KKR on Indonesia: Harnessing its Potential

Following a recent trip to the region, Henry H. McVey,  outlines several investment conclusions in his latest report:

• Indonesia’s macro game plan now seems more in synch with the potential obstacles the country faces. Perhaps more important, though, is that central bankers, government officials, and CEOs all now seem more committed to delivering on the “game plan” needed to elevate Indonesia into one of the elite destinations for investor capital.
• Within our ASEAN footprint, Indonesia has clearly emerged as one of the most attractive pure-plays on our view that global capital flows will increasingly migrate towards economies with large domestic consumption.
• Within the region, we see several industries in transition where investors should be buyers when prices become more realistic. These include E-commerce, health services, wellness, entertainment, nourishment, education, and even consumer financial services.
• While absolute rates are low in Indonesia relative to history, local debt actually still looks compelling.
• Consistent with this view on local debt, we are now more sanguine on emerging market currencies.
• Private Credit in Indonesia represents an opportunity, but deal sizes are still small and sourcing engines will likely be needed to boost capital deployment in this product area.
• Our research on Indonesian Public Equities suggests that we are at an inflection point.
• Similar to what we have seen in other big emerging markets, we believe that the opportunity for investors to use Private Equity to arbitrage the Public Equity markets is large and growing.

After completing a comprehensive deep dive on Indonesia back in early 2013, my colleague Frances Lim and I authored a report titled “Indonesia: Turning Potential Into Reality.” The punch line of the report was that, while Indonesia enjoys massive demographic tailwinds, the country needed to clean up its finances, improve its infrastructure, and further diversify its economy before it would be ’all clear‘ for increased capital deployment by foreigners.

Whether we were lucky or good when we voiced our concerns, we will never know. But we do know that the United States Federal Reserve, by hinting that it would be making a shift in monetary policy, immediately thereafter shocked Indonesia and many of its emerging market peers by inspiring what is now called the ‘Taper Tantrum.’

Fast forward to Spring 2017, and the outlook for Indonesia appears quite different. Deficits are more balanced, the currency is more stable, and infrastructure outlays are accelerating. Our recent onsite visit to Indonesia with our local team of KKR professionals confirmed a similar feeling, and as such, we came away from our trip believing that Indonesia has — at least on the macro front — finally begun to visibly turn its long-term potential into near-term economic and investment realities. We note the following:

• • The country’s macro game plan now seems more in synch with the potential obstacles the country faces. Just consider that government funding for infrastructure projects jumped by over 20% in the latest 2017 budget, and it now stands at 2.5 times what was allocated just three years ago. Meanwhile, the country’s reserve base is now near record levels, and unlike many other EM countries we visit, there is no excessive credit overhang about which to worry. Maybe more important, though, is that central bankers, government officials, and CEOs all now seem more committed to delivering on the “game plan” that is needed to elevate Indonesia into one of the EM market’s elite destinations for investor capital.

• Within our ASEAN footprint, Indonesia has clearly emerged as one of the most attractive pure-plays on our view that global capital flows will increasingly migrate towards economies with large domestic consumption. In Indonesia, GDP-per-capita is still increasing 8.2% per annum (i.e., 2.5 times as fast as the U.S.), which represents a distinguishing feature in today’s growth-starved, geopolitically unsettled world. Indeed, with half its population of 260 million under the age of 30, private consumption as a percentage of GDP already totals 58%, a figure that we think could increase another five to seven percentage points during the next decade.
• Within the region, we see several industries in transition where investors should be buyers when prices become more realistic. E-commerce, health services, wellness, entertainment, nourishment, education, and even consumer financial services all represent strong secular growth areas that warrant investor attention. However, valuation matters, and as good as these opportunities may be, these secular tailwinds are not worth harnessing unless investors can partner with the right local entrepreneurs.
• While absolute rates are low in Indonesia relative to history, local debt actually looks compelling. Now that Indonesia has been upgraded to investment grade by all three major ratings agencies, it is one of the highest yielding sovereign securities in the world within its ratings designation.
• Consistent with this view on local debt, we are now more sanguine on EM currencies. This statement is significant, as currency usually accounts for one-third of the total return equation during an EM performance cycle. If we are right, then less capital will need to be allocated towards hedging on a go-forward basis.
• Private Credit in Indonesia represents an opportunity, but deal sizes are still small and sourcing engines will likely be needed to boost capital deployment in this product area. From a structural standpoint, however, Indonesia lacks local deposits, and its bank executives are increasingly shying away from complexity, particularly in the middle market. Meanwhile, foreign banks have pulled back, with loans as a percentage of GDP falling to 13% in March 2017, compared to a peak of 16% in September 2015. In our view, this backdrop could be bullish for private credit, particularly as there are a growing number of more difficult transactions that require speed of execution.
• Our research on Indonesian Public Equities suggests that we are at an inflection point. After a multi-year period of stagnant growth, earnings are poised to finally reaccelerate, we believe. As such, we expect the Indonesian Public Equity index to outperform many of its more prominent EM peers during the next few years. Not surprisingly, though, within the Indonesian Public Equity index investors has efficiently bifurcated valuations between banks and consumer stocks, a gap we do not see closing in the near term.
• Similar to what we have seen in other big EM markets, we believe that the opportunity for investors to use Private Equity to arbitrage the Public Equity markets is large and growing. For example, in Indonesia, the Public Equity benchmark actually has a zero percent weighting to Technology, one of the areas we find most compelling in the region. So, if we are right about the growth trajectory of areas like e-commerce, mobile payments, and logistics, then large institutional investors will want to move beyond the public indexes to gain private exposure to areas of the economy that actually capture the bullish GDP story that we have been highlighting.

In terms of the bigger picture, we left Southeast Asia (SEA) even more convinced that the global macro outlook we laid out in January (see Outlook for 2017: Paradigm Shift) has momentum. Indeed, spending time in the region with CEOs, central bankers, and sell-side experts only reinforced many of our core investment themes, including the following: 1) Emerging Market Equities have turned up and may have begun a multi-year outperformance run versus Developed Market Equities (Exhibits 1 and 2), 2) our thesis about performing private credit over non-performing private credit is a global, not a specific regional insight (which is good for SEA, including Indonesia), 3) consumer spending on experiences over things is gaining momentum in both developed and developing markets; and 4) we continue to see investment opportunities on a global basis to buy complexity (e.g., carve-outs, dislocated securities), but sell simplicity (e.g., over-priced sovereign debt and high PE consumer staples stocks).

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