 18.5 million in 2002 to USD 41.3 million in 2006, although when looking at individual industries the figures can be skewed by one large deal (Exhibit 7).
exhibit 7 Average deal size in selected industries

Average Deal Size USD million 350 300 250 200 150 100 50 0 2002 2003 2004 2005 Financial services Media 2006
Average Transaction Size - All Industries Telecommunications Computer related

In terms of value, however, financial services (USD 10.3 billion), telecommunications (USD 8.2 billion) and media (USD 7.1 billion) are actually the three dominant industries. Computer-related enterprises (USD 2.3 billion) and information technology (USD 1.9 billion) lag far behind, exceeded in value by various other diverse sectors. Deals in telecommunications may be fewer in number, but the individual volumes being invested are larger compared with deals in IT and computer-related sectors.
exhibit 8 In five years time, which sectors will you be investing in?
Consumer/Retail/Services 25% Environment/Renewable/Alternative/Clean Energy 19% Healthcare 13% Telecommunications, Media and Technology 11% Energy/Resources 9% Biotech/Life Science 6% Distribution/Logistics 4% Financial Services 4% Infrastructure 3% Transport 2%
Looking ahead, our respondents expect the investment profile to be very different. Asked which sectors they think their private equity fund will be focusing on by 2012, the respondents put consumer markets, including the retail sector, at the top of the list (Exhibit 8). This is an industry that had received relatively little private equity investment in the past five years. The interest in personal consumption reflects the growing wealth and personal disposable incomes of millions of consumers in markets such as China and India, the opening of new markets in countries like Vietnam with its young population and and the potential for a consumer revival consumer revival in Japan. The second most popular sector is environmental technologies, including renewable energy and waste technologies. This, too, is not among the hot sectors today, but the respondents evidently see a bright future for it going forward, reflecting global concerns about sustainable development and global warming. Healthcare, telecommunications, and media and technology (especially in areas relating to IT and computer hardware) are projected to remain strong target sectors over the next five years.
exit strategies
According to the Asian Venture Capital Journal, 2006 was a record year for IPOs in Asian private equity: PE-backed offerings doubled to USD 30.4 billion as mainland Chinese banks were floated in Shanghai and Hong Kong. Trade sales were a distant second at USD 11.6 billion, down 48 percent from 2005 as bank disposals in Korea stalled.9 The executives surveyed were asked how they exit today, and how they think their equity fund will dispose of their investments in two years and five years time (Exhibit 9). IPOs emerged as the preferred exit strategy currently (52 percent), ahead of trade sales (42 percent).
9 Extracted from the database of the Asian Venture Capital Journal.
Respondents predicted that the situation could reverse within two years, with trade sales (46 percent) surpassing IPOs as the preferred exit route (44 percent). This outlook will however be affected by developments in the debt and equity markets, as this will determine the extent and the ease with which companies can leverage their investments and the attractiveness of the stock markets to new listings.
exhibit 9 How do you exit your investments today, in two years, and in five years?
60% 50% 40% 30% 20% 10% 0% IPO Trade sale 5% 9% 1% 1% 3% Other 17% 52% 44% 43% 42% 46% 37%
Secondary buyout
n Now
n 2 years
n 5 years
Interestingly, in five years time, respondents see a more significant role for secondary buyouts (17 percent), which involve selling the investment to another private equity fund. This may indicate expectations of a continued boom in private equity funds, with newcomers seen as willing to pay premium prices for the holdings of older funds in order to get a foothold in the market. While still substantial, trade sales will account for a lower 37 percent of disposals. IPOs will remain steady at 43 percent.
Criticisms of private equity and regulatory responses

The private equity industry has been under sharp attack in the US and the UK, and to a lesser extent in Australia. In a recent report10 widely picked up by the media, credit-ratings agency Moodys challenged some of the benefits PE houses claim to bring to businesses. Even though PE-backed private companies in the US are not covered by the strictures of the Sarbanes-Oxley Act and the requirement to report quarterly earnings, the current environment does not suggest that private equity houses are investing over a longer term horizon than do public companies, the report asserts. Moodys also expressed concern about the willingness of private equity houses [in the US] to issue special dividends despite commitments to reduce leverage, sometimes within 12 months of the transactions closing. Reports such as this have added to the demands from investors, politicians, trade unions and other quarters for more regulation of the industry; regulators and legislative bodies are beginning to respond. In the UK, the Financial Services Authority is keeping a watching brief on leverage, transparency and conflict-ofinterest issues. In Australia, the Takeovers Panel has circulated a draft Guidance Note on insider participation in control transactions for private equity companies and other M&A participants. In Taiwan, the Financial Supervisory Commission is considering raising the threshold for de-listing of public companies to head off possible de-equitisation caused by PE buyouts. PE players say they recognise the need for reasonable regulation, but they worry that emotionalism, fear-mongering and misunderstanding among certain stakeholders could force regulators and politicians to impose overly restrictive requirements. One alarming example is Korea, where prosecutors are investigating or have indicted at least three international private equity houses for alleged price manipulation, insider trading and other supposedly illegal practices. One Korean newspaper publicly accused a US private equity firm of being a habitual and wicked tax evader.11 Controversy is perhaps bound to arise as more and bigger private equity players enter the arena, larger deals are announced, and iconic listed companies are targeted. The following sections of this report detail some of the common criticisms levelled at private equity and the regulatory responses that have arisen in key markets.
10 Rating Private Equity Transactions, special comment by Moodys Investors Service, July 2007. 11 Public Scorn for Private Equity, in BusinessWeek, 4 December 2006.
excessive leverage
There is a growing perception in the public mind that PE firms saddle the company they have taken over with heavy debts, an impression caused in part by the massive sums private equity players recently paid to buy out public companies. In the first half of 2007, for example, private equity groups agreed to pay USD 8.9 billion for Orica Limited in Australia, USD 976.8 million for Fu Sheng Industrial in Taiwan, and USD 698.4 million for MMI Holdings in Singapore.12 These transactions followed a USD 8.7 billion bid in 2006 for Australias Qantas Airways, a deal which fell apart despite the airlines board acceptance of the offer. Along with the equity component of PE investments, there is usually a significant component of debt. PE players say they do leverage their portfolio companies balance sheet when needed, but they insist that it is in their interest to borrow prudently. In Australia, David Jones, managing director of CHAMP Private Equity notes that, the average ratio of debt to equity in buyouts has been almost exactly 70 percent debt, 30 percent equity, regardless of the size of the buyout, which is a reasonable ratio.13 Jones notes that the Reserve Bank of Australia (RBA) came to a favourable assessment, which concluded that private equity exposures currently amount to less than 3 percent of total loans in the Australian banking system.14 The debt-to-equity ratio may be lower in the rest of Asia, where local banks, having gone through the crucible of the 1997 Asian financial crisis, generally follow conservative lending practices. Chris Rowlands, Managing Partner Asia at 3i, estimates the debt-to-equity ratio of PE-backed portfolio companies across Asia Pacific at 50-50.15 In Europe in the last few years, weve seen debt levels increasing strongly as the banking industry became aggressive, Rowlands says. In Asia, typically with the cycles and volatility here, we have seen more balance between equity and debt.
The global debt market

The unprecedented nature of the global debt market has helped fuel the recent PE boom. Its features include: Low interest loans driven by high levels of liquidity and the reduction in risk spreads High leverage there is no doubt that in the larger deals in the US, the banks have also loosened their lending requirements, helping to drive the record volume of leveraged buyouts. And it is this leverage that changed significantly over the past four years; according to Standard and Poors analysis, in 2001 deals were being done at 4x EBITDA while in the first half of 2007 they were being done at over 6x EBITDA (source: Ratings Direct Report, Standard & Poors, July 2007) Favourable financing structures particularly covenant-lite financing arrangements which lacked the protective covenants that subject the borrower to tests to show they are maintaining financial ratios at agreed levels. One covenant lite feature was toggle notes which allowed borrowers to either make interest payments in cash or borrow more money to pay interest on the money already borrowed. Collateral requirement loosened where there was no security over assets/business for the loans Bridge loan facilities typically were
exhibit 10 Sources of new debt in the next two years

100% 60% 80% 40% 20% 0% Local banks Mezzanine Regional Intemational (Asia-Pacific) (North American/ funds/providers banks European) banks Hedge funds
provided by the banks capital markets arm with the understanding that the buyout firms would find investors to take over the banks stake after the deal closed.
n Decrease
n Stay the same
n Increase
12 Top PE Buyouts in Asia, 1H07, report by Thomson Financial, 7 July 2007. 13 KPMG interview with David Jones, Managing Director of CHAMP Private Equity and Chairman of the Australian Venture Capital & Private Equity Association, July 12 and 20, 2007. 14 Financial Stability Review, report by the Reserve Bank of Australia, March 2007. 15 KPMG interview with Chris Rowlands, Managing Partner Asia, 3i, 13 July 2007.
Going forward, the respondents to this study say the banking system is not likely to become more of a source for private equity debt (Exhibit 10). Over the next two years, just about half of our respondents expect increased borrowings from Asia Pacific banks (55 percent), local banks (53 percent), and international banks (48 percent). In contrast, 70 percent expect to see increased levels of sourcing from mezzanine funds or providers. The worries that Asias financial systems may face higher risks because of increased exposure to private equity buyouts thus appear to be overblown. Mezzanine funds typically source capital from sophisticated individual and institutional investors that are hedged and able to absorb losses.
exhibit 11 Types of private equity funds

8% 10% 44%
11%
n Generalist n Venture n Fund-of-fund/gatekeeper n Buyout n Growth Capital
27%
Moreover, despite their current high profile, buyout specialists are still in the minority in Asia Pacifics private equity industry. Asked to describe what type of private equity firm they are, only 10 percent of our respondents characterise their fund as a buyout fund (Exhibit 11). A larger share say their fund is generalist, meaning it invests in all stages of a companys development (44 percent), provides venture capital to start-up enterprises (27 percent), acts as a fund-offunds that finances other private equity funds (11 percent), or injects growth capital into later-stage companies in need of expansion support (8 percent).
exhibit 12 Do you buy public companies to turn them private (P2P)?

14% 39%
n Yes n No, but would consider it n No, and would not consider it
47%
All that said, however, the indications are that buyouts may become more of an area of focus in Asia Pacific. Nearly half (47 percent) of respondents say that, while they are not engaged in P2P today, they may consider doing so in the future (Exhibit 12). Rowlands, for example, says that 3i is planning to launch a buyout business in Asia Pacific. To date, 3is regional strategy has concentrated on growth capital, but Rowlands sees opportunities with mid-sized targets in the USD 2 billion range. These may be public companies that could be taken private, family corporations with no business successor, or conglomerates looking to sell off stakes or non-core divisions. What this means for leverage trends in the region and how regulators will respond to them is an open question. In a survey of 13 banks in the UK, the Financial Services Authority (FSA) found a 17 percent increase in bank exposure to leveraged buyouts, from EUR 58 billion as of June 2005 to EUR 67.9 billion as of June 2006.16 The FSA judges system-wide exposures to be substantially greater because banks are increasingly distributing debt to non-banks such as managers of Collateralised Loan Obligations (CLOs) and Collateralised Debt Obligations (CDOs), and hedge funds. The authority has not taken any action so far, except to continue monitoring bank lending. In the US, the spate of mega-buyouts such as the USD 45 billion private equity deal for electricity generation company TXU and USD 33 billion for hospital chain HCA have raised concerns about the return of the disastrous junk-bond boom of the 1980s. US buyouts are typically funded by a mix of bank borrowing, high-yield bonds and equity. According to the Moodys report, leveraged buyouts accounted for 18 percent of new high-yield issuances in the beginning of 2007, compared with about 5 percent between 2003 and 2004. But the Private Equity Council, the recently formed industry group in the US, estimates that the average PE deal since 2002 is in the range of 60 to 66 percent debt, still lower than the 90 percent or more in the 1980s.17
16 Private equity: a discussion of risk and regulatory environment, Financial Services Authority discussion paper, June 2006. 17 Testimony of Douglas Lowenstein, President of the Private Equity Council, before the House Financial Services Committee of the US Congress, 16 May 2007.
The recent turmoil in global markets caused by problems in the sub-prime mortgage sector in the US has cooled any excessive leverage in private equity buyouts. Banks have re-priced risk upwards after the collapse in July of two hedge funds run by US investment bank Bear Stearns and the decision by Frances BNP Paribas in August to halt withdrawals from three investment funds. The five funds held securities and derivatives tied to sub-prime mortgages. The resulting credit crunch has affected the financing of already agreed private equity buyouts such as the takeover of US carmaker Chrysler18 and caused market speculation about the impact on a number of large, unconcluded deals, including the aforementioned TXU and HCA buyouts. Some deals have collapsed, such as JC Flowers consortium bid for Sallie Mae, with others delaying their completion as buyers and sellers wait for more clarity from the markets or deals are renegotiated. Future deals will almost certainly be affected, but a slowdown, rather than an implosion, is the most likely consequence. There are a handful of transactions that LBO firms could sign in March that they couldnt sign today (particularly mega-market deals), concludes PE Week Wire, an industry newsletter published by Thomson Financial. But LBO firms can do most of them, so long as they are willing to accept less favourable terms and buyout firms have proven quite apt at acceding to such requests. Remember Clear Channel and all those other deals where public shareholders kept demanding higher prices? Well, now its the lenders turn.19 It is also a market where vendors need to be more realistic about asset prices. Less leverage which is more expensive means that prices should fall. In August the sale of the Home Depot distribution business was re-priced from USD 10.3 billion to USD 8.7billion as the debt crisis took hold. The markets should expect lower debt/EBITDA multiples in future. According to Standard & Poor's,20 these multiples averaged 4x in 2002 but grew to over 6x by 2006. Finally, this is now a market where trade buyers will be more competitive as the synergies from a deal they may obtain outweigh the gains no longer available to PE from higher leverage than a listed corporation typically has. Private equity houses have consistently brought more than simply leverage to their investments in Asia Pacific. At this point in the credit cycle, their governance model, with its unrelenting focus on operational improvement for value enhancement, is needed more than ever. Private equity must now operate in a more risk-averse environment, but it is one in which their core propositions and governance model designed to enhance shareholder wealth should continue to make a significant contribution to the economy and to those who invest in them.
18 JPMorgan, Goldman Bond Risk Rises as Chrysler Loan Sale Fails, Bloomberg, 25 July 2007. The two banks could not sell USD 10 billion in Chrysler loans for a takeover by Cerberus Capital Management, forcing DaimlerChrysler, Chryslers European parent, to lend Cerberus part of the money needed to complete the deal. 19 PE Week Wire, 27 July 2007. 20 Ratings Direct Report, Standard & Poors, July 2007
Rowlands of 3i sees a silver lining. The recent tightening of credit will bring greater discipline to current M&A activity, he argues. The larger private equity players will broadly welcome an adjustment. At 3i, with a strong balance sheet, in-depth sector knowledge and a wide international network, we can work closely with companies in which we have already invested and take balanced and informed decisions about new opportunities. As banks shy away from covenantlite lending, there would be less scope for private equity firms to load balance sheets with excessive debt.
Accusation Excessive leverage used as part of PE deals
Country
UK
Regulatory/legislative opinion and industry response

The UKs Financial Services Authority (FSA) noted in 200621 that credit from lenders in respect of PE-backed buyouts and acquisitions has risen substantially, raising concern that PE houses are relying on excessive debt. No action has been taken other than to continue monitoring bank lending. The British Private Equity and Venture Capital Association (BVCA) maintains that this is not a regulatory issue for PE, as rising credit levels is a trend that also applies to banks and other areas of the financial sector.22 In testimony before the US House of Representatives Committee on Financial Services in May 2007,23 Andrew Stern, president of the Service Employees International Union (SEIU), complained that leverage involved in buyout deals can create significant pressures that could result in bankruptcy. In response, Douglas Lowenstein, president of the Private Equity Council, said that PE deals in the US since 2002 average in the range of 60 to 66 percent debt, much lower than the 90 percent or more in the 1980s.24 Both the House of Representatives and the Senate are considering legislation to address the risks of excessive leverage and other private equity issues. The Council of Financial Regulators comprised of the heads of the Australian Prudential Regulatory Authority (APRA), the Australian Securities and Investments Commission (ASIC), the Australian Treasury, and the Reserve Bank of Australia (RBA) conducted a review and concluded that higher leverage levels due to LBO activity do not pose a significant near-term risk but said the council will monitor developments closely.25 AVCAL, the Australian Private Equity & Venture Capital Association, endorsed the comments and findings, in particular the councils comments on debt, effects on tax revenue, and broader effects on the capital markets. Leverage is not yet an issue in Asias developing markets since the majority of private equity investments to date has been growth capital and cash investments. There are also limits on the amount of leverage that can be used in many markets. But leverage may become an issue as buyouts increase in number and deals become more complex with the increasing use of mezzanine and other types of debt. According to current foreign exchange regulations, foreign owned holding companies are required to bring in requisite funds from abroad and are not permitted to leverage funds from domestic market for investments in Indian companies. If debt is taken at the foreign holding company level with the intention of pushing it down to the Indian company by merging the foreign holding company into the Indian company, the debt in the Indian company would qualify as an External Commercial Borrowings (ECB) and would be subject to the ECB guidelines which are inter alia stringent in terms of restrictive end use requirements. Tax Deductibility of interest expense in the hands of the Indian merged company is also a contentious issue.
US
Australia
China and Southeast Asia
India
21 Private equity: a discussion of risk and regulatory environment, Financial Services Authority discussion paper, June 2006. 22 Issue affects non-PE backed companies in the same way, British Private Equity and Venture Capital Association submission to the Treasury Select Committee, May 2007. 23 Statement of Andrew L. Stern, President of the Service Employees International Union, to the US House of Representatives Committee on Financial Services, 16 May 2007. 24 Testimony of Douglas Lowenstein, President of the Private Equity council, before the House Financial Services Committee, 16 May 2007. The council represents ten of the leading PE firms in the US, including Bain Capital, Blackstone Group, Carlyle Group, Kohlberg Kravis Roberts & Co, and TPG Capital. 25 March 2007 Financial Stability Review, report by the Reserve Bank of Australia. The relevant section states: While the recent increase in LBO activity in Australia has led to some pockets of increased leverage within the corporate sector, it does not appear to represent a significant near-term risk to either the stability of the financial system, or the economy more broadly. The exposure of the Australian banking sector to private equity is well contained, and both the leverage and the debt-servicing ratios for the corporate sector as a whole remain relatively low. Looking forward, however, it is likely that the increase in business leverage that is currently underway has some way to run. Given this, together with the potential implications of LBO activity for the depth and integrity of public capital markets, as well as the importance of investors understanding the risks they are taking on, the agencies that make up the Council of Financial Regulators will continue to monitor developments closely.
Lack of transparency
The trend of private equity firms taking over large corporations and turning them private is also raising questions about transparency. Unlike publicly traded companies that are subject to securities laws, it is well known that private equity buyout firms operate outside of the public eye, with little oversight, Andrew Stern, President of the Service Employees International Union, recently told a US House of Representatives committee.26 It is critical that the industry provide more transparency and disclosure so that the people who might be affected by a given deal workers, community members, shareholders and others are aware of the potential impact on their lives. In general, PE funds are transparent with their own stakeholders. They have to be, says a private equity professional in Hong Kong, who requested anonymity. The general partner knows everything about the portfolio company he wants to know; if he doesnt, hes unprofessional. The limited partner gets all the information he needs from the general partner, if he wants it. If he doesnt get it, he has picked the wrong GP, but then there are very few of those out there. The information then gets passed on to the institutional funds and individual investors that put money in the limited partnership. As for regulators, they get the information needed, this interviewee says, because like other private companies, PE-backed portfolio companies must register and file annual returns with the companies registry, as well as pay taxes to the revenue authority. The question, therefore, is how much information should be shared with wider public and the media. Its about journalists who believe they have a right to this information because they are the ultimate protector of the public, says the PE practitioner. I disagree. If you give me your money to manage and we have a contract, there is no reason why the world should know about this contract. Its not a public company, after all. In a public to private deal, the situation is different and stakeholders will need more information. Commercial and competitiveness issues must also be taken into account in dealing with the media and other outsiders. The reality, however, is that the media can wield great influence on public opinion, and thus on the actions of politicians and regulators. In the UK, the FSA has noted the limited transparency of the PE industry to the wider market, and said it was monitoring the situation. In response, the British Private Equity and Venture Capital Association (BVCA) asked Sir David Walker, former Executive Director of the Bank of England and former Chairman of the Securities and Investments Board, to head a working group that would draft a voluntary code of practice to improve private equitys transparency. In a recent consultation document,27 the Walker Working Group judged as satisfactory the reporting arrangements between PE firms and investors, but said the buyout end of private equity has inadequately informed employees, suppliers and customers as well as the wider public interest. It should be noted, however, that tends to be during the buyout process. Once the process is complete, it is usually in the buyer's interest to ensure that there is a flow of information between stakeholders to motivate and retain relationships.
26 Testimony of Andrew Stern, President of the Service Employees International Union, before the House Financial Services Committee of the US Congress, 16 May 2007. 27 Disclosure and Transparency in Private Equity, a consultative document by the Walker Working Group, July 2007.
Sir David proposed that portfolio companies that were formerly listed as FTSE 250 companies or where the equity consideration on acquisition exceeded GBP 300 million or where the company has more than 1,000 employees and an enterprise value in excess of GBP 500 million should report to an enhanced standard beyond that required in the 2006 companies legislation. The suggested requirements include filing of the annual report on a company website within four months of the year-end, and financial reporting covering balance sheet management, including links to the financial statements to describe the level, structure and conditionality of debt. General partners are asked to publish an annual review on their website that informs their approach to business and the governance of their portfolio companies. In addition, private equity firms will be expected to be more accessible to specific enquiries from the media and more widely. Confidentiality concerns will constrain responses that can be given in some situations, but the line between openness and secretiveness should be drawn with much greater flexibility than hitherto, especially in respect of large transactions which, in the listed sector, would attract very full public presentation. If adopted by the BVCA, these voluntary guidelines will also cover the Asia Pacific units of UK private equity firms, such as 3i. But US and other funds, including local PE houses, are not obligated to follow them, although it is possible that they will at least adapt some of the standards that they believe are applicable to the region. We are studying the report to see what will have relevance for us here in Australia, says Katherine Woodthorpe, Chief Executive of the Australian Private Equity & Venture Capital Association (AVCAL).28
Accusation Lack of transparency
Country
UK

In its June 2006 discussion paper, the FSA stated that transparency of the PE industry to the wider market is limited, even though transparency to existing investors is extensive. It is maintaining a watching brief on this issue. The BVCA has formed a working group that aims to implement a voluntary code of practice to improve the level of disclosures made by entities backed by PE houses. Public officials and others in the US have called for greater transparency in the US private equity industry. The Private Equity Council places the issue in the context of PE firms getting listed. PE firms that go public will be required to meet the same disclosure as all other public companies, including Sarbanes-Oxley and other securities laws, it says.29 But the council warns that moves in the Senate to substantially raise taxes on private equity funds that seek to become publicly-traded partnerships will discourage such listings, and therefore negatively affect private equity transparency.
US
28 KPMG interview with Katherine Woodthorpe, Chief Executive of the Australian Private Equity & Venture Capital Association (AVCAL), 23 July 2007. 29 Private Equity and Publicly-Traded Partnerships S. 1624, response by the Private Equity Council to S.1624, a bill increasing taxes on private equity funds that seek to become listed partnerships introduced by Senator Max Baucus and Senator Charles E. Grassley on 14 June 2007.
potential conflicts of interest

The issue of conflict of interest has been raised mainly in the UK and Australia. A primary concern is that the fund manager must run the fund both to maximise the returns to the investors while balancing this with the returns it should make to itself as the fund manager (under pressure from its owners and staff). While no regulatory action has so far been taken, in the UK the Financial Services Authority has been raising awareness of the issue through speeches and newsletters. In Australia, the Takeovers Panel is asking for submissions on a proposed Guidance Note and Issues Paper on Insider Participation in Control Transactions, which was driven by PE but covers all public M&A transactions. The private equity industry participated in the drafting process, and AVCAL has expressed support for the Guidance Note.
Accusation Potential conflicts of interest
Country
UK

The FSA sees conflicts of interest since the fund manager must run the fund both to maximise the returns to the investors and also to balance this with the returns it should make to itself as the fund manager (under pressure from its owners and staff). The FSA also believes that conflicts of interest may arise in dealing with the affairs of customers, investors and companies owned by the fund. It is using speeches and newsletters to raise awareness of this issue. In response, the BVCA has developed guidelines promoting an ethical culture where conflicts of interest should be addressed and not be taken lightly.30 On 21 February 2007, the Takeovers Panel published a draft Guidance Note and Issues Paper on Insider Participation in Control Transactions, which was driven by PE but covers all public M&A transactions. Submissions have been received, but the findings have yet to be published. The private equity industry was represented on the Takeovers Panel during the preparation of the draft Guidance Note and issues paper. AVCAL has written to the Takeovers Panel to express its support for the draft Guidance Note.31
Australia
tax leakage
A common perception in Asia and elsewhere is that private equity firms are making such windfall gains that they should be required to share their bounty with the rest of the community. In the US, some in the House of Representatives want to double the tax on the earnings of PE firms from 15 percent to 30 percent. The Private Equity Council warns that entrepreneurial risk-taking would suffer and the efficiency of capital markets would be impaired if the measure were to pass.32 In Korea, some PE firms have been criticised as tax evaders and profiteers. In the case of the Korea Exchange Bank, for example, the original private equity investment in 2003 is estimated at KRW 1.4 trillion. When the PE firm asked for bids for the bank last year, the offers reportedly went as high as five times
30 British Venture Capital Association 31 Private Equity in Australia, submission by the Australian Private Equity & Venture Capital Association (AVCAL) to the Senate Standing Committee on Economics, 10 May 2007. 32 Private Equity and Carried Interest HR 2834, position paper by the Private Equity Council, 2007.
the original investment. The sale has been delayed pending resolution of legal problems. Until the tax authorities introduced a new withholding tax regime on Korean source income, those gains would have been taxed at a minimal rate. In Japan, various changes in legislation in recent years provide a mechanism to tax private equity profits on exit from their investments. The so-called Shinsei tax levies a 20 percent tax on sales of investments by funds, a measure that was prompted in part by the exit of a consortium of private equity firms from the former Long Term Credit Bank, which the consortium bought out of receivership in 2000. Renamed Shinsei Bank, the bank was sold in 2005 for more than four times the original investment, with no local tax payable. Such exits would now be subject to tax, although US-based funds may not need to pay because the Japan-US tax treaty gives them protection in certain situations. Tax leakage is not an issue in Hong Kong and Singapore, where capital gains are not taxed. In China, however, the newly approved Enterprise Income Tax Law could lead to the introduction of a 20 percent withholding tax on dividends paid out of Chinese portfolio companies. Several funds are in the process of relocating the intermediate holding company from the British Virgin Islands to Hong Kong, Mauritius or Barbados to mitigate the adverse impact of a dividend withholding tax. In India, tax exemptions enjoyed by foreign venture capital investors (FCVIs) outside of specified sectors such as nanotechnology, biotechnology and IT hardware and software have been withdrawn. Some form of taxation is probably inevitable in most jurisdictions, but private equity firms should at least make their voices heard before new taxes are imposed.
2007 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG 2007 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis--vis third parties, nor does KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis--vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. International have any such authority to obligate or bind any member firm. All rights reserved.
Accusation Tax leakage
Country
UK

Corporate entities claim that tax relief for shareholder debt given to PE houses is inequitable. The UK government has responded to this by stating that the Treasury has no plans to examine the tax-deductible status of interest. The BVCA has denied that there is special treatment afforded to PE houses, in that tax deductibility of interest on debt is available to all UK companies; only arms length interest is tax deductible for the borrower. Senate bill S. 1624 aims to tax publicly-traded partnerships such as the recently listed Blackstone Group at the standard rate of 35 percent corporate tax, instead of the capital gains tax rate of 15 percent. In the House of Representatives, House bill HR 2834 aims to raise taxes on the investment gains of private equity funds (regardless of whether they are listed or unlisted) to 35 percent from the current 15 percent. The Private Equity Council is lobbying against both bills, arguing among other things that they will hinder entrepreneurial risk-taking, hold back PE firms from acquiring and enhancing the competitiveness of underperforming or undervalued companies, and potentially reduce the returns of pension funds, foundations and university endowments that provide the bulk of private equity capital. The Senate enquiry into the economic impact of private equity, having regard to submissions from the Australian Taxation Office as well as industry funds, found that there is no compelling case for leakage from the tax system but did note that this was an area for continued close monitoring. In China, private equity investments have generally been conducted through offshore special purpose vehicles (SPVs) to minimise tax liabilities, as well as to allow an exit route via overseas listing. In September 2006, several Chinese regulatory agencies met to revise and promulgate the Regulations for the Acquisition of Domestic Enterprises by Foreign Investors. In relation to PE investors, these regulations created additional barriers due to the difficulty for PRC founders to create offshore SPVs so as to receive PE investments. In addition, this new regulation further imposes a one-year listing requirement when PRC founders are permitted to establish offshore SPVs. A newly approved Enterprise Income Tax Law proposes to introduce a 20 percent withholding tax on dividends paid out of Chinese portfolio companies. This will have an impact on PE fund structures using the Cayman Islands and the British Virgin Islands to hold the Chinese portfolio companies. Several funds are in the process of restructuring their investments, seeking to mitigate the adverse impact of dividend withholding tax by relocating the intermediate holding company from BVI to Hong Kong, Mauritius or Barbados.
US
Australia
China
India
Until recently, a foreign venture capital investor (FVCI) could invest in any Indian sector and all streams of income earned by them were tax exempt in India. However, in the 2007 tax budget, the exemption was limited to investments in specified sectors (including nanotechnology, IT hardware and software, bio-technology, dairy and poultry industries, pharmaceutical R&D sector, and certain hotel/convention facilities). Income earned from PE investments made in non-specified sectors will now be taxable at both the PE fund level and the beneficiary level. But as most PE FVCI investment vehicles are housed in tax favourable jurisdictions (such as Mauritius or the Cayman Islands), the impact has not been far-reaching. The 2007 tax budget also amended Employee Stock Ownership Plan (ESOP) regulations, whereby ESOPs will now be taxable in India as a fringe benefit payable by the employer company. This amendment could have an impact on actual profitability (and hence the valuation) of the company in which PE investments have been made
Accusation tax leakage (continued)
Country
India

Preference share (other than fully convertible) capital will now need to comply with External Commercial Borrowing (ECB) guidelines on interest/dividend coupon caps and end-use fund restrictions on the purchase of capital goods, implementation of new projects, modernisation or expansion of existing units/business facilities, and overseas direct investment in joint ventures/wholly owned subsidiaries. It is estimated that about 30 percent of Indian PE investments are structured as preference share capital, and so the new end-use restrictions could negatively affect PE investors. Funds raised via preference shares can no longer be used for general corporate purposes, funding of working capital, repayment of existing loans and acquisition of shares and/or real-estate.33 These guidelines also place restrictions on borrowers raising ECB in order to modulate the capital inflows through ECB by modifying some aspects of the policy34 India has entered into Double Taxation Avoidance Agreements with several countries. It is interesting to note that the data published by the Government of India suggests that about 37 percent of total FDI into India made during the last 15 years has been routed through Mauritius to take advantage of the favourable tax treaty between India and Mauritius. While tax concessions under the India-Mauritius treaty have been a constant matter of debate within Indian Revenue circles, a recent ruling of the Apex Court in India upheld the benefits conferred under this treaty. However, there are indications that the Indian Revenue may consider amending the India-Mauritius Treaty by including anti-treaty abuse clauses.
Japan
There have been various changes in legislation in recent years aimed to provide a mechanism to tax gains on exit from private equity investments. The so called Shinsei tax was introduced, aimed at grouping the holdings of partnerships in order to calculate thresholds that would determine whether the transactions are taxable in Japan. There have also been numerous amendments to the M&A rules (both tax and regulatory) allowing various mergers that were previously not permitted for either tax or regulatory purposes. Industry reaction to the Shinsei tax was initially negative, but it is not a particular issue for US-based firms because the Japan-US tax treaty gives protection to gains in certain situations. The Korean tax authorities introduced a new withholding tax regime on Korean source income such as dividends, interest, royalties and capital gains remitted to a foreign recipient (for example, foreign funds) located in tax havens designated by the tax authorities. Such a tax haven would be subject to the Korean withholding tax rate on dividends, interest, royalties and capital gains, rather than having the withholding tax reduced under tax treaty between Korea and the tax haven. This new rule applies to payments made as of July 1, 2006. To be eligible for the tax treaty benefits, a foreign recipient in the tax haven should obtain confirmation from Korean tax authorities that the foreign recipient in the tax haven is the beneficial owner of such income. The tax haven list includes only Labuan in Malaysia at this time, but the list may be updated at any time.
Korea
33 Previously, the ECB policy did not permit utilisation of ECB proceeds in real-estate activities, but development of integrated township was kept outside the purview of real estate, and hence was considered as a permissible end use utilisation of ECB proceeds. Under the modified ECB guidelines issued in May 2007, the exemption accorded to the development of integrated township as a permissible end-use of ECB has been withdrawn. 34 Borrowers raising ECB greater than USD 20 million are required to park ECB proceeds overseas for use as foreign currency expenditure for permissible end-uses. This would be applicable to ECB exceeding USD 20 million per financial year both under the Automatic Route and under the Approval Route. Borrowers proposing to avail ECB up to USD 20 million for rupee expenditure for permissible end-uses would require prior approval of the Reserve Bank of India under the Approval Route. However, such funds shall be continued to be parked overseas until actual requirement in India.
Negative impact on employment

The impact of private equity investment on employment levels is not yet a burning issue in Asia Pacific, where robust economic growth in many countries is creating more jobs than ever before. Nevertheless, it is worth looking at the reaction elsewhere for indications of how the issue may arise in the region, particularly if the anticipated increase in buyouts materialises. As Exhibit 11 shows, most private equity activity in the region is still focused on generalist, venture and growth capital, so PE involvement tends to lead to expansion and more hiring, rather than the opposite. But the situation may change if buyouts become as popular and as big in the region as in the US and Europe. The buyer always cuts costs, says Kelvin Chan, Senior Vice-President at Partners Group in Singapore.35 But in general you cannot look at these transactions on a short-term basis. The long-term results have shown that private equity and buyout firms actually make a company more competitive and a bigger employer. Unite, the UKs largest trade union, is lobbying the House of Commons to extend protection to workers affected by private equity deals. Its deputy general secretary, Jack Dromey, says that the experience of his members with private equity is all too often job uncertainty, poorer pay, pensions put at risk and even unemployment.36 In the US, the Service Employees International Union is urging Congress to pass legislation that would ensure that private equity works for working people and for the rest of the country, if the industry does not take steps on its own to protect the interests of employees and the community at large.37 PE practitioners typically cite research from Europe that credits private equity with net employment increases. There have been numerous studies by the BVCA and EVCA [European Private Equity & Venture Capital Association] that show companies with private equity participation generate 20 percent more employment growth than companies that do not have private equity, says 3is Rowlands. In a recently published survey, the BVCA found that companies backed by private equity and venture capital in the five years to 2006 increased worldwide staff by an average of 9 percent per annum, faster than employment increases among FTSE 100 and FTSE Mid-250 companies at 1 percent and 2 percent, respectively.38 In a 2005 survey, the EVCA found that private equity created 1 million jobs between 2001 and 2004 in the 25 EU member states, a compound annual growth of 5.5 percent eight times the 0.7 percent average growth rate of employment in these economies.39 No region-wide study has yet been conducted in Asia. Last year, AVCAL commissioned a study that found that 76 percent of the 50 PE-backed Australian companies polled plan to hire more employees in 2007.40 A region-wide study along the same lines will provide a more complete picture, and further bolster private equitys claim of having a positive effect on Asia Pacific employment in the long term.
35 KPMG interview with Kelvin Chan, Senior Vice-President at Partners Group and Chairman of the Singapore Venture Capital & Private Equity Association, 11 July 2007. 36 Jack Dromey, Protect workers from the private equiteers, The Financial Times, 2 July 2007. 37 Testimony of Andrew Stern, President of the Service Employees International Union, before the House Financial Services Committee of the US Congress, 16 May 2007. 38 Statement on trade union comment about private equity industry, by BVCA Chief Executive Peter Linthwaite at www.bvca.co.uk. 39 Private equity in the public eye: 2007 global private equity environment rankings, a report by Apax Partners and the Economist Intelligence Unit, 2007. 40 Economic Impact of Private Equity and Venture Capital in Australia, a report by AVCAL 2006.
other issues
Regulators and legislators around the world are being asked to respond to several other issues relating private equity. These include the impact of deequitisation arising from buyouts, conflicts of interest involving private equity, inadequate regulation, and systemic risk to capital markets and the economy.
Accusation Negative impact on employment
Country
UK

Unite, Britains biggest trade union, has called for new legal protection for workers in private equity deals. Deputy General Secretary Jack Dromey said that the experience of his members with private equity is all too often job uncertainty, poorer pay, pensions put at risk and even unemployment as factories and plants are closed.41 The BVCA responded by noting that its recent survey entitled The Economic Impact of Private Equity reveals that PE/VC backed companies in the five years to 2006 increased worldwide staff by an average of 9 percent per annum, faster than employment increases among FTSE 100 and FTSE Mid-250 companies at 1 percent and 2 percent, respectively.42 The House of Commons will release its report on employment and other private equity issues before the end of 2007.43
US
In a recent document,44 the Service Employees International Union in the US questioned the credibility of private equity studies that claim the industry creates jobs since private companies do not publicly disclose information about their employees or company growth, adding that it was unclear how employees benefit since industry studies make little attempt to look behind the numbers at what is happening to workers and communities. The Private Equity Council concedes that private equity employment data have not yet been developed in the US, but it believes that the increased employment numbers reported by various surveys done in Britain and the rest of Europe mirror what is happening in America.45 Congressional hearings on this and other issues are currently ongoing.
On de-equitisation, Taiwans Financial Services Commission is considering a change in the stock markets de-listing rules. Whilst the USD 976.8 million Fu Sheng deal is the islands first private equity buyout, concerns have been raised about the effect on the stock market, which is seeing more de-listings than new public offerings.46 The regulator may raise the threshold for de-listing from the current 50 percent of shareholders present during the vote (a quorum of twothirds of the total shareholders is required).47 Similar concerns have been raised in Australia, but no regulatory action is imminent there at this time.48 On the adequacy of regulation, the US Securities and Exchange Commission recently adopted a new rule that explicitly makes it a fraudulent, deceptive, or manipulative act, practice or course of business for investment advisers of private equity funds, venture capital funds, hedge funds, and mutual funds to make false or misleading statements to investors or prospective investors in the pooled investment vehicle.49 The ruling closes a loophole in the Investment Advisers Act, which was enacted before the rise of private equity funds. Private equity regulations are also being revised in India as part of the overall fine-tuning of foreign investment incentives. Finally, there are fears in Australia about the systemic risk posed by private equity activities. The Senate has referred an inquiry into private equity to the Standing Committee on Economics, whose findings have yet to be published. In its submission to the committee, AVCAL said it recognises as a general principle that increased debt leads to an increase in risk. But private equity firms in Australia, it pointed out, conduct extensive due diligence and have extensive experience in operating businesses with increased debt. The track record of the private equity industry shows that it is well equipped to manage businesses throughout the economic cycle, AVCAL concluded.50
41 Jack Dromey, Protect workers from the private equiteers, The Financial Times, 2 July 2007. 42 Statement on trade union comment about private equity industry, by BVCA Chief Executive Peter Linthwaite at www.bvca.co.uk. 43 Jean Eaglesham, Commons private equity report to be delayed, The Financial Times, 11 July 2007. 44 Behind the Buyouts: Inside the World of Private Equity, study prepared by the Service Employees International Union, April 2007. 45 Public Value: A Primer on Private Equity, by the Private Equity Council, 2007. 46 Private equity in Asia, The Lex Column, The Financial Times, 21 April 2007. 47 Taiwan regulator debates buyout reforms, The Financial Times, 4 July 2007. 48 Australia rethinks value of private equity buyouts, by Tim Johnston, International Herald Tribune, 16 May 2007. 49 SEC Votes to Adopt Antifraud Rule Under Investment Advisers Act, media release by the US Securities and Exchange Commission, 11 July 2007. 50 Private Equity in Australia, submission by the Australian Private Equity & Venture Capital Association (AVCAL) to the Senate Standing Committee on Economics, 10 May 2007.
Accusation Lack of or inadequate regulation
Country
UK

In its June 2006 discussion paper, the FSA commented with regard to regulation that current architecture is effective, proportionate and [the industry is] adequately regulated. It recently changed the auditor reporting requirements for certain investment firms for accounting periods ending on or after 1 January 2007, reducing the regulatory administrative burden. On 11 July 2007, commissioners of the US Securities and Exchange Commission (SEC) voted 5-0 to adopt a new rule that will make it a fraudulent, deceptive, or manipulative act, practice, or course of business for an investment adviser to a pooled investment vehicle to make false or misleading statements to, or otherwise defraud, investors or prospective investors in that pool. In a media statement, SEC Chairman Christopher Cox said the rule applies to investment advisers not only of hedge funds, but also of private equity funds, venture capital funds, and mutual funds.51 The Private Equity Council, the first US trade association for private equity individuals, intends to set out a self-regulatory scheme in the US that is in line with BVCA schemes. PE investments in each Indian sector are governed by the Foreign Direct Investment (FDI) Guidelines and Foreign Exchange Control Guidelines. Apart from this FDI route, private equity funds can also register as a Foreign Venture Capital Investor (FVCI), giving them the benefit of free entry and exit pricing of the Indian investment. However, PE investment (i.e. entry and exit) in Indian listed companies is governed by the Takeover Code regulations. The Government of India along with the Foreign Investment Promotion Board are revisiting the foreign investment caps in each sector and will revise the existing guidelines in the near future. The revised foreign investment guidelines may also include a change in the definition of direct and indirect foreign holding in Indian companies. There has been criticism in Australia about the potential of private equity buyouts to narrow the options available to ordinary investors as they take public companies private.52 David Jones, chairman of the Australian Private Equity & Venture Capital Association, says buyouts last year accounted for only a small fraction of the market capitalisation of all companies trading in the Australian Securities Exchange.53 More companies in Taiwan are being de-listed compared with the number of new public offerings, raising worries about de-equitisation as more and more private equity firms propose buyouts.54 The Financial Supervisory Commission is considering raising the threshold for delisting.55 Under current rules, a company can be de-listed if two-thirds of shareholders are present at the meeting, and 50 percent of those shareholders vote to de-list. In the UK, the existing status of private equity funds, typically via limited partnerships and Collective Investment Schemes (CISs) offers benefits over listed investment vehicles, since there is a prohibition in the Listing Rules that stops listed vehicles taking control of the companies that they invested in. This has led to accusations that private equity funds enjoy preferential market access. The FSA issued a consultation paper in December 200656 that outlined changes in listing rules to remove this prohibition. Congressmen Dennis Kucinich and Henry Waxman expressed worry about the implications of private equity funds going public such as Blackstones IPO, which they feared would allow public investors to participate in hedge-fund type investments that have previously been considered unsuitable.57 Congressional hearings on this and other issues are currently ongoing. In August 2007, an inquiry by the Senates Standing Committee on Economics published its findings in relation to an inquiry into private equity investment and its effects on capital markets and the Australian economy. In their report, the Committee suggested that private equity is not a threat to the public capital markets and that there are limits to the growth of the sector that will mitigate against significant equity market risks.58
US
India
de-equitisation
Australia
Taiwan
playing field unlevel
UK
Listing of private equity funds
US
systemic risk to capital markets and the economy
Australia
51 SEC Votes to Adopt Antifraud Rule Under Investment Advisers Act, media release by the US Securities and Exchange Commission, 11 July 2007. 52 Australia rethinks value of private equity buyouts, by Tim Johnston, International Herald Tribune, 16 May 2007. 53 KPMG interview with David Jones, Chairman of AVCAL and Managing Director of CHAMP Private Equity, July 12 and 20, 2007. 54 Private equity in Asia, The Lex Column, The Financial Times, 21 April 2007. 55 Taiwan regulator debates buyout reforms, The Financial Times, 4 July 2007. 56 Financial Services Authority: CP06/21 Investment Entities Listing Review 57 Joint letter to Christopher Cox, Chairman of the US Securities and Exchange Commission, by Dennis J. Kucinich, chairman of the Domestic Policy Subcommittee and Henry A. Waxman, Chairman of the Committee on Oversight and Government Reform, both of the US House of Representatives, 21 June 2007. 58 Private equity investment in Australia, report to The Senate by the Standing Committee on Economics
The growing reach of Sovereign Wealth Funds

Sovereign Wealth Funds (SWFs) are state-owned funds which invest national wealth into assets such as stocks, bonds, property and infrastructure. Traditionally these funds have been a vehicle for oil-rich nations to diversify their national income. Recent years have seen the establishment of SWFs by East Asian nations with large current account surpluses who are attempting to achieve better returns on their foreign exchange reserves. Morgan Stanley has estimated that total SWF assets globally could be as much as USD 2.5 trillion in 2007, with Asia Pacific accounting for approximately 35 percent of this amount. The sheer size of these funds means that they will be significant players in global asset markets for the foreseeable future, with private equity likely to be an important part of their asset allocations. SWFs may compete directly with private equity firms for investment opportunities, or indeed invest directly in private equity firms, such as CICs USD 3 billion investment in the Blackstone Group. As with private equity firms, SWFs face scrutiny due to the lack of publicly available information. This has led to concerns by many governments that foreign SWFs are investing for political and strategic reasons rather than solely for financial gain.
Key national players in Asia Pacific are: Australia: In 2004, the Australian government announced that it would be establishing an SWF into which it would invest budget surpluses to meet its retirement benefit liabilities. The fund aims to hold USD140 billion by 2020 and will be governed by a broad investment mandate. The funds chairman has indicated that they are not looking to take controlling interests in companies, only to be more active in publiclytraded securities markets than in private equity.
SWFs in the Asia Pacific Region

Country Fund name Acronym Estimated assets (USD billions) 330 200 100 100 51 30 20 18 15 864 Inception
Singapore China (PRC) China (PRC) Singapore Australia Brunei Malaysia China (ROC) Total
Government of Singapore Investment Corporation China Investment Company Ltd Central Hujjin Investment Corp Temasek Holdings Australian Government Future Fund Brunei Investment Agency Khazanah Nasional National Stabilisation Fund
GIC CIC n/a n/a FFMA BIA KIC KN NSF
1981 2007 2003 1974 2004 1983 2005 1993 2000
South Korea Korea Investment Corporation
Note: The asset figures listed above are estimates only, as many of the funds do not publish detailed financial information and are subject China: Chinas economic to significant flows of capital from central bank reserves. performance has led to a dramatic Source: Morgan Stanley Research:How Big Could Sovereign Wealth Funds Be by 2015? 3 May 2007 increase in the size of Chinas foreign exchange reserves. The creation of SWFs reflects an increased desire to improve the returns on these reserves, which had previously been invested in sovereign debt. With limited public disclosure from the funds, it is not currently clear what mandates and objectives these funds have.
Korea: Korea Investment Corporation was established in 2005 as a government-owned investment management company, specialising in overseas investments. It is mandated to manage part of Koreas foreign exchange reserves and other public funds. Currently it manages USD 17 billion of foreign exchange reserves from the Bank of Korea and USD 3 billion of foreign exchange stabilisation funds from the Ministry of Finance and Economy. Malaysia: Established in 1993, Khazanah Nasional is the investment holding arm of the government of Malaysia and is empowered as the governments strategic investor in new industries and markets. It has stakes in more than 50 companies with assets valued in excess of USD 18 billion. Singapore: Singapore has long made use of SWFs to manage its national investments, establishing Temasek Holdings in 1974 and GIC in 1981. With an estimated 75 percent of investments being in Singaporean assets, Temasek owns stakes in many of the nations largest and landmark companies. Their focus is now being widened with a long-term balanced portfolio target of approximately one-third exposure each to Singapore, rest of Asia (ex-Japan), and OECD (ex-Korea) and other economies. GIC was established to manage Singapores foreign reserves, with its investment portfolio managed in turn by GIC Asset Management Pte (responsible for investments in publicly traded securities); GIC Real Estate Pte Ltd (investments in property); and GIC Special Investments Pte Ltd (operating as a private equity investor, taking direct controlling stakes in companies and making direct investments in infrastructure).
Private equity performance analysis

In Asia Pacific, private equity is helping many companies become regional and global players, an undertaking that requires not only financial backing but more importantly, technical expertise, management skills and an international network of contacts. Satish Deshpande, Head of Private Equity at NV Advisory Services in India, points to a small Indian auto-parts maker whose acquisition of two enterprises in the UK and the US has placed it on track to grow by more than 30 percent annually over the next few years. This was made possible, says Deshpande, because one of our founding partners sits on the board of major auto companies in the US, so we were able to make introductions and help the company get short-listed in the bidding.59 The fact that the Indian company had private equity investment, in his view, was a critical factor given the undeveloped credit rating system in India. The two companies we feature as case studies at the end of this chapter illustrate other ways private equity add value to enterprises. Little Sheep, a restaurant chain in China known for its hotpot cuisine, became more efficient and profitable with the injection of international know-how by two nonexecutive directors brought in by 3i, Nish Kankiwala, former CEO of Burger King International, and Yuka Yeung, KFCs Hong Kong Master Franchisee CEO. In Australia, pay TV provider Austar was burdened in 2002 by AUD 400 million in debt, an obligation it was unable to service because its EBITDA was only AUD 22.6 million. Financial engineering, combined with a focus on business fundamentals, by CHAMP Private Equity helped turn its fortunes around. Austars stock price, at about AUD 0.25 in 2002, had soared 420 percent to AUD 1.30 when CHAMP exited in 2005.
ipo performance
In an attempt to quantify the effect of private equity involvement in Asian companies, KPMG analysed the stock performance of PE-sponsored initial public offerings versus that of their non-PE sponsored peers that went public in 2005 and 2006. The analysis focused on four markets: Australia, Hong Kong, India and Japan. The companies were grouped in age-range buckets (meaning that companies in the 100-200 days bucket have been trading for 100 to 200 days, those in the 201-300 bucket have been trading for 201 to 300 days and so on). The comparison days were the IPO offer price and the closing price at the end of May 18, 2007.
59 KPMG interview with Satish Deshpande, Head Private Equity, NV Advisory Services Private Limited, 19 July 2007.
exhibit 13 Stock market performance of Australias PE and non-PE companies

160 140 120 Gain/loss % 100 80 60 40 20 0 -20 100-200 days 201-300 days 301-400 days 401-500 days 501-616 days
n PE-sponsored companies -Average Price Gain/Loss n Non-PE-sponsored companies -Average Price Gain/Loss
Number of PE-sponsored companies: 12 Number of non-PE sponsored companies: 131 Source: Bloomberg, AVCJ database and KPMG Analysis
exhibit 14 Stock market performance of Indias PE and non-PE companies

250 200 Gain/loss % 150 100 50 0 100-200 days 201-300 days 301-400 days 401-500 days 501-616 days
The results for Australia and India were positive. As Exhibit 13 shows, PEsponsored companies in Australia which have been trading for 501 to 616 days were up better than 130 percent on average compared with the 42 percent gain of their non-PE sponsored peers in the same bucket. In India, the average share price of PE companies in the 501-616 days bucket had risen 195 percent as of May 18, while the non-PE companies in the same bucket had an average price gain of 99 percent.
exhibit 15 Stock market performance of Hong Kongs PE and non-PE companies

250 200 Gain/loss % 150 100 50 0
100-200 days
201-300 days
301-400 days
401-500 days
501-616 days
Interestingly, there is little difference between the average price performance of PE and non-PE companies in Hong Kong (Exhibit 15). This may be due to the growing number of Chinese companies which are listing in Hong Kong in tandem with the China A-share market. Many of these are outperforming their Hong Kong peers and therefore distorting overall performance.
exhibit 16 Stock market performance of Japans PE and non-PE companies

0 -10 -20 Gain/loss % -30 -40 -50 -60 -70 100-200 days 201-300 days 301-400 days 401-500 days 501-616 days
The number of IPOs in the sample period in Japan is larger (24 PE companies and 246 non-PE companies), but the results are the direct opposite of the trends in Australia and India, with most companies in the period showing price losses instead of gains. This can be attributed to some Japanese markets, such as the Tokyo Stock Exchange Second Section and Mothers Index for example, entering into a period of decline starting the first quarter of 2006. Both of these markets have been popular with IPOs. Retail investors, who tend to dominate small cap IPO issues, may also have been weary of entering the market, resulting in reduced funds in the market, and subsequently lower valuations. The pricing trends in Australia and India represent the potential of private equity firms to add value and rewarded by the market accordingly, while those in Japan may indicate that market conditions, volatile sectors and perhaps individual
failures by PE firms can sour investments in PE-sponsored companies. The picture should become clearer going forward, when more PE companies are listed and longer term trends can be assessed.
Financing, management and processes

Private equity firms are unequivocal about the benefits they can bring to companies and economies in Asia. The overwhelming majority of this studys respondents 90 percent say they are hands-on investors (Exhibit 17). They are not short-term investors that demand instant results. They are in for the long haul and are not likely to head for the exits during temporary bad times. exhibit 17 What is your involvement in the portfolio company?
10%
n Hands on n Hands off
90%
The approach of 3i in Asia illustrates the hands-on nature of the private equity business. Management has to put together a plan for us to buy into, explains Rowlands. We test that plan, we look at it from different angles, we get consultants to help us out, we get reactions from experts, and then we come up with what we think is a realistic base case. Typically, a 180-day action plan is implemented, covering operations, legal, marketing, financial and other matters. In the next three to five years, which is generally how far into the future performance can be realistically measured, 3i takes an active role in strategysetting at the board level and provides guidance and advice on management and operations issues. exhibit 18 What are the key benefits that you bring to portfolio companies? (degree of commonality on a scale of 1 to 10)
Provision of capital required for investment to grow the business General management guidance at board level Improved corporate governance Ability to recruit the best managers to the business Optimised financing structure Business process improvement A greater focus on long-term commercial performance Accelerated growth through synergies with other portfolio companies Links to other financial sponsors IPO process knowledge 1.0 2.0 5.3 5.3 5.1 5.0 4.8 3.5 3.3 3.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0 5.9 6.7
Asias private equity funds pride themselves on the value they add to their investments. Asked to rate the key benefits they bring to their portfolio companies, the respondents in this study first cite their role in providing capital needed for growth (Exhibit 18). The second most cited benefit is provision of general management guidance at the board level, followed by improved corporate governance, ability to recruit the best managers to the business and ability to optimise financing structure.
exhibit 19 Key benefits by fund type, finance/capital structuring
Venture
Growth Capital
Generalist
Buyout
10
Least important n Links to other financial sponsors n IPO process knowledge
Most important
n Provision of capital required for investment to grow the business n Optimised financing structure
Broken down by fund type, the responses show a remarkable unanimity on the benefits the private equity firms believe they deliver to portfolio companies (Exhibit 19). Regardless of whether their fund is in venture capital, growth capital, generalist or buyout, the respondents single out the provision of capital to grow the business as their most important contribution. The second most important benefit is their ability to optimise the portfolio companys financing structure.
exhibit 20 Key benefits by fund type, management/processes
Venture
Growth Capital
Generalist
Buyout 1 2 3 4 5 6 7 8 9 10
Least important n Improved corporate governance n General management guidance at board level n Business process improvement n Abiltiy to recruit the best mangers to the business
Most important
There are differences in emphasis in the area of management and processes (Exhibit 20). Venture capital funds emphasise the provision of general management guidance at the board level, and their ability to recruit the best managers to run the business. Growth capital funds also focus on board-level guidance, but also give equal importance to their ability to improve corporate governance. Little importance is given to the recruitment of good managers, implying that growth funds tend to retain current management. Generalist funds give equal importance to corporate governance, general management guidance and recruitment of the best managers. Buyout funds focus strongly on the improvement of business processes, an indication of the type of target companies that would most appeal to them, namely underperforming and complacent enterprises that will benefit from costcutting.
exhibit 21 Key impact of private equity funds on various economies

60% 50% 40% 30% 20% 10% 0%
Greater China
India
Korea/Japan
Oceania
Southeast Asia
n Improved focus on research and development n Growth of small businesses n Increased ability for local businesses to compete on the regional stage n Increased ability for regional businesses to compete on the global stage n Employment growth n Increased ability for the country as a whole to attract external investment
Private equity funds regard their activities as having an impact beyond their own immediate portfolio companies. The respondents in this survey say their main contributions relate to helping regional businesses compete globally, helping countries attract external investment, and helping small businesses survive and thrive. It is interesting to see how private equity can deliver different benefits to different markets (Exhibit 21). Increased ability to attract foreign investment is seen as the key contribution in Greater China (54 percent) and India (47 percent). Private equity is also regarded as a contributor to making regional businesses competitive on the global stage in both countries, as is the case in Korea and Japan (49 percent) and Oceania (44 percent). In Southeast Asia, private equitys main contributions are seen to be helping small businesses grow (49 percent) and helping local businesses compete on the international stage (49 percent).
Case study: Little Sheep

When private equity firm 3i paid USD 20 million60 last year for a minority stake in Mongolian lamb hotpot chain Little Sheep, it knew exactly what it was getting. Due diligence had confirmed that the 500-outlet restaurant was profitable, but the investigation also revealed a number of areas that required some attention in order for the Chinese enterprise to realise its full potential. We saw that there was a lot to do in terms of protecting the brand by sorting out which were the fake stores and which were the genuine franchises, improving the overall operational quality and consistency, and ramping up central support for this part of the business, recalls Chris Rowlands, Managing Partner Asia at 3i. Twelve months later, Little Sheeps revenues were growing by 40 percent per annum, far in excess of the 15-20 percent expansion of Chinas fast food sector. The ratio of directly owned to franchised outlets, at 70 to 430 preprivate equity, is now a more balanced 105 to 221. Most of the 116 outlets that were closed had been Little Black Sheeps restaurants that were operating without a full agreement with the company. Next year, Little Sheep plans an initial public offering in Hong Kong, where it has opened four stores. One of the first things 3i did was to install two non-executive directors with extensive fast-food industry experience. They are Nish Kankiwala, a former president of Burger King International, and Yuka Yeung, KFCs Hong Kong Master Franchisee CEO. The two men are part of 3is People Programme, a global network of seasoned senior executives who help the London-listed group find deals and serve on the boards of 3i investments. They provided guidance and external views, Rowlands says of Kankiwala and Yeung. Things like how to motivate staff, what KPIs to focus on, how to increase same-store growth all the advanced restaurant management skills that Little Sheep needed to know. They also helped focus Little Sheeps attention on franchise management and the protection and enhancement of the brand. Started in Baotou in Inner Mongolia in 1999, the enterprise had expanded quickly, becoming Chinas largest restaurant chain by the time 3i came in. But there was no centralised franchising system, allowing copycats to purloin Little Sheeps signage and logo, and putting the brands reputation at risk with substandard food and service. The creation of a standards committee and a mandatory training program for franchisees is helping correct the situation. Rowlands says Little Sheep is on track to open 45 new outlets a year, creating more jobs to replace and even exceed the numbers that had been lost. As a minority shareholder, 3i oversees its investment at the board-level and has not pushed out the previous management. Founder Zhang Gang remains as board chairman and a new CEO has been named from within the ranks. Everyone is intent on making the company the biggest and the best dining business in China, says Rowlands. If they succeed, equal credit should go to the art and science of private equity investing.
60 Another private equity firm, Prax Capital, invested USD 5 million alongside 3i.
Case Study: Austar

On the face of it, Australias CHAMP Private Equity got a bargain in 2002 when it paid just USD 34.5 million for bonds with a face value of USD 500 million. The bonds were issued by a US company called UAI, which was going through Chapter 11 bankruptcy filings after failing to service its obligations. CHAMP was interested in UAIs sole asset a 51 percent indirect stake in Austar, an Australian subscription TV provider. But Austar was also about to collapse, having breached covenants with banks that lent it AUD 400 million. Austars EBITDA earnings before taxes, debt and amortisation was a paltry AUD 22.6 million a year. Was CHAMP being played for a chump? As an experienced private equity house, CHAMP had done its homework. It learned many things about the company by talking to a former Austar CFO. We asked him to a case study, and it looked interesting, recalls David Jones, CHAMPs managing director. We asked him to do more work, and it still looked interesting. A commercial due diligence indicated that there was significant business opportunity. The industry was undergoing rationalisation, creating an orderly market environment, reducing the cost of new programming and satellite arrangements, and making possible the shared development of interactive and near video on demand (NVOD) applications. CHAMP also examined an internal turnaround plan developed by Austars management. The plan focused on initiatives such as the closure of the regional office network, outsourcing of field sales and the internet network, price rises, increasing footprint by 200,000 homes, and reduction of churn through operational improvements. The projected EBITDA uplift was substantial but believable, says Jones. What Austar needed to do was to fix its capital structure to stop the bank distraction and implement the plan. Legal thicket CHAMP proceeded to negotiate the legal thicket around Austar. After coming to terms with the New York bankruptcy court over how much to pay for UAIs bonds (a 93 percent discount, at USD 34.5 million), the PE firm struck an agreement with Liberty Global (LGI), then known as United Global Communications, for joint control of Austar. LGI owned 31 percent of UAI, with the US bondholders owning 63 percent. CHAMPs bond purchase made it the majority owner of UAI, and thus gave it control of UAIs 81 percent stake in Austar (the rest of the 19 percent was in public hands). LGI had pre-emptive and other rights with regard to UAI, and could have effectively stopped CHAMPs deal with the bondholders. Because it had to attend to other challenges in its other business units, LGI agreed to let CHAMP drive the Austar turnaround plan. The partnership with LGI yielded other benefits. We gained access to their global pay TV expertise and also some programming, says Jones. They had international experience and we had local experience. CHAMP knowledge of the Australian system was important because the deal required a waiver from ASIC, the local regulator. Under Australias Takeovers Code, getting to own
20 percent of a company before making an offer for the rest of the shares is a criminal offence. We had to go to ASIC to explain that Austar had big problems, that the bonds were in a separate market and in bankruptcy court in New York, that we were doing an arms length trade there, says Jones. In the end, ASIC granted the new owners relief, with the proviso that they make an equivalent offer to the rest of Austars shareholders after buying the bonds. Financial engineering The equivalent offer was AUD 0.16 per share, which is the value of the USD 34.5 million CHAMP paid for the bonds in Austar equity terms. The PE firm duly offered AUD 0.16 per share for the 19 percent in public hands, but virtually no one accepted. CHAMPs entry boosted the stock price beyond AUD 0.40 per share, 150 percent higher than the offer price. The new owners embarked on a new strategy. Austar launched a rights issue priced close to the strong market price, and got a 93 percent acceptance rate. The offer yielded AUD 75 million in new capital, which was used for capital expenditures and debt reduction. The new owners also had to deal with Austars massive bank debts. The rights offering enabled Austar to pay the banks AUD 45 million, but the amount was just a tenth of what was owed. Restructuring the borrowings was a complicated workout because 15 financial institutions were involved and most of the loans were already in the respective banks difficult-to-work with workout divisions. Seven banks accounted for 9 percent each of the total debt, with the rest having lower exposure, meaning that there was no one dominant lender to take the lead. It took CHAMP four months to get the banks on board in May 2003. The loans were restructured in mid-2004 into senior debt of AUD 290 million and hybrid debt security of AUD 115 million, resulting in improved flexibility and lower longer term cost for Austar. Freed from the distraction of the debt, Austars management focused on executing the turnaround plan. We assessed management carefully, and we formed the view that they were a capable team, even though they were partly responsible for getting Austar into its problems, says Jones. With some direction, focus and accountability, we believed we could work with them, and that turned out to be the case. To incentivise management, executives who bought Austar shares at AUD 0.16 had each of those shares matched with two shares at the prevailing market price, funded by a company-provided loan. Managers were also vested with shares provided the company met its internal rate of return targets. CHAMP exited the investment in 2005 on the back of Austar posting 2005 EBITDA of AUD 125 million. It sold 224 million shares to LGI at AUD 1 per share and another 298 million shares to Goldman Sachs at AUD1.15. The total proceeds came to AUD 556.8 million, a six-fold return on the PE firms AUD 81.6 million investment (purchase cost of the bonds and the rights offering). One main beneficiary is Australias pension funds, which are major investors in CHAMP. Private equity had worked its magic once again.
The way forward

Around Asia Pacific, business management, operations and corporate governance need to be improved and this is something that private equity has proved it is equipped to help with. Private equity can help create deals in emerging markets, where industries are fragmented, companies are sprawling and due diligence is tough. It also fills an important need as deals get bigger and the focus shifts to larger companies. As roll-ups are carried out, private equitys established network of contacts, ability to attract world-class management teams and put together financing on attractive terms become even more important. There are many avenues available to Asian companies as they seek to improve their management, including M&A, partnerships and internal transformation. However, the PE industry is in a position to help many of these local champions as they seek to compete on a more international footing. Private equity participation or buyouts are certainly options they can consider. However, this is where private equity in Asia can become vulnerable to negative public and media opinion. Takeovers can ruffle local feathers, especially when national assets are at stake. Emotional and nationalistic feelings can complicate already complex commercial considerations. Isolated instances of excessive profit-making and overzealous deal-making can also tar the rest of the industry. The challenge for private equity funds in Asia is to remain sensitive to Asian business ways, which emphasise partnership rather than confrontation, moderation rather than excess. Private equity is now in the public domain. This means PE companies should engage more actively with the wider community, including the media. As nonpublic entities, private equity funds are obliged to disclose their financial results and activities only to their shareholders. As the Walker Working Group in the UK suggests, however, they should consider being more transparent to the larger market and all community stakeholders, particularly when they embark on buyouts involving state assets or well-known companies. The companies they invest in should also improve their level of transparency, including activities that affect employee numbers. One truth is fairly self-evident. The self-regulatory and voluntary approach is to be preferred to possibly heavy-handed regulatory edicts, and the civil and criminal penalties that they may prescribe. Towards this end, Asias private equity players should arm themselves with on-the-ground knowledge of exactly what is going on not only in their own businesses but also in their local market and the rest of the region. How well the industry communicates to the media and the general public these facts about what they do and the benefits they deliver to their host countries could influence how regulators and legislators will act in resolving various issues involving private equity in Asia. As noted, there are moves in several countries to develop reporting standards among private equity funds and the portfolio companies operating in their market. In addition, some national associations want to develop a code of ethics and a code of behaviour as part of a system of self-regulation of the industry. These moves should be across Asia Pacific, both individually by national associations and also by co-oordinating and co-operating with each other.
The structures are already in place. Private equity and venture capital associations have been formed in Australia, China, Hong Kong, India, Indonesia, Japan, Malaysia, Singapore, South Korea, Taiwan and Thailand. Seven of these associations are founding members of the Asia Pacific Venture Capital Alliance (APVCA), which was established in 2001 and has its secretariat in Kuala Lumpur. The APVCA aims to strengthen communications and networking among national associations, their members and institutional investors, provide an effective platform to jointly evaluate issues, threats and opportunities, and engage in dialogue and cooperation with government agencies and multilateral institutions. In our view, APVCA and the national associations should also add to their mission the conduct of national and regional studies on the impact of private equity on businesses and economies, and the role of interfacing with the media in an open and professional manner. These two aims complement each other, since the associations will not have much to tell the press if they have little data about the latest trends and developments across the region. Bringing this about will require financial resources and political will. Most associations, including the APVCA, will need more support and funding to shoulder this responsibility. Kelvin Chan, of the Partners Group wants to set up an Asia Private Equity Institute that will harmonise standards and valuation methodologies across the region, as well as conduct studies about the industry. With seven full-time staff, AVCAL in Australia is probably the best equipped among the Asia Pacific associations. Every association is always looking for more funding, says Dr. Woodthorpe, its chief executive. But we manage, and we have many professional practitioners who assist us. Our membership is strong in supporting our work in more than just the purely financial way. AVCAL patterned its 2006 study on the impact of private equity in Australia on research by the British Private Equity and Venture Capital Association. At the moment, we are trying to make sure that our research is as rigorous as possible, says Dr. Woodthorpe. Then wed certainly be looking at how we can enable others [in Asia Pacific] to carry out surveys with similar questions so they can all be correlated. Jamie Paton, former chairman of the Hong Kong Venture Capital and Private Equity Association and currently a member of its executive committee, says We have appointed this year a PR firm to be involved with the association. In addition we are holding a conference around the theme of what the industry is doing for companies and the added value being put in to try and counter people being negative about the industry. Paton agrees that PE firms need to be more media savvy. But there are other people in our industry, and we should be hearing from them too. We all have a responsibility to spread the positive impact our industry has on economies, he says, pointing to investment bankers, lawyers, accountants, limited partners and pension funds. KPMG member firms are responding with this study, the findings of which we believe put the private equity industry in better perspective. In Asia, as in the rest of the world, private equity companies must communicate to the media and the public what they already know: that what they are and what they do, while pragmatic, can ultimately drive efficiency and prosperity. By providing options in the financing and nurturing of businesses, private equity companies advance both their own interests and those of the larger community.
For more information on KpMGs private equity Group in asia pacific, contact:
Asia Pacific PE Group Leadership david Nott Tel: +61 (2) 9335 8265 e-Mail: david.nott@kpmg.com.au Australia Jonathan dunlop Tel: +61 (2) 9335 7633 e-Mail: jonathan.dunlop@kpmg.com.au China and Hong Kong SAR Honson to Tel: +86 (21) 2212 2708 e-Mail: honson.to@kpmg.com.cn India vikram utamsingh Tel: +91 (22) 3983 5302 e-Mail: vutamsingh@kpmg.com Indonesia david east Tel: +62 (21) 574 0877 e-Mail: deast@siddharta.co.id Japan Masami Hashimoto Tel: +81 (3) 5218 8815 e-Mail: masami.hashimoto@jp.kpmg.com Korea edward Kim Tel: +82 (2) 2112 0770 e-Mail: edwardkim@kr.kpmg.com Malaysia Hock eng Lim Tel: +60 (3) 2095 3388 e-Mail: hockenglim@kpmg.com.my Asia Pacific Regional Coordinator robert stoneley Tel: +852 3121 9850 e-Mail: robert.stoneley @kpmg.com.hk New Zealand ian thursfield Tel: +64 (9) 367 5858 e-Mail: ithursfield@kpmg.co.nz Philippines vicente J. sarza Tel +63 (2) 885 7000 ext: 220 e-Mail: vsarza@kpmg.com Singapore diana Koh Tel: +65 6213 2519 e-Mail: dianakoh@kpmg.com.sg Taiwan Jay Cheng Tel: +886 (2) 2715 9716 e-Mail: jaycheng@kpmg.com.tw Thailand tanate Kasemsarn Tel: +66 (2) 677 2750 e-Mail: tanate@kpmg.co.th Vietnam rupert Chamberlain +84 (8) 946 1600 rupertchamberlain@kpmg.com.vn
The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.
2007 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis--vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. Printed in Hong Kong. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Publication date: November 2007
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Private Equity - Implications For Economic Growth in Asia Pacific

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Private Equity - Implications For Economic Growth in Asia Pacific

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p r i vat e e q u i t y

Private Equity: Implications for Economic Growth in Asia Pacific

inside private equity in asia pacific

the growing reach of sovereign Wealth Funds

Private Equity: Implications for Economic Growth in Asia Pacific

Private Equity: Implications for Economic Growth in Asia Pacific

David Nott Regional Leader KPMG's Private Equity Group

Private Equity: Implications for Economic Growth in Asia Pacific

Private Equity: Implications for Economic Growth in Asia Pacific

Private Equity: Implications for Economic Growth in Asia Pacific

About the study

Respondent Job Function

19% 13% 19%

n Partner/equivalent n Investment Director n Investment Executive n Fundraising/Investor Relations

n Greater China n Oceania n Southeast Asia

n Rest of World n India/Pakistan n Japan/Korea

Current Investment Profile

Private Equity: Implications for Economic Growth in Asia Pacific

Private Equity 101

Private Equity: Implications for Economic Growth in Asia Pacific

Inside private equity in Asia Pacific

exhibit 1 Value, volume and new fund-raising by private equity funds

Private Equity: Implications for Economic Growth in Asia Pacific

n Increase n Decrease n Stay the same

exhibit 3 What are your key reasons to invest in Asia Pacific?

10 Private Equity: Implications for Economic Growth in Asia Pacific

n Pan-regional n Single country focus

Private Equity: Implications for Economic Growth in Asia Pacific 11

exhibit 7 Average deal size in selected industries

Average Transaction Size - All Industries Telecommunications Computer related

12 Private Equity: Implications for Economic Growth in Asia Pacific

9 Extracted from the database of the Asian Venture Capital Journal.

Private Equity: Implications for Economic Growth in Asia Pacific 13

14 Private Equity: Implications for Economic Growth in Asia Pacific

Criticisms of private equity and regulatory responses

Private Equity: Implications for Economic Growth in Asia Pacific 1

The global debt market

exhibit 10 Sources of new debt in the next two years

n Stay the same

1 Private Equity: Implications for Economic Growth in Asia Pacific

exhibit 11 Types of private equity funds

n Generalist n Venture n Fund-of-fund/gatekeeper n Buyout n Growth Capital

Private Equity: Implications for Economic Growth in Asia Pacific 1

exhibit 12 Do you buy public companies to turn them private (P2P)?

18 Private Equity: Implications for Economic Growth in Asia Pacific

Private Equity: Implications for Economic Growth in Asia Pacific 19

Accusation Excessive leverage used as part of PE deals

Regulatory/legislative opinion and industry response

China and Southeast Asia

20 Private Equity: Implications for Economic Growth in Asia Pacific

Private Equity: Implications for Economic Growth in Asia Pacific 21

Accusation Lack of transparency

Regulatory/legislative opinion and industry response

22 Private Equity: Implications for Economic Growth in Asia Pacific

potential conflicts of interest

Accusation Potential conflicts of interest

Regulatory/legislative opinion and industry response

Private Equity: Implications for Economic Growth in Asia Pacific 23

24 Private Equity: Implications for Economic Growth in Asia Pacific

Accusation Tax leakage

Regulatory/legislative opinion and industry response

Private Equity: Implications for Economic Growth in Asia Pacific 2

Private Equity: Implications for Economic Growth in Asia Pacific 1

1 Private Equity: Implications for Economic Growth in Asia Pacific

Private Equity: Implications for Economic Growth in Asia Pacific 1

Private Equity: Implications for Economic Growth in Asia Pacific 2

2 Private Equity: Implications for Economic Growth in Asia Pacific

Private Equity: Implications for Economic Growth in Asia Pacific 2

Private Equity: Implications for Economic Growth in Asia Pacific 3

3 Private Equity: Implications for Economic Growth in Asia Pacific

Private Equity: Implications for Economic Growth in Asia Pacific 3