Canary in the coal mine: GP economics under stress

Uncertainty breeds job applications. According to one China-focused GP, 2-3 years ago he received 5-10 resumes for each position advertised; now the firm's mailbag bulges with the same number of applications - but they are coming on a daily basis and he isn't even hiring.

"Everyone wanted to jump around between firms for a higher pay check but now they beg to join at any price because they are worried about the organizations they are with," the GP notes.

This is classic end-of-the-party syndrome. In times of plenty, LPs are willing to write big checks and forgive small misdemeanors. As soon as the market tightens up, performance is placed under the microscope - and not just by would-be investors. As soon as managers are left wondering where their next allocation is going to come from, junior and mid-level staff start wondering about their next career move.

"The first thing that happens is people leave," says Juan Delgado-Moreira, head of Asia at Hamilton Lane. "You are at junior managing director level with transaction experience and you see the firm is not going anywhere. You are marketable and less tied to the GP economics. You aren't interested in spending the next five years trying. When firms start losing young, quality MDs it's like a canary in a coal mine."

The question for Asian private equity is how many canaries and how many coal mines. Enough funds were certainly raised during the boom period of 2006-2008 - $172 billion went into more than 1,200 vehicles, compared to $56 billion for 840 vehicles in the three years before that - for there to be a significant number of underperformers.

However, the chances of attracting capital for a new fund, or a sufficiently large sum to keep the team together, rest on more than just the fortunes of one vintage. Track records, the consistency or suitability of strategy, the make-up of the investment professionals, and perceptions about opportunities in the target markets all come into play.

Even if a fund is smaller than its predecessor, which means fewer fees to go around and reduced deal firepower, there isn't necessarily an exodus.

"People are more approachable now but we don't have a flood of CVs coming in. It's not happy anywhere so there aren't funds beating down the door to hire people," says Michael Di Cicco, Asia Pacific financial services partner at Heidrick & Struggles. "But in terms of salary, bonuses have been beaten down. The model of a 12-month bonus is more like nine or six months."

The other side to a disappointing fundraise is cutbacks - office closures, redundancies and truncated mandates. While some senior level retirements are voluntary, others are enforced: partners who take a large portion of the fund economics but who have underperformed personally might be ousted by their team.

Areas of vulnerability

Inviting industry participants to name firms under pressure draws a predictable long list of those that have been fundraising for a while or are thought to be delaying a launch. In some cases, it is difficult to distinguish the internal churn that affects most GPs from signs of a potential meltdown.

On a geographical basis, three markets crop up most often: India, which more than any country in Asia has been pilloried by LPs for failing to deliver on its promise; China, particularly the once fast-rising now fast-sinking renminbi space; and Australia, where managers are impacted by changes in the domestic LP base.

The first casualties are the funds that never really got off the ground. With no assets under management they aren't in a position to invest in the team and tend to fade back into advisory work. This has proved to be the case for several of the Indonesian GPs that tried and ultimately failed to raise funds when sentiment towards the market was at its peak in 2011 and 2012.

Private equity firms on Fund II or III might also find themselves in the danger zone. "I look at Fund I and the performance of those assets. If there is no carry at all, that raises a red flag," says Delgado-Moreira. "If there is enough carry to pay for the retention of the team, then it can work. Fund II won't pay for retention because the carry won't come for about seven years under a European waterfall structure. It is important to retain talent over the course of Fund II and III, and performance of Fund I is key."

Once a firm gets to Fund IV and above the pressure usually eases somewhat. Although no one wants to manage portfolio run-off for a GP that is dead in the water, LPs and junior and mid-level talent are willing to be patient where they have visibility on past and future performance. Furthermore, even if there is staff turnover, the team is likely to have deepened, making the impact easier to absorb.

Indian GP ChrysCapital Partners is an interesting example in this respect. Having raised $1.26 billion for Fund V in 2007 - before returning $300 million to LPs, plus the fees incurred on this capital, citing limited opportunities - the firm returned to market in late 2011 with a target of just $500 million for its sixth vehicle. Ashish Dhawan, ChrysCapital's founder and senior managing director, also stepped down ahead of the fundraising.

More capital could have been raised for Fund VI, but it closed at $510 million as LPs bought into a strategy shift that now sees the firm target smaller equity tickets, where there is less competition, in the same sectors it operated in before. Meanwhile, the retirement of Dhawan - and the departure of another partner, Brahmal Vasudevan, who spun out to form Creador - meant the economics could be spread more evenly between the team that remained, led by six managing directors.

"The carry pool got freed up as people left," says Gulpreet Kohli, a managing director at the firm. "We get less fees than before and so some of us obviously took a hit, but that's okay. We still have fees coming from the older funds. If you're a new organization a smaller fund size makes a huge difference but for older organizations it doesn't make that big a difference."

Kohli adds that a $500 million fund, operating under a 2/20 fee structure, is enough to sustain a mid-size Indian franchise; it is when funds dip to near the $100 million mark that alarm bells start ringing.

This view is supported by Vishal Nevatia, managing partner of India Value Fund Advisors (IVFA). Last year the firm trimmed its $700 million fourth fund, raised in 2009, by 15%, telling LPs that a jump in valuations from 2010 had slowed the pace of capital deployment. IVFA returned the additional fees as well, but the team hasn't been affected.

"In 2012, our core team increased from 16 to 24. We did this with a view that, yes, the fund re-sizing has happened, but we should build a team based on the next 4-5 years, not based on now," Nevatia says. "If one has reduced revenues and increased costs, then the residual left for the partners is significantly less than before. We take the long-term view that real wealth creation for partners should come from carry and not fees."

Of the eight senior executives IVFA has added, six are operating partners. This taps into a wider trend whereby Indian GPs are switching from a passive to a buy-and-build style of investing. Praneet Garg, a director at Asia Alternatives, observes that there have been more additions on the operating than the deal side in the last 2-3 years. "They decide what the fund size is going to be and then look at the existing team and whether it meets the needs for the strategy. They might want to get rid of some deals guys and bring in operating guys," he says.

In addition, the two investment professionals that IVFA hired in 2012 are relatively junior, with only 5-7 years of experience. This tallies with developments elsewhere in the region, as GPs opt for youth and value over experience and expense. Heidrick& Struggles' Di Cicco says that his clients are trying to put more value into levels below managing director and delaying promotions as a cost-cutting exercise.

For others, youth can mean stability and diversity. Derek Sulger, managing partner at China mid-market firm Lunar Capital, brought on board younger professionals from operating and other non-banking backgrounds and invested in training them up. "It takes a lot of time and effort, but I prefer our focus on culture versus hiring mid-level guys from the outside," he says. "I worry about the effect on our culture of bringing on board people who are too eager to jump too fast, as if always anticipating the next boom."

The China example

As the market where private equity interest has been at its most frenetic in recent years, China has the dubious honor as progenitor of some of the asset class' least sustainable fundraising and team-building strategies, on the renminbi and US dollar sides, respectively.

Renminbi funds were undone by the abandon with which they emerged. Commitments reached $30.9 billion in 2011, five times the figure from 2009, and this was only possible because managers relied on intermediaries to reel in wealthy backers. Managers were often handing over a large chunk of their economic interest in the GP in return for fundraising support. Vincent Huang, a partner at Pantheon, previously told AVCJ that intermediaries were charging 1-2% up front and then half of the annual management fee and carry.

A manager's primary motivation for operating a fund under these conditions was the prospect of raising a second vehicle - with better terms - on its coat tails. When it became apparent that the large public market returns on which these investment theses were predicated would not be forthcoming, the managers had no incentive to stick around. Renminbi fundraising plunged to $4.2 billion in the second half of 2012.

The alignment of interest issues are nowhere near as warped for China-focused US dollar funds, but there are situations where GPs have been found wanting. 

Of particular note is a tendency to concentrate the economics around 1-2 key individuals, or even a third-party sponsor, at the expense of the wider team. A failure to share the wealth and convince junior team members that they have a long-term stake in the business is responsible for the churn that has characterized the industry in recent years.

In these more straightened circumstances, managers have two options: become more institutional, spread the economics and professionalize the management; or fire all but the most essential people and try to maximize their personal economics.

"Option two is easier right now because it's quicker - raising a fund can be a 24-month process. It is easier to pare down," says Heidrick & Struggles' Di Cicco. "But funds will get to the size where the founders, who are getting the lion's share of the carry, realize that to get to the next level they have to take a smaller piece of the pie."

Asia Alternatives' Garg claims to have similar worries about some of the Indian GPs that appear on his radar. "What is concerning is when a smaller fund is raised and the GP slows down on building the team and doesn't add new members that maybe required to fill the gaps they have," he says. "Another issue is once a smaller fund is raised, the GP enters perpetual fundraising mode because they are thinking about the next fund. This can be a big distraction."

Not all domestic GPs - Chinese or Indian - fall into this category. Indeed, parallels are drawn between ChrysCapital and its equally seasoned Chinese counterparts. CDH Investments, for example, is routinely cited as a firm that has managed to retain a core team and develop talent around it. The GP started out 10 years ago with six investment professionals, of which two were deal leaders; now it has a headcount of 40 with 15 deal leaders.

But then CDH's latest fund - its fifth - has a target of $2 billion, one third larger than the previous vehicle. It can claim to have reached the relatively safe third phase of GP evolution, where both investors and investment professionals have tasted carry.

A new reality

LPs say that a sustainable compensation structure is a key consideration in manager selection and the younger firms AVCJ spoke to claim to operate with this in mind. Vasudevan took a leaf out of ChrysCapital's book when setting up Creador. Just as the Indian GP's senior executives were the ones to forego fees when Fund V downsized, leaving junior team members untouched, so Creador's three founders took the hit when the debut fund closed at $132 million, short of the $350 million initial target.

"It is important for people like me, who are running smaller funds, to secure the layer of guys who have been contributing as we start performing over the next 3-5 years," he says. "These are the guys who will be targeted by larger firms. In many cases they prefer the entrepreneurial culture of a small firm but we have to pay competitive salaries and this means offering carry pieces that are larger than someone would get at the same level in a global firm that provides global carry."

If Creador I achieves a 3x multiple, for example, then around $50 million in carry would filter down through what is currently a 13-person team. Based on that performance, there would also be the expectation of more to come in Fund II. Other mid-market GPs throw in further incentives, such as holding back a portion of carry and giving the top dealmakers a bit extra later on and promoting people to levels they might not be able to reach at that age with a global firm.

Lunar Capital, which is currently investing its $150 million third fund, operates a GP participation plan open to those who achieve promotion to vice president or above. Carried interest is distributed on a performance basis, but with it comes the responsibility to invest in the fund. If the GP commitment to the fund is $10 million, an individual receiving 5% of the firm's carry has to contribute a similar percentage of the GP commitment.

"You get substantial upside, but you have to put skin in the game," Sulger says. "I believe this old fashioned approach of having to ‘eat what you cook' is the best way."

Regardless of the incentives that can be pumped into contracts to secure staff loyalty, the reality for many mid-market private equity firms in Asia is that the days of plenty are over. Emerging markets are far more competitive than they once were and the macroeconomic environments of certain countries are becoming less helpful. The returns might not be as great and a host of GPs will go out of business, but this might encourage stability within the teams that remain.

"Pre-financial crisis, everyone was making more money because of good fee structures and large fund sizes," says IVFA's Nevatia. "But the economics is getting reset for the whole industry so people have to reset their expectations in terms of the money they can make."

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• Topics
• Fundraising
• People
• Greater China
• South Asia
• Performance
• Fundraising
• Appointments
• Asia
• China
• India
• ChrysCapital Management
• India Value Fund Advisors
• Creador
• Lunar Capital Management