Global supply chains must become more vertically integrated yet multi-dimensional in a politically shifting, risk-off world. The trend is now a key factor in private equity strategy in Asia

Supply chains have become linear in recent decades as part of a broader theme of globalisation. Now, there is a growing sense the world has reached peak globalisation, setting up a nuanced megatrend of supply chain re-fragmentation. This puts private equity firms in Asia in an advantageous position.

The advantage relates to the growing appeal of China Plus One strategies, whereby companies have aimed to move supply chain capacity from China – which represents about 30% of global manufacturing output – to the broader region, especially South and Southeast Asia.

This is partly dispassionate diversification, hedging bets on getting goods from point A to point B by adding suppliers and logistical channels, but the thesis is also permeated by geopolitical tension. For example, recent developments have encouraged friend-shoring – shifting of supply chains to politically allied markets – which in turn makes investment in those markets incrementally more attractive.

Meanwhile, emerging Asia’s large availability of labour, as well as its wide dispersion of wages, skills, and education levels establish the region as suitable for both traditional and next-generation manufacturing.

The net effect is that emerging Asia should see net increases in investment and job creation and greater global demand in terms of new friend-shoring supply chain capacity over the next 10-15. In theory, this bodes well for consumers, businesses, and investors in those countries.

The question remains, however, whether it is too difficult to justify the higher costs that come with diversifications in this vein in a tightening macro environment. This is especially pertinent where the end markets are weaker economies and the companies and investors involved are smaller operators.

Like many investors, Kenneth Leong, CFO and COO of Axiom Asia, a fund-of-funds that backs regional middle-market and venture GPs, is beginning to see it as an unignorable cost.

“The heightened geopolitical tensions, conflicts, and pandemic have exposed vulnerabilities in global supply chains. Companies and investors need to reevaluate their supply chain strategies – to be more resilient, more risk-diversified – despite the associated higher costs,” Leong said.

“Risk mitigation and regulatory compliance will be the key justifications for higher costs. While the immediate costs may be higher, the longer-term benefits of a resilient and diversified supply chain will outweigh these initial cost considerations.”

Local nuance

No one interviewed for this story said that supply chain diversification risk was being specifically priced into deals. But there is a recognition that rising input costs of raw materials, labour, and transportation will have immediate impacts on strategies and margins if not, eventually, valuations.

Much will depend on the local variables when friend-shoring, near-shoring, or otherwise expanding capacity in new jurisdictions. Beyond tax and land incentives, there must be sufficient local suppliers of the relevant inputs, including the required labour at the required price. In some jurisdictions, such as the Philippines, high electricity prices and typhoon damage are often considered deal breakers.

Technological developments, notably in 3D printing and robotics, can reset the calculus on the viability of a market entry to some extent, but not if too many inputs need to be imported or trade policy changes disrupt sourcing options. These expansions will alternately include increased and decreased compliance costs around environmental, social, and governance (ESG) standards.

Agreements likely to realign trade routes in the region include the Indo-Pacific Economic Framework (IPEF), the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), and the Regional Comprehensive Economic Partnership (RCEP). Their full economic impact remains to be felt.

“If you understand how things are made on the ground and the whole chain, you have to force all your suppliers to diversify. That’s not just the guys supplying the chip – because they need to get electronics grade sulfuric acid from someone else,” said Jovasky Pang, CEO of Southeast Asia-focused Archipelago Capital Partners.

“You need people to really go down the chain to make sure that all your suppliers – at least down three levels ­– are diversified as well. And that’s demanding.”

Investor feedback about the China Plus One phenomenon remains largely anecdotal, but some statistical evidence is emerging that confirms the shift is underway. Notably, Section 301 China tariffs introduced by the US, which cover products related to technology transfer, have appreciably displaced US-China trade connections toward Southeast Asia.

In July 2017, 17.7% of US imports covered by Section 301 came from mainland China; that number fell to 10.1% as of July last year, according to S&P Global Market Intelligence. During the same period, Southeast Asia’s share of US trade covered by Section 301 went from 7.8% to 10.7%. Mexico increased marginally.

“If you’re investing for the next 30 years, I don’t think you’re going to be betting on China being the factory of the world. They don’t even have the workforce to sustain that,” said Wai San Loke, co-founder of industrials specialist Novo Tellus Capital Partners, flagging China’s population decline.

“The macro shift isn’t China or zero ­– it’s China plus others. The question is whether China is growing faster than the others, and it’s not. Will China still be there? Yes. Will it be growing at 10%? Probably not. Will it be shrinking? Perhaps. Who’s going to take that?”

Political flashpoints

Amidst the structural shift, the impact of inevitable flashpoints has been exaggerated. For example, attacks by Houthi militants on Israel-affiliated ships in the Red Sea have wreaked havoc on Suez Canal-dependent East-West supply chains. China-US container leasing rates have surged, with the Ningbo-New York route jumping 223% between November and February, according to Container xChange.

Manoeuvring around logistics issues is one area where private equity can be proactive, however. Core value-add moves in this regard include optimising procurement by adding suppliers that run different routes and setting preferred terms by locking in future procs with long-term shipping contracts.

EmergeVest, a Hong Kong-based GP specialising in Asia-Europe supply chains, offers a case in point. In response to the Red Sea attacks, the firm’s flagship portfolio company, EV Cargo, organised a daily taskforce to monitor the situation and began implementing Suez transit alternatives such as increased rail freight and innovative sea-air combinations.

“We have to take a more thoughtful view and talk to customers about where inventory should be positioned, where lead times should be, where they should set up distribution centres, how do you serve markets in a different way,” said Heath Zarin, co-founder and CEO of EmergeVest and EV Cargo.

“Instead of sending goods all to one point and using that as your distribution centre, you set up a distribution point somewhere else that can unlock different opportunities. As an operator, that’s how you can add value when there’s a disruption.”

Generalist GPs have fewer logistical levers to pull, relying more on supply chain strategy guidance in the form of scenario analysis, performance monitoring, leadership buildouts, and maintaining discipline in execution. Identifying alternative suppliers and relevant industry contacts in new jurisdictions must be primarily driven by company management and strategic shareholders.

Investcorp-backed food company Viz Branz offers insight on this point. In the wake of the Russia-Ukraine war, the Singapore-headquartered breakfast cereal maker had experienced price hikes of as much as 40% for wheat. Meanwhile, the company’s Myanmar-based business, which previously imported the bulk of its ingredients from Singapore, was isolated by the country’s 2021 coup.

China represents about 80% of Viz’s business, so China Plus One was never a diversification priority. Indeed, during Investcorp’s holding period to date, the company has retained its three China bases but closed one of three ex-China factories. This was the Pakistan facility; the Myanmar and Singapore plants are still active.

There is scope to re-expand with another Southeast Asian entry, but this would be about diversifying production capacity to accommodate more flexible and economic rollouts of new products rather than deemphasising dependence on China.

The contraction from six to five factories was part of a production optimisation scheme that has seen output increase and supplier relationships consequently multiply. Raw materials that were previously sourced from one or two suppliers now have 3-4, diversified by location and capacity. Strategic connections, especially via Investcorp co-investor China Resources, have been critical.

“Whatever you’re doing, other companies are doing the exact same thing. The challenge then becomes, when you go to that supplier as part of that diversification, that supplier is getting calls from other companies as well,” said Walid Majdalani, head of emerging markets private equity at Investcorp.

“That’s where the importance of shareholders like China Resources comes in ­­– as well as the strength of the management team – to get into the queue and be able to negotiate a financially lucrative set-up.”

Digital drivers 

The private equity playbook in supply chain diversification also intersects cleanly with existing strengths around industry modernisation, particularly the shift toward e-commerce.

As retail digitalises, middlemen are being cut out of the equation via direct fulfilment models while the targeting of niche demographics and erratic demand patterns has become more essential. To play at the speed of the internet and minimise product failure, manufacturers must be able to adjust product designs efficiently.

The migration of Chinese supply chain capacity to Southeast Asia plays into this theme, with several investors observing that emerging markets represent especially credible e-commerce waypoints. Vietnam’s VI Group sees its home market as a proven manufacturing opportunist, able to nimbly pivot with consumer demand and service online expectations.

For example, Vietnam quickly repurposed much of its manufacturing capacity to become the global leader in facemask production with the onset of the pandemic. To this end, VI portfolio company Boo, a youth fashion brand, temporarily became the second-highest seller of facemasks on Amazon.

David Do, a managing director at VI, attributes Vietnam’s e-commerce amenability to a manufacturing workforce with outsized skills in drawing and code, key requirements for reactive product design modifications. There is also the idea that the predominance of smaller factories, with generally lower minimum order quantities (MOQs) versus China, enhances adaptability.

“We have factories that have learned how to make flatpack furniture, which lends itself to e-commerce, and generation Z wants natural wood furniture that’s flatpacked. That’s a whole new category that’s being created that Vietnam is very good at because the manufacturing lines are small,” Do said.

“If you have small production lines, you have lower MOQ. You can launch a product online and crank it out. If it doesn’t take off, you won’t have lost a lot of money. You have a lot more flexibility and seasonality.”

VI’s standout deal in terms of illustrating openings related to supply chain diversification is Yes4All, a sporting goods and furniture retailer that is one of the largest contract manufacturers of its kind on Amazon. The company is registered in Delaware, has a factory in Los Angeles, and runs its financials in US dollars, but product design, inventory management, and customer support happen in Vietnam.

Yes4All is touted as the first Vietnamese manufacturer with the potential to list in the US. VI, which took a minority stake in the business about a year ago, hints that supply chain diversification is set to gradually begin shaping divestments as much as deal sourcing and operational work. The GP has realised several exits to Japan and Korea but never in the US. “This opens up a new universe,” Do said.

Proponents of India as a China Plus One destination observe that much of the engineering design skill to be found in Vietnam and other Southeast Asian manufacturing hubs can also be sourced on the subcontinent, at the same price and at much greater scale.

As with the software and IT industries, global technology hardware players like Intel, Texas Instruments, and Qualcomm companies have set up engineering teams in India. Captive talent is expected to gravitate to the broader export market amidst the government’s push to ramp up local manufacturing.

The potential spoiler is stubborn dependence on imported energy. It is suggested that supporting the country’s growth ambitions – including fostering a domestic manufacturing industry – would lead to a deeper politically unpalatable reliance on fossil fuels.

India’s Catamaran, an investment vehicle launched by Infosys co-founder Narayana Murthy, is keen on domestic manufacturing, largely based on tailwinds related to China Plus One. Precision manufacturing and renewables, as high-skill-oriented domains, are the preferred targets.

“What countries like Vietnam don’t have is the ability to create a local supply chain. It’s one thing to get all the parts in a mobile phone, put it together, and export it. It’s another thing to source all those parts locally,” said Deepak Padaki, president of Catamaran.

“Southeast Asian economies are not big enough to create that entire supply chain, whereas in India, that is the focus right now – how many of the components can you create and source indigenously.”

Catamaran has backed at least two private companies in this theme, including Aequs, an aerospace and toys contract manufacturer with a footprint in France and the US that claims to be vertically integrated. There is also Log9, a start-up touted as bringing electric vehicle (EV) battery supply chains, including components at the cell chemistry level, into India for the first time.

The long game

This is a long game that may not be suitable for many PE investors. In consumer, supply chain diversification is mostly an immediately addressable hygiene issue related to procurement and logistics decision-making. In heavy industrial and high-tech categories, there are often more urgent and less negotiable ESG and political motivations to diversify – and not enough time to do so.

“If it’s semiconductors and EV and it’s a total rethink, then it shouldn’t be a PE deal,” said one investor. “A PE deal is a five-year timeframe thing. It’s impossible to totally change the supply chain structure in that timeframe because it’s defined by the industry, not by a company.”

Still, high-tech solutioning has come to represent yet another supply chain gambit for PE investors. Last month, a mix of strategic and financial investors provided a USD 202.5m round for Singapore-based chip design and packaging company Silicon Box. The plan is to achieve supply chain diversification through technology, both in the end product and the production process.

Essentially, Silicon Box is aiming to snap a virtual monopoly held by US-based Nvidia and its Taiwanese manufacturing partner TSMC in the production and distribution of graphics processing units (GPUs), the only type of chip that can practically handle generative artificial intelligence (AI). The company claims to be only the second operator to provide advanced packaging of GPUs with high bandwidth memory.

It’s an apolitical play yet inseparable from the China-US tech war that has defined much of the supply chain diversification agenda. Silicon Box’s factory in Singapore mostly serves Western customers, but the company will work with Chinese companies if this doesn’t inhibit existing business relationships.

“We had a lot more interest from US-based and China-affiliated investors, and we were pretty choosey about taking money from either block because we wanted to focus on the technology and not take advantage of this current geopolitical situation. That might have been easier for us from a financial standpoint, but we tried to stay neutral,” said Mike Han, head of business at Silicon Box.

“It could have been a lot easier for us to build elsewhere because there’re huge government incentive programmes we could have tapped into. But we chose to come here [Singapore] partly because we’re experienced working here but also because we wanted to prioritise technology independence.”

In a way, the idea that chips, themselves components of larger products, have subcomponent diversification issues all their own suggests there is an absolute backstop to the de-globalisation process in supply chains. Eventually, all products must pass through the spheres of influence of both the world’s two largest economies. Their overlap is inevitable.

Loke of Novo Tellus, whose Southeast Asia portfolio brims with security-sensitive technologies, notes that most of the companies have China links. He recognises technology bifurcation and supply chain resilience through diversification as simultaneous but distinct trends, contributing to an East-West divide but not an utter decoupling.

As supply chains become more politically volatile and unpredictable, perhaps especially in technology, companies and investors that previously benefited from the economies of outsourcing with increasingly pursue more costly vertical integration strategies. If buyers and sellers of those products want prices to remain the same, they may have to get used to experiencing shortages.

“People understand that you can’t just depend on one place, but as the word supply chain implies, it is a chain, and the China link is very difficult to escape. If one of your core components depends on China and China shuts down, your Vietnam factory isn’t going to produce that for you,” Archipelago’s Pang added.

“You have to understand the core dependencies of your entire supply and maybe except the fact that there are going to be disruptions.”