It’s who you know

12.03.13 / Author: Tim Burroughs, Asian Venture Capital Journal

Although not overrun with GPs, Indonesia’s mid-market is difficult to penetrate. Access to local networks through which deals can be sourced is a good first step. After that, it’s entrepreneur management.

Garuda Indonesia wants to more than double the size of its fleet to around 200 planes – and it needs people to fly them. In addition to placing several sizeable aircraft orders with Airbus, the flag carrier is looking to hire new pilots and keep its existing staff flight ready, which means there is no shortage of demand for places at local flight schools. Factor in the rapid expansion plans of Indonesia’s emerging budget carriers and the proxy for the country’s consumption story becomes clear.

“Nobody thinks about aviation – it’s obscure and esoteric,” says Tom Lembong, CEO and managing partner of domestic GP Quvat Management. “But there has been a boom in budget airlines and the pilots have to do a certain number of hours in a simulator to retain their certification. They need access to flight schools and simulator providers.”

Investing around the edges of Indonesia’s consumer sector has become a prevalent theme as competition for deals has grown. Away from the large-cap deals that have attracted regional and global buyout funds, the country’s mid- market may be populated by fewer GPs but there is still competition for deals.

The commodities boom has created a generation of ultra-wealthy families. The latest Cap Gemini-RBC Asia Pacific Wealth Report estimates Indonesia had 32,000 high net worth individuals (HNWI) – defined as those with investable assets in excess of $1 million – in 2011, a fraction of markets like China and India yet the country’s HNWI population grew faster than any other in the region across 2010 and 2011.

According to Lembong, these families are increasingly behaving like VC investors, committing up to $50 million to deals. However, they are seen as fad-oriented, hence Quvat’s interest in the obscure. “If you are in areas that are more contrarian, you don’t see them,” he says. “A rich family that made its money in palm oil would struggle to get its head around aviation.”

Underpenetrated, Impenetrable

Indonesia’s mid-market – with the consumer sector front and center – is widely seen as a sweet spot, and it is growing. According to AVCJ Research, transactions of $60 million or less amounted to $118.7 million in 2012, the highest level on record and nearly six times the figure for 2006. Yet the number of disclosed investments in this segment remains relatively small and anecdotal evidence suggests deal flow is patchy. It is fairly typical of a nascent private equity market and some industry participants question whether the mid-cap or large-cap spaces can deliver on their promise, at least in the near term.

“A lot of people see from a macro perspective that Indonesia has a lot of potential but the micro reality is more challenging,” says Mark Thornton, managing director of Indonesia Private Equity Consultants (IPEC), who left his position as head of Southeast Asia at 3i in 2011 to search for independent opportunities in Indonesia. “You can put together a robust investment strategy and raise capital, but in reality you can only deploy a certain amount each year. While there is huge potential, near-term visibility on deals is limited.”

This view isn’t shared by all and Thornton admits that more established GPs with track records and substantial teams on the ground are better equipped to address the challenges of the mid-market. These typically come in three forms: identifying companies that are fast growing and investable without the support of databases; making inroads with owners and management to the point they are comfortable selling equity to outside investors; and reaching a mutually acceptable entry valuation.

The ease with which GPs surmount these obstacles depends on numerous factors, but most can be traced back to the strength of local networks.

According to Brahmal Vasudevan, CEO of Creador, which recently closed its debut Indonesia, Malaysia and India-focused fund at $132 million, his team has met with around 300 companies in the past 12 months, completing two deals while another 7-8 are at various stages of development.

“We would normally expect to talk to 150-200 companies a year, enter into 10-12 formal discussions, and close 2-3 deals,” he says. “It could be about two years in between the first meeting and an investment being made. We cultivate relationships that might result in deal flow.”

Much of this time is spent educating entrepreneurs on what private equity can bring. While there might be a basic understanding of the asset class among local business owners, it is often tinged with suspicion – that they are giving away a slice of their growth rather than bringing in a partner that could accelerate and sustain expansion.

According to Vasudevan, mid-market companies are trading at a 30% discount to their larger counterparts and if an entrepreneur has never previously considered PE backing this might actually make the valuation process easier because there is no competition for the deal.

Certainly, once entrepreneurs become savvier as to the premium private equity investors might pay, their valuation expectations rise. Thornton recalls working with a company that planned to list on London’s AIM bourse but failed to get its offering away due to deteriorating market sentiment. The entrepreneur needed $20 million in capital and a good offer was received on reasonable terms. However, the terms were deemed not reasonable enough and the entrepreneur simply decided to wait until he could find a better deal.

Possible alternatives range from equity provided by rival PE firms and bank financing to local family offices and mezzanine debt providers. If a company is growing at 25% per year in revenue terms, the owners might see little point in giving up equity when they can get debt financing and rely on the proceeds of rapid expansion to pay down the senior, regardless of the high interest rates and onerous covenants.

Some industry participants go so far as to suggest that the traditional blind pool private equity growth capital model just might not be appropriate for Indonesia. Wouldn’t it be better to manage a $100 million special account for an LP with a special situations mandate that permits investment regardless of capital structure? While there are merits to having this kind of flexibility – some local PE firms offer debt solutions in addition to equity – the broader issue is how the asset class presents itself as a long-term value proposition.

Who You Gonna Call?

In this context, the ability to call on the services of people who are already familiar with target companies and can make the requisite introductions and kick-start the private equity education process is invaluable.

These individuals might come from investment banking, consulting or audit backgrounds and have worked with the companies before. For example, Cyril Noerhadi, Creador’s senior managing director, was previously CEO of the Jakarta Stock Exchange, a partner at PricewaterhouseCoopers, and then CFO of oil company Medco Energi. Brian O’Connor, founding partner at Falcon House Partners Indonesia Fund 1, was head of Indonesia at Lehman Brothers before rising to Asia Pacific COO, while his colleague Samir Soota previously worked at KPMG and Quvat.

Most private equity firms active in the country, if they aren’t brand names in their own right, are staffed by people with extensive deal- making experience in the country. Even then, it takes time and effort to develop relationships with a view to generating PE deal flow, and there is no guarantee of success.

Teezar Firmansyah, a partner at Antara Capital Partners, notes that Indonesia’s cultural diversity presents another complicating factor – there are more than 300 ethnic groups, and although Javanese account for more than 40% of the population, different groups require different treatment. “If you have the money and expertise, that’s great, but you also need to know the person,” Firmansyah says. “I closed a deal within one month because I understood the entrepreneur’s background as well as his business model. If you don’t understand the people it could take one year or longer.”

With CVC Capital Partners preparing to make a lucrative partial exit from Matahari Department Store, Indonesia’s fourth-largest retail brand, it is hoped that this deal will serve as a poster child for the positive effect of private equity, and its impact will trickle down to the mid-market.

But there are already a number of success stories within the mid-market itself of companies that were once quite raw – with imperfect bookkeeping, tax compliance and management systems – becoming industry champions.

The obvious example is Alfamart, which sits above Matahari in the Indonesian retail rankings, sharing a convenience store duopoly with Indomaret. Northstar Pacific Partners led a consortium to take a significant minority stake in Alfamart in 2007, supporting the original co- founder’s purchase of the business from Philip Morris, which had picked it up as part of a wider acquisition and was keen to divest.

Three years later, the private equity firm exited for a reported 5x return. Alfamart now has a market capitalization of around $2.5 billion and the co-founder, Djoko Susanto, is worth more than $1 billion.

“At the mid-market end the check sizes are smaller and so the target companies are less established, but when they do succeed the results can be quite spectacular,” says Quvat’s Lembong. “In our experience, the number one factor is the caliber of the local partner and manager. There have been time when we have judged badly on the local partner and, even with a strong investment objective, the outcome has been mediocre. In other situations, we got the investment thesis wrong but the local partner was so formidable the outcome was okay.”

As long as Indonesia’s consumer sector continues to produce stars like Alfamart it will also see a fair number of companies that suck in private equity capital and sink without a trace. Lembong compares it to project finance in terms of the execution risk involved – an entrepreneur might want to double his business in size, predominantly through green field developments – and the amount of close attention required.

Positive Developments

Yet there are already signs that the sector is maturing, creating opportunities for private equity in terms of investments and exits. Firstly, a new generation of entrepreneurs is emerging. Typically in their 30s and 40s and educated overseas, these people are running family businesses in a less straight-laced fashion than their forbears. There is an acceptance that a private equity partner can help expand companies, either organically through the introduction of better systems or inorganically via lateral acquisitions. The family may no longer own 100% but they might own 70% of a much larger business.

Secondly, for those investors that are able to identify, partner with and develop mid-market firms, potential exit channels are widening. In addition to IPO and trade sale options, other PE investors are increasingly keen buyers.

Indeed, this lies at the heart of Capsquare Asia Partners’ investment thesis. The GP, which recently closed its debut fund at $75 million, deliberately took a step away from the competition and entered early-stage private equity. It deploys $10-15 million per transaction – mostly for control positions, unlike the bulk of the mid-market – and the goal is to improve transparency, governance and management so that portfolio companies are attractive to other PE firms or strategic investors.

“There are very interesting business models out there that wouldn’t satisfy later-stage PE mandates,” says IPEC’s Thornton. “These companies might take a year or two longer to mature but everybody realizes it’s a market where investments are difficult to buy and if you can make a business easier to buy you can extract a premium for that.”

Much the same applies higher up the food chain. Vasudevan of Creador, which has a fund nearly twice the size of Capsquare’s vehicle, notes that three or four global private equity firms have expressed an interest in portfolio companies.

“We seek to add scale and institutionalize family-owned mid-market companies and aim to make them attractive to regional and global funds to add to our exit alternatives,” Falcon House’s O’Connor. “In Southeast Asia, secondaries will likely be an important theme in the coming years.”