In recent years, Southeast Asia has begun attracting U.S. private equity investors and strategic buyers for the same reasons that China did two decades ago: low-cost manufacturing facilities, inexpensive labor and a growing population of consumers. Now that China’s economy is faltering, the 10 countries that are members of the Association of Southeast Asian Nations (ASEAN) -- Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar (also known as Burma), the Philippines, Singapore, Thailand and Vietnam – are poised to benefit.
The ASEAN countries represent a huge market. Taken together, they have a population of about 625 million people, skewed heavily toward youth, with 65 percent of the people under 35. Their combined economies make Southeast Asia one of the fastest growing regions in the world, with five of the countries ranked among the top 25 in the world as measured by gross domestic product (GDP) growth. Singapore’s GDP per capita ranks among the top 10 in the world, higher than the U.S., and Indonesia’s GDP also ranks in the top 10.
Not surprisingly, the region’s road to economic growth is not without some bumps. Most notably, in Malaysia, there have been recent protests against Prime Minister Najib Razak, who is accused of taking $700 million from a state investment fund he established in 2009 to boost the country’s economy. Cabinet ministers have said the money is a political donation from Middle Eastern donors, and the fund denies paying the prime minister.
Nevertheless, the fund has been investigated for mismanagement, including overpaying for investments and paying high fees to investment bank Goldman Sachs (NYSE: GS).
Some investors have set up shop in the region. For example, Navis Capital Partners was founded in 1998 by Nicholas Bloy and Richard Foyston, both of whom spent many years at the Boston Consulting Group in Asia. Navis, headquartered Kuala Lumpur, Malaysia, boasts offices throughout Southeast Asia. Managing $5 billion, Navis has made 60-plus control investments, typically in the $50 million to $150 million range. It has deployed 60 percent to 70 percent of its capital to the more-developed markets of the region, including Indonesia, Malaysia, Singapore, Thailand and Vietnam.
Logistics, consumer goods, food and beverage, infrastructure, education and health care are among the region’s promising sectors, says Jean-Christophe Marti, a senior partner at Navis who is based in Singapore. Retailers are attractive to investors because consumer spending is growing throughout Southeast Asia.
Navis has acquired ownership stakes in two retail businesses in 2015. In Thailand, the firm invested in Nitipon Clinic, a chain of centers providing facial treatments and other cosmetic procedures, such as skin whitening and spot removal. And in Singapore, Navis backed Imperial Treasure, a chain of 21 fine-dining restaurants.
In a related deal, French-backed private equity firm L Capital Asia reportedly spent $100 million for a 90 percent stake in Crystal Jade, a chain of 120 casual-dining restaurants, based in Singapore and China. Crystal Jade was founded in 1991 by the same family that started Navis-backed Imperial Treasure.
In the for-profit education sector, Advent International bought a stake in Singapore-based the Learning Lab, which provides tutoring services to high-school and pre-high-school-aged children, for about $220 million in 2014.
For certain sectors in Southeast Asia, the first investors to establish a foothold will have an advantage, says Andrew Rice, senior vice president of the Jordan Co. The region represents an opportunity that’s “not going to happen overnight,” he says. “But you’re going to see more and more U.S. firms go there, and if you can get in on the ground floor and have that early-mover advantage, in certain industries that can be a big plus.” Jordan’s Rice knows all about pioneering new territory. The New York PE firm began investing in China in the 1990s, long before most competitors.
For 20 years, China dominated the attention of M&A investors looking to Asia for opportunities. In addition to inexpensive labor, the country offered a fast-growing domestic market, relative economic stability and infrastructure to support growth, with the government investing heavily in highways, railways, airports, sea ports and industrial parks. For more, read Choosing China.
Now, China’s unprecedented run of economic growth is stalling. Although the Chinese government still claims that GDP is growing at a 7 percent clip, private economists estimate growth at about 4 percent.
Commodity suppliers that have been feeding the Chinese growth engine have seen demand tapering, indicating a slowdown and uncertainty about the pace of future growth.
For investors seeking low-cost sourcing opportunities for U.S. companies, China was the place to go, and the country’s own consumers were creating growing, viable markets as well. And until about five years ago, there wasn’t a lot of competition for deals in China, says Rice, who heads up Jordan’s operations support group’s international unit, helping U.S. portfolio companies expand overseas.
But the field of competitors has become more crowded. Now, companies in China that become targets are chased by domestic Chinese investment firms, along with a growing contingent of international firms, which has pushed valuations much higher.
“As an investor, if you find a great company but you have to pay too much for it, then it’s not a good deal all of a sudden,” Rice says. “We’re still interested in China long term, but there’s not the low-hanging fruit like there used to be.”
While Jordan has not invested in Southeast Asia since 2000, some of the firm’s portfolio companies have key suppliers in the region, and the firm is looking into several potential strategic partnerships, says Rice, who visited Singapore, Indonesia and Vietnam in June.
China’s labor costs have been rising, particularly in its coastal areas, because fewer Chinese people are migrating to those areas from inland rural areas. To compensate for the labor costs, vendors in those areas are raising their prices and minimum order requirements.
“The coastal side of China is not the answer to all sourcing needs any more--whether there are labor dynamics or whether there are volume constraints--as the supply of labor tightens up,” says Roberto Ferranti, principal at Baird Capital, the direct private investment arm of Robert W. Baird & Co.
Ferranti, who works on improving operations and developing overseas relationships for Baird’s U.S. companies, says that searches for sourcing that used to end with China now typically include Vietnam, Thailand, Cambodia or India as well.
“Over the years, we’ve seen the dynamic evolve quite a bit where China used to be the de facto answer for a lot of our sourcing projects, and over the last three or four years, there’s been a quite visible trend where China is one of the solutions, but not the only solution for sourcing needs,” he says.
Southeast Asian countries can now beat coastal China sources on price for certain types of manufacturing.
“On the sourcing side, you’re seeing companies realizing that it’s costing a lot more to have a certain product made in China, but they can go down and have it made in Vietnam for 20 to 30 percent less,” Rice says. “So for products that are not high value-added, you’re starting to see a lot more of that manufacturing move to Vietnam or the Philippines, or Malaysia. Laos has a few areas that are pretty good, but they’re very small, and Cambodia still has a long way to go. Indonesia has some good areas, but overall their infrastructure is very poor.”
Navis Capital’s Marti says the rise in Chinese labor costs are benefitting Indonesia, Malaysia and Vietnam. In addition to cheaper labor, those countries also have a lower blended cost because of cheaper utilities and more efficient logistics.
For the next couple of years, China and India suppliers will still have the advantage for manufacturing that requires access to large amounts of capital and raw materials, as well as advantages for infrastructure and other capabilities, Ferranti says. But Southeast Asia countries will have the advantage for items with high labor costs.
“If you’re looking at other industries where there is a high degree of labor content—think about textiles, for example—that’s an area where other regions will emerge, and already are,” such as Cambodia and Vietnam, Ferranti says.
For example, in 2014, Swiss specialty chemical-maker Archroma, a portfolio company of U.S. PE firm SK Capital Partners, bought BASF SE’s (FRA: BAS) Singapore-based textile chemicals business. Archroma also has a textile business headquartered in Singapore, and the deal allows the company to ship to Asian customers more quickly.
Trains, planes and automobiles
Southeast Asian countries are devoting resources to their own infrastructure projects that are expected to pay economic growth dividends and boost their appeal to companies and private equity investors. Singapore and Malaysia are building a high-speed train line between Singapore and Kuala Lumpur, with construction scheduled to begin this year, which will lead to industrial park construction along the line. Other countries are planning their own transportation projects.
“You’re going to start seeing highways and trains going through Vietnam all the way up into China; you’re going to see Vietnam linking into Cambodia and Laos, which gets you over into Thailand,” Rice says. “These projects are five to 10 years in the making, but they’re massive projects that lead to very real positive value for business.”
Most tariffs between ASEAN member countries are scheduled to end by Jan. 1, 2016, and other steps will help unite the region’s economic community, such as establishing links between stock markets, banks and reinsurance markets in the countries. The effect of the ASEAN changes-- along with trade agreements with India, Australia, China and other Asian countries, and the Trans-Pacific Partnership-- will be to encourage economic development and M&A deals over the long term.
“The impact of the ASEAN Economic Community (AEC) for us is a positive,” says Marti. “We see more activity, more entrepreneurs looking to partner with funds like us to grow.”
The AEC agreements and other factors are leading to more integrated, cheaper, more efficient logistics for some sectors, and driving more M&A activity and investor interest in logistics businesses, Marti says.
As large companies seek to establish a presence in Southeast Asia, others will follow, Rice says. “Our view is that as the Fortune 500 companies of the world and the Fortune 1000 and their counterparts in Europe, say: ‘We need to have a presence in Southeast Asia, because we need to be part of this fast-growing market,’ then they’re going to want their mid-sized companies that are their key suppliers to follow them.”
Serving local customers
Rice expects many middle-market companies that come to Southeast Asia initially to supply their large international customers will evolve into serving local customers. Rice says thousands of Chinese companies are setting up factories in Vietnam, so they can sell their products to the Philippines, Indonesia, Malaysia and other ASEAN countries, taking advantage of the tariff breaks and remaining competitive. Indian, Korean, Japanese and, lately, U.S. companies are employing the same strategy.
“When these tariffs go away for trade between the ASEAN countries, that’s going to mean that if you’re importing from China or Japan or Korea or the U.S., it’s going to cost 5 percent to 10 percent more overnight, compared to competitors with production within ASEAN. That’s causing folks to say: ‘Man, we’ve got to get inside that tent,’” Rice says.
Rajiv Louis, a Jakarta-based managing director on the Carlyle Group’s (Nasdaq: CG) Asia buyout team, says there is some concern within the ASEAN governments about how China will affect the trade pact. Another unknown is how their economies will be affected by the free flow of labor expected between the ASEAN countries and potential influx of goods made in other ASEAN countries.
“Theoretically, this is what people expect—the free flow of labor—but most people, even the people in government, don’t feel it’s going to be as porous in terms of labor movement as someone would have expected with North American Free Trade Agreement or the European Union,” Louis says. “It’s more the tax-free movement of goods that could be potentially dumped that I think they’re worried about.”
The middle-market M&A environment in Southeast Asia has been challenged in recent years by currency valuation fluctuations and the slowdown of growth in China, Louis says. “Growth has slowed down considerably from what it used to be over the last four or five years,” he says. “In big part, that’s due to the slowdown in China, which is now looking like the new normal rather than a one-off event in China.”
Southeast Asia is adapting to a new normal as well, with businesses adjusting to a slower pace of growth and consumption than they had been used to, and a lack of major expansion drives with capital requirements, Louis says.
Investors have needed to take into account the currency fluctuations over last 12 to 18 months when choosing how to invest and considering investment returns. Another factor for U.S. investors has been the prognostication of how those emerging market countries that are running deficits will be affected if the U.S. Federal Reserve raises interest rates.
Indonesia, the largest Southeast Asian economy, is running a current account deficit and relies heavily on external financing of its deficit spending, so potential Fed rate increases will impact its economy. Meanwhile, Thailand has a strong financial market and is more insulated, so it doesn’t rely on external financing for government spending.
Another potential risk for U.S. middle-market companies looking to acquire operations in Southeast Asia is the different customs, cultures and the business practices in the region.
“It always takes time to build proper relationships, and relationships in Asia are extremely important,” Rice says. “There’s also a risk that if you want to set up an operation, it’s harder to find good people. Skilled laborers in places like Vietnam and Indonesia are not as readily available as in places like China, and when you want to hire managers, finding somebody—whether it’s accounting, sales, production, and quality control—ideally you want to find somebody who’s worked with other Western firms before, so that they understand the best practices, and the proper procedures and controls of a Western firm.”