Singapore is joining Shanghai and New Delhi as a major hub for private equity (PE) activity in Asia’s hottest emerging markets. Across the Asia-Pacific region, PE interest is shifting as more investors focus on opportunities beyond China and India. But to succeed in Southeast Asia’s dynamic—and increasingly competitive—emerging markets, PE firms will need to raise their game.

Although overall PE investment activity has been slack since the global financial crisis, investors’ interest in Southeast Asia remained robust, particularly for small and midsize deals. Investments valued at less than US$50 million and between US$100 million and US$199 million increased by 62 percent and 43 percent, respectively, in 2010.

Heightened enthusiasm for PE opportunities in Southeast Asia emerged strongly from a recent survey of institutional investors active in the Asia-Pacific region. Along with revived confidence in Australia, the economies of Southeast Asia have seen the biggest jump in PE investors’ interest. In 2010, only 7 percent of respondents to the latest Bain & Company Southeast Asia PE survey rated these markets as “most attractive”; this year, nearly three times as many did. Indonesia and Singapore rank as the prime targets of investor focus. Respectively, 32 percent and 23 percent of respondents described themselves as “very bullish” about their prospects. Farther afield, 15 percent expressed optimism about PE’s prospects in Malaysia and Vietnam in 2011.

New capital flows into the region

Increasingly, investors are putting their money behind their optimism. With Asia-focused funds wielding some US$185 billion in 2010, new capital under management surged by 6 percent and accounted for 12 percent of all new global funds raised. More of that new capital is starting to bypass China and India and is heading directly to Southeast Asia. And in one of the more notable developments of the past year, PE firms are raising capital for funds that focus on a single market in the sub-region. For example, the Quvat Capital Partners III fund and the North Star fund together raised more than US$1 billion for deployment in PE investments in Indonesia alone over the past year.

Flush with capital, PE funds expect to close more deals in Southeast Asia. In the Bain survey, nearly three-quarters of respondents said they expect their funds’ deal activity to increase. And they expect to pour more money into the deals they do. Nearly 70 percent forecast that they will invest as much as US$100 million annually over the coming two to three years. Last year, only half of the funds surveyed anticipated committing as much. About one-third expect that the size of the individual deals they consummate will be larger, with strong increases anticipated in growth investments and private investments in public equities.

When we asked where that money would be directed, three sectors—each of them with a compelling growth story—topped PE fund managers’ lists of targets.

• Consumer: With urbanisation and rising disposable incomes spurring more consumption by young populations across the region, more than 80 percent of survey respondents expect that consumer goods and retail will remain the most attractive sector in 2011.

• Healthcare: Expansion in this sector, too, will be driven by rising living standards, fuelled by government investment in hospitals and clinics, medical equipment, pharmaceuticals and other health infrastructure.

• Energy: Rising commodity prices will spur massive capital investment in natural resource development, oil and gas exploration and production, and related upstream and downstream services to power the region’s rapid growth.

Competition is heating up

The combination of a greater number of PE funds wielding more capital and scrambling to invest in Southeast Asia will inevitably increase competition to land the best deals. The Bain survey respondents cited difficulty in finding attractive companies to invest in and sellers’ inflated price expectations as two of the biggest constraints on PE.

One PE fund expectation that has yet to catch up with the tough new competitive realities: PE investors think they will continue to reap outsized returns. In our survey, fund managers remain optimistic that returns will continue at historic high levels or even improve. Yet, recent data reveal that returns are being squeezed. The percentage of PE exits that earned a cash multiple of less than one times the initial investment increased slightly over the past year, as those that realised a multiple of more than three times dropped.

To bring expectations into alignment with Southeast Asia’s new realities, PE funds will need to adapt in three critical areas:

Proprietary sourcing. To find the best companies quickly and avoid the risk of overpaying, fund managers need to forge local alliances and have people on the ground who can spot these opportunities before competitors do. For example, TPG, a major US firm, is teaming up with a local PE fund in Indonesia. Taking another approach, a European-based global fund has formed an alliance with a leading industrial group in the region, giving it a first look at acquiring business units the conglomerate decides to divest. Fund managers also can raise their visibility with target companies by participating in conferences, boosting marketing activities, and opening local offices.

Enhanced due diligence and deal-execution process. Funds that excel in converting more acquisitions into winners and avoiding the losers use a probing due-diligence process to dig deeper into a potential target’s operations before they commit to an investment. Superior due diligence is especially critical in Southeast Asia because PE firms are targeting smaller companies—often private ones or carve-outs of larger companies—where information often is less transparent.

More hands-on portfolio activism. To boost value creation, fund managers need to complement their deal teams by hiring dedicated operating partners and recruiting talent who combine experience in both banking and operations. Leading firms are strengthening their internal portfolio-operating team, establishing value-creation committee, and developing a playbook to institutionalise best practices. As they expand, PE firms will want to develop a network of outside experts across their geographic footprint and increase their use of external support.

As they have learned in every attractive new region, PE investors need to tailor their approach to the specific characteristics of each market. Southeast Asia is no exception. The diversity of small, distinctive markets in the region requires nimbleness and flexibility, and funds that develop those traits will be best positioned to win.

Suvir Varma is a partner with Bain & Company and leader of the firm’s Private Equity practice for the Asia-Pacific region. Sebastien Lamy is a principal with Bain. Both are based in the firm’s Singapore office.