Business, EUROMONEY, Vietnam - Sat June 29, 2013

Vietnamese PE toils with investors

Private equity pioneers admit they’ve made mistakes. Now, they’re struggling to raise new funds, but they are not giving up. New sectors and revised exit strategies will be key to the next wave of deals.

Six years ago, Vietnam’s private equity sector was as hot as they come. Investors piled into one of the world’s great frontier states, a rapidly urbanizing nation of 90 million consumers all trying to get up the next rung on the ladder.

But that was 2007. Between then and now there has been a financial crisis and a European debt crisis. China accelerated; the western world slowed to a crawl. Vietnam suffered its own economic spasm. Inflation spiked from barely 5% in late 2009 to five times that level two years later. Economic growth slowed from nearly 7% in 2010 to 5% in 2012 and is tipped by the Asian Development Bank to top out at 5.2% this year.

And nonperforming loans continue to rise. In May 2013, State Bank of Vietnam governor Nguyen Van Binh warned that soured loans stood at around 10% of the total stock of lending (about $13 billion), rather than previous estimates of 6%. That number could yet rise further. “It’s not a pretty sight in Vietnam at all,” mourns a Singapore-based fund manager with long-standing investments in the country.

Private equity in particular has been hammered. Deals struck by overexcited funds in 2007 and 2008 proved heavily overvalued. Some collapsed; others proved the undoing of entire funds; a few clung on gamely, recovering a modicum (but rarely all) of their value.

Chris Freund, founder and managing partner of Mekong Capital, one of only three sizeable, pure PE firms operating in the country (the others are VI Group and Private Equity New Markets, also based in Ho Chi Minh City) admits that all private equity firms “made deals that didn’t work” when the market was hotter.

“There were times in the past when [PE firms] threw money around too much,” Freund says. Even Mekong struck deals where “in retrospect we did overpay”. He claims that the market has since settled down. “The deal landscape has changed a lot. We are rejecting deals that we would have done five years ago. Our standards are more disciplined and we [now] hold out for perfect deals rather than good deals.”

That’s fair – though being wise after the event has hardly helped the country’s ailing private equity sector. “People do conclude that this is a risky place to invest,” says Andy Ho, chief investment officer at VinaCapital, a multi-asset-class firm that operates several PE funds. (VinaCapital oversees around 150 active investments, down from a peak of 200, while Mekong oversees 15.) “Like most fund managers, we are trying to raise fresh capital, but there has not been a whole lot of success, in part because Vietnam hasn’t got a good reputation.”

It’s notable that in its Asia-Pacific private equity outlook 2013, Ernst & Young admitted that Vietnam was far from the average PE investor’s first choice to deploy resources, noting that the nation’s “weak economy and high inflation” had created “considerable disincentives” to investment.

Indeed, the country’s private equity sector might never return to its halcyon days, when funds would open and close in a matter of months. These days, notes Freund, “it’s less clear whether [new or previous] investors can be convinced to [pump capital] into new funds.”

Freund is aiming for first close on Mekong Enterprise Fund III – the firm’s first new fund in six years – in the second half of 2013, with final close by mid-2014. He’d like to raise $150 million, but recognizes that $100 million might be a more “suitable” size, given the “size of the pipeline deals we are currently finding.”

Yet activity is here if you look hard enough. Vietnam’s economy is hardly quiescent. Foreign direct investment continues to flood into the country, from such companies as Samsung and LG. And the rewards are still here, albeit accompanied by the levels of risk usually found in frontier states.

Besides, Vietnam’s private equity sector is hardly a dead parrot. There’s life in the old bird yet. Take the way that leading private equity firms are adapting to the demands of a colder and more challenging investment climate. Four key themes stand out here.

The first is the nature of deal exits. In the recent past, most egresses occurred through IPOs, a process beneficial for investor, corporate and stake-holding private equity player. That was fine when markets were firing on all cylinders. Now, not so much. Vietnam’s IPO market showed a solid uptick in 2012 over the previous year. But volumes are still markedly down from earlier highs: total equity capital market issuance fell from $1.23 billion in 2007 to just $315 million in 2012. And that, again, has clouded the view of many investors. Ho says: “A lot of foreign investors are concerned about investing in [Vietnam] deals that have no clear exit.”

So private equity players have adapted. VinaCapital hasn’t completed a single IPO-led investment exit for four years. Instead, it has taken a different tack, opting to sell full or partial stakes in managed assets. Many of these stakes are bought by much larger corporates that are regional or global in scale.

In the 24 months to the end of April, VinaCapital has exited 10 investments through trade deals. In December 2012 it sold its stake in Keating Capital Partners, controller of SCG Building Materials, one of Indochina’s largest construction materials firms, to Thailand’s Siam Cement, for $32.6 million. That deal generated an internal rate of return of 33%. (VinaCapital aims for a “base case” IRR of between 25% and 30%, Ho says; the firm’s average IRR over the eight quarters to the end of March 2013 is 34%.)

Further deals over the past two years included the asset manager selling its stake in the International School of Ho Chi Minh City, a leading Vietnam-based international school, to UK based Cognita, making three times its initial investment and generating a profit of $18.1 million. In a similar deal in early 2013 VinaCapital sold its 23.6% stake in Hanoi Liquor to UK drinks company Diageo, making five times its initial investment and posting a profit of $51.6 million.

The second shift is more gradual, but in keeping with the nature of Vietnam’s developing status. In past years, private equity players such as Mekong and VI Group, as well as mixed-asset investors such as Dragon Capital and VinaCapital, flitted across multiple sectors. Some invested heavily in real estate, both before and just after the financial crisis, hoping to benefit from soaring house prices and commercial rents.

That thinking has changed. Ho isn’t alone when he points to the type of deals that successful private equity players now specialize in: basic goods and services, catering to and complementing a large but relatively poor populace with outsized future expectations.

“Our investments are increasingly uncorrelated to economic volatility,” Ho says. “We choose businesses that historically cater to the basic needs of society, whether that means education, healthcare, food and beverages, or mobile telecoms. It’s also easier to create exits this way, as asset buyers tend to be large firms seeking to expand their operations in Vietnam.”

He says this strategy is unlikely to change much. He points to private equity in wealthier regional nations such as Thailand or Indonesia: “These countries are far ahead of Vietnam economically, but look at the PE deals you tend to see in both places. Again, they are in retail and food and beverages, sometimes tourism: industries that provide the same basic needs.”

Freund points to a similar strategy at work at Mekong Capital. The company made a far-sighted investment in Vietnamese mobile phone retail chain MobileWorld in 2006, buying a 32.5% stake for $3.5 million. In March 2013, it pouched a $7 million profit on an 11-times return, including dividend payments, after cutting its stake to 25.8%.

The third theme is one that could be seen either as a pragmatic shift toward greater regionalism or as an admission that Vietnam isn’t the investor honeytrap it once was.

Take VinaCapital’s decision in the first quarter of 2013 to join forces with two regional investment houses: Thailand’s Finansa, and Indonesia-based Batavia Prosperindo, financial players active in their respective local PE markets. The three are jointly raising capital to invest in a new fund, named Asean Alliance AAF, that will aim to invest primarily in Thailand, Vietnam and Indonesia and, when a deal looks particularly fruity, in Myanmar and the Philippines.

The aim with the new fund, set to finalize fund raising in the third quarter of 2013, says Ho, is to offer a “diversified portfolio of investments to people interested in investing across southeast Asia, but less focused on single-country transactions. Vietnam is still a challenging single-country story to sell to investors. Through the new fund, we offer exposure to a network of companies spread across the region.”

VinaCapital and its partners hope to close the fund “by the end of the year,” Ho says, raising no less than $300 million and probably no more than $500 million. An anchor investor is doing due diligence on the fund, and Ho has been piling up the air miles, flitting from Europe to the US to east and southeast Asia in search of fresh capital.

Ho points to the combined investment prowess of the three investors: $3.1 billion in historical booked profits; an average per-deal return of 3.6 times original collateral; an IRR of 39%. Yet there’s a flip-side to this story: $300 million isn’t a stellar sum for a landmark regional fund promoted by three sizeable PE players. If they can’t rustle up interest, who can?

The final shift in thinking has taken place gradually, and across the entire industry. In Vietnam’s early private equity days, roughly around the mid-1990s (Dragon Capital was founded in 1994, with Mekong Capital forming in 2003 and VinaCapital a year later) PE firms preferred to vest their money with state-owned enterprises.

Around the millennium, the thinking changed. SOEs were out; private enterprises were in. PE firms opted to take minority stakes in these non-state firms (VinaCapital is fairly typical in seeking to invest $5 million in a company and depart when its stake is worth between $15 million and $20 million) and exit when the time was right. Along the way, they pointed and prodded when necessary, but largely left internal management to its own devices.

Yet this is also changing. Mekong Capital, for one, is increasingly opting for a more overtly aggressive investment strategy through management buyouts. This is rare for Vietnam, and for much of southeast Asia. Freund says his firm is “being very careful about [how to approach MBOs], but it is definitely our focus now”.

Besides, there are two further pragmatic reasons behind this change in tack. The first is quality of personnel. Vietnamese firms tend to embrace loyalty: personnel utterly unsuited to a corporate position can stick around for years because no one would think to fire them. “A lot of business owners say they are committed to building a strong team, but they aren’t really,” notes Freund. “There is a weakness among many [Vietnam] firms in that they overestimate the value of loyalty relative to performance. If someone isn’t doing their job and isn’t getting results, they should leave.”

Mekong no longer invests in firms that offer hollow promises about changing, Freund adds. “We are now focusing on investing in firms that we believe are likely to build good teams.” If they don’t fulfill that criterion, Mekong drops its interest or focuses on its new strategy: buying the firm out, and, when necessary, replacing existing management with tried-and-tested executives, preferably with some sort of international experience.

Much of this thinking has been spurred, Freund admits, by the firm’s investment in MobileWorld. The Vietnamese cellphone retailer was a minnow when Mekong bought in, with just five outlets and a market share of 8%. Now it boasts 232 stores, controlling a fifth of the market. And while MobileWorld’s most direct peer, Nettra, also controls 20% of the market, the amount earned per store is vastly different: market data shows Nettra earning $24,000 a store each month, against MobileWorld’s $600,000.

Freund says MobileWorld’s success is overwhelmingly attributable to the quality of the five executives who founded and still manage the firm. Chairman Tran Le Quan previously managed SonyEricsson’s Vietnam operations. Chief executive Nguyen Duc Tai headed strategy and planning at a local cellphone operator. The remaining three were specialists in mobile networks, IT and finance. “A key reason why MobileWorld has worked so well as a company is that they all contribute, they all work hard as a team, and they all bring something special to the table,” says Freund.

But there’s another reason why MobileWorld has thrived while others have stagnated: data. “They may very well be the most information-driven firm in Vietnam, in any industry,” says Freund. “Too many companies go on gut feelings in Vietnam: assuming, from long experience, that they know the market.” MobileWorld, says Freund, doesn’t fall for that trap. “Data works here, just as it does everywhere else. The only difference is that MobileWorld uses it. They are the exception rather than the norm in Vietnam. I’d love to find more companies like them, but it’s not easy.”

That explains Mekong’s obsession with finding new versions of MobileWorld in sectors across the country. Or, whenever necessary, creating such companies by leading MBOs and then securing the management talent any aspiring corporate needs.

Private equity in Vietnam is in transition. This isn’t the gung-ho market of five or six years ago – but that’s probably a good thing. PE firms are learning to become more selective, to play the region, and to be more aggressive – spearheading buyouts and replacing deadwood with talent. It’s a more hard-headed approach, but it’s far from heavy-handed: the upshot will be that Vietnam, run for so long by state apparatchiks, might finally get the private sector it desperately needs.

Investors are returning to the market, slowly. Freund says interest from around the world is “rising again, albeit from a low base”. VinaCapital’s Ho adds: “There are good deals out there, and there are good companies out there. It’s just a case of getting investors interested.”

It’s worth noting that MobileWorld, a bit-player in a fast-growing sector seven years ago, is now a primary case study on the MBA programme at the University of California, Berkeley. If that doesn’t convince investors from west and east to commit to another round of PE funding in Vietnam, perhaps nothing will.

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