Private-equity firms [1] have become increasingly controversial in the Asian landscape after mounting stunningly successful bids for a range of Asian financial companies in Japan and South Korea, and more recently a range of other assets, including Australia’s national airline, Qantas. Politicians of all hues, as well as assorted left-leaning stakeholders such as trade unionists, have protested the trend, calling back the old term of “vultures” and “barbarians” [2] at such funds.

The furor led to an intensive investigation and finally an abrogation of a successful transaction in South Korea’s banking sector late last year. More recently, leaders of Southeast Asian countries have voiced concerns about the size of such funds, which dwarf some of their stock exchanges’ entire market capitalization. To a large extent, Thailand’s attempts at imposing capital controls last month were aimed at ensuring that large private-equity firms did not end up converting the country into a private limited corporation owned exclusively by foreigners in distant lands.

How it works

Typically, private-equity firms collect funds from the superrich rather than the middle-class investors ordinary mutual funds attract. These funds are backed by large amounts of debt made available by banks and, sometimes, other investors such as hedge funds. The total pool of money is devoted to identifying companies whose market value (number of shares times share price) is well below the “real” value of assets and operations.

Once the company is purchased from the hands of public investors, new owners tend to rationalize operations quickly, by focusing on cutting excess costs as well as selling assets that do not form a core part of the business strategy. Such asset sales are usually used to pay back outstanding debt. Over a period of time, the company’s operations improve and it achieves a turnaround.

After such a turnaround, the private owner of the company goes back to the stock market for a listing, selling the “new” company to public shareholders. Profits, and losses, can be quite large in such a turnaround situation.

Vultures and scavengers

In much of Europe and North America, the popular (rather than financial) press indulges in name-calling when it comes to private-equity investors. There seems to be something quite sinister about a secretive group of people taking over a well-known public company and turning its operations upside down. Even Hollywood has been unable to keep its hands away from such raiders, as films such as Wall Street and Pretty Woman show the opposite ends of the spectrum. Indeed, in the latter film, a rapacious private-equity investor is taught life’s values by a streetwalker.

Keeping this in mind, and also Asia’s natural surpluses of capital, why then does the region need these private-equity investors? Surely the markets in Asia are capable of making rational judgments – or at least that is how the argument would be framed.

Why Asia needs the barbarians

Much of Asian manufacturing capacity can be sourced back to ministerial fiats issued as part of various industrialization programs. Starting with Japan, South Korea and Taiwan, and working toward the rest of Asia, including mainland China and large tracts of Southeast Asia, most capacity was financed by cheap bank loans that were pushed through by governments keen on achieving industrial growth.

Many Asians save more than they spend, leaving banks with substantial funds at their disposal. While the process of finding creditworthy borrowers usually proves daunting for banks, doing so in an environment of government-directed lending becomes more dangerous still. Borrowing from banks for special projects, though, allowed the industrial families to keep risks to the minimum – if the project flopped, the banks bore most of the cost, and could in turn depend on the government for a bailout if such losses threatened to make them bankrupt.

While in Japan most of the funds were diverted toward a clutch of holding companies belonging to powerful prewar industrial conglomerates, in other parts of Asia the financing route usually followed political sycophants. Thus a number of the controlling families in Korea, China and Southeast Asia owed their wealth to political masters, who were duly rewarded with monetary gifts, unstinting support and other perks.

The result of all this was both to distort the true cost of capital across Asia and to establish a new group of wealthy oligarchs. Neither point can be sneezed at – the first is the main reason Asian countries have excess capacity in many industries. This is visible in areas ranging from commercial real estate in China to the manufacturing capacity for LCD (liquid crystal display) panels. Meanwhile, wealthy oligarchs control the economies of many countries, even as their families have disproportionately small economic stakes in their empires. In turn, this causes further gambling, usually at taxpayers’ expense.

Where in Asia

The biggest impact of private equity will likely be in China and India, where current capital controls and ownership restrictions make hostile takeovers quite onerous. In both countries, there are too many companies that are controlled by wealthy families or tycoons, which in turn have pushed out more creditworthy borrowers.

Private-equity players, much as in Japan and South Korea, will perhaps be called in to rescue China’s banking sector. At first blush, this seems an odd thing to state, given that the country’s largest bank now ranks as the world’s third-largest by market capitalization. However, this nugget ignores ground realities such as the optimistic valuation of assets by banks in providing loans, generally low credit standards, non-existent documentation, and poor understanding of corporate accounting. This is the main reason I cited the example on January 13 to highlight investors’ focus on gaining from a weakening US dollar. [3]

In the next few months, as Chinese companies start implementing global standards in accounting, a number of investors are likely to express disappointment about the performance of “their” companies, in turn pushing down share prices. For banks, the situation is fraught with danger, as in addition to failing companies; they will also have to deal with overextended consumers in large cities such as Shanghai.

In the case of India, the banking system does not need as much ownership-driven redress, as the broader corporate sector does. There are too many family-controlled companies in India that suffer from incompetence; this is particularly true in the manufacturing sector, where the country lags China (albeit in revenues more than in profits). Onerous laws and trade unions make the operations of large companies unusually tough, but private ownership could certainly help many of these firms to achieve greater balance between stakeholders.

In both China and India, private-equity investors are likely to provide the impetus for much needed consolidation in industries ranging from steel manufacturing to process outsourcing. Such consolidation, while initially owned by foreigners or run by private equity firms, will eventually create larger and more successful public companies. The biggest positive of all, though, will be the elimination or reduction of government intervention in many sectors, allowing capital pricing to achieve an appropriate and economic level in both countries.

1. Private-equity firms typically enact debt-financed buyouts of publicly listed companies, extracting value by wide-ranging restructuring of operations and asset sales. They are closely related, but still distinct from, venture capitalists, who tend to finance new businesses, and hedge funds, which operate mainly in public markets.
2. The term “barbarians at the gates” was coined in response to one of the largest private-equity buyouts of all time, the acquisition of RJR Nabisco by KKR in the 1980s. See Enter the barbarian, Asia Times Online, April 25, 2006.
3. See The thief and the scorpion, Asia Times Online, January 13.