Asia PE performance: Special measures

China accounts for one in five of the world's population and one in three of its deaths from lung cancer. Aequus Capital Partners wants to help do something about it. The newly-formed PE firm is looking to invest in companies with technologies focused on early-stage diagnosis and treatment of cancer.

It is part of a strategy that will leverage government efforts to drive private sector participation in Chinese healthcare. In many cases, the technologies will be established overseas and Aequus will roll them out locally. The PE firm may also invest in the diagnostic and check-up centers that use these technologies. It wants to raise a $200 million pan-regional fund, most of which will be deployed in China.

"The capital requirement is in our sweet spot and the government is very open to driving specialized care away from public hospitals and providing access even at tier-two city level through these clinics," Amit Kakar, co-founder of Aequus, says of the check-up center opportunity.

A total of 742 funds in Asia have been successfully raised since 2006 with healthcare forming part of the remit, according to AVCJ Research. Funds claiming to be healthcare only number 88, although it includes several that have seen some strategy drift. Nearly half are affiliated to corporations, governments and financial institutions. Only 22 truly independent funds have been raised in the last three years, and half of those were renminbi-denominated vehicles.

But Aequus could be part of a new breed of GP. It is very much mid-market. It is a spin-out from a larger platform - Kakar used to lead Asia healthcare investments for Avenue Capital, while his two co-founders previously worked at CLSA Capital Partners and medical devices-focused GP Dinova Capital. It is also a sector specialist.

Whether the transition involves larger firms building up silos of expertise in certain industry verticals or smaller players emerging to target particular niches, PE investors in Asia are finding their sweet spots. This is part natural evolution and part necessity. Specialization is a well-trodden path by Western GPs, but Asian managers are also responding to particular concerns about performance. A general observation by LPs over the last two years is that Asia hasn't delivered the returns expected. Consequently, there is now greater scrutiny of how managers add value to portfolio companies.

Even without this pressure, tougher macroeconomic and exit environments in certain markets are challenging the historical notion that a growth investment will see stellar growth. Now more than ever, portfolio companies need deep expertise in addition to capital.

"The market is more penetrated and prices reflect the level of competition and capital, so it is more a case of what you do with companies," says Katja Salovaara, senior portfolio manager for private equity at Finland-based pension insurance system Ilmarinen. "We are a looking for investment skill and value-add, but I also think Asia has an issue with continuity and keeping talented teams together."

She adds that certain markets in Asia haven't lived up to expectations over the past few years and trail distributions in the US and Europe. There may be more exits to come from these markets, so "we are getting to the moment of truth." These sentiments are echoed by other LPs, though with varying degrees of earnestness.

Damage assessment

As to the root cause of these performance concerns, industry participants identify two issues. First, Asia has struggled with a public markets downturn. While US and European stock indices are close to record highs, facilitating strong distributions to LPs, emerging markets have seen a sell-off in recent years. Exits are not easy and money isn't coming out.

Second, the region is still dealing with the consequences of its own growing pains: the surge of interest in Asia ahead of the global financial crisis led to imprudent allocations to inexperienced GPs and inefficient deployment of capital.

Having raised $55.8 billion over the three years to 2005, Asia-focused managers raised $174 billion over the next three. Between 2006 and 2011, $433.5 billion was invested in Asia by single country, regional and global GPs, with the latter years witnessing an explosion in activity from newly-raised renminbi funds. Since 2008, the region has seen less than $300 billion in exits.

"Way too much money has flown into Asia in the last few years and if you look at funds that had performance when they were at $100 million suddenly were managing $1-2 billion, it's not surprising it's not surprising there are some negative surprises," says Thomas Kubr, executive chairman at Capital Dynamics.

Cambridge Associates has the net IRR accruing to LPs from all Asia-focused PE and VC funds at 13.3% on a 10-year basis, trailing buyout funds from Australia, Western Europe and North America. On a five-year basis, Asia beats Western Europe but trails the other two markets and then ranks second after North America by three-year returns. On a one-year basis, Australian funds lead the way with a net IRR of 25.9%, followed by Asia on 24.8%.

"On the face of it, Asia PE and VC has just about kept pace with returns from buyout strategies in Australia, Western Europe and North America. This may suggest that, if additional risk was imputed to Asian investments, there has not been additional return over that of other geographies to compensate for that risk," says Vish Ramaswami, managing director for investment research at Cambridge Associates.

Strip out all but the top quartile funds, though, and the picture changes. On a five, three and one-year basis, the region outperforms Western Europe and North America, with a one-year net IRR of 46.9%. Given the nascent state of the market, a sizeable difference in performance between good and poor funds is perhaps unsurprising, but it does emphasize the importance of manager selection.

One of the implied criticisms of the phase during which everyone piled into the market is they were not discerning enough.

"If your investment thesis is too macro-oriented and you under appreciate the importance of the GP, you are going to get stuck," says Donald Pascal, president of Commonfund Capital. "Growth investing looked like a sweet spot in China and India - you could ride the macro tailwinds of growth, find some good companies, and get multiple arbitrage. There was a wave of easy money, but that was the early days. A lot of investors plowed money in and some have been quite disappointed."

Preqin tracks all sub-sets of private equity across Asia, Europe and North America. The data, which cover vintage performance in net IRR terms from 1997 through 2011, are instructive in underscoring the differences between then and now. For 1999 through 2003, the median returns generated by Asian funds were better than of their European and North American counterparts in all but one vintage. In 2001, even third quartile managers produced a net IRR of 20.3%, while the top quartile reached 38.4%.

Over the course of these few years, China-focused managers such as CDH Investments were prolific. They restructured companies offshore, doing most of the work pre-investment, and then filed for IPOs in Hong Kong almost as soon as the money went in. IRRs were robust. However, regulatory reforms encouraging Chinese companies to go public domestically and a listings logjam created by the volume of PE firms pursuing pre-IPO strategies made the exit process more complicated and time-consuming.

Any risk-adjusted premium generated by Asia began to erode from around 2006 - also the year when fundraising really took off. The median return from the region has surpassed North America only once over the next six vintages, while top quartile managers have beaten North America's top quartile on two occasions.

"At the start of any market you get supernormal returns because you have naivety and a smaller number of players. Then capital floods in, new players emerge, prices are bid up, and if you have any problem in the system - as you could argue we've had with the paucity of IPOs and the impact on exits in places like China and to some degree India - returns moderate down to a median position," says John Morrison, managing director at Munich Private Equity Partners (MPEP).

Allocation implications

So what does this mean for LP allocations to Asian private equity? For those that seek to construct diversified portfolios, the answer is not much. Asia has to feature to some extent and many of these groups consider themselves underweight on the region. For those chasing pure alpha, irrespective of manager location, Asia could fall in the pecking order.

Yet Ilmarien has no specific geographic allocation, preferring to follow the best opportunities, and Salovaara expects Asia to feature more prominently over the next five years. The group, which is in the process of increasing its global private equity allocation from 5% to 8%, first backed an Asia-based GP in 2007 and has proceeded with caution. "Our approach is bottom-up in the sense that we focus on finding the right managers," Salovaara adds.

MPEP considers itself to be comparatively overweight on Asia for a Europe-headquartered investor but has no plans to alter its allocation. The long-term opportunity presented by the region remains attractive. This is not a pure GDP growth play; expectations of a growing acceptance of private equity in Asia, particularly in terms of how businesses can be improved and management enhanced, are more important.

Put another way, reservations about performance have not destroyed LP confidence in Asian GPs, but investors are developing more nuanced approaches as to how and through whom they want exposure to the region.

There was a window in which Chinese companies could be quickly flipped into IPOs but it has closed; the public markets are selective and exit multiples less heady. Perhaps more importantly, the general investment environment in emerging Asia has changed. Economic conditions in China and India are challenging and entrepreneurs are now looking for expertise in addition to capital.

"If you don't have a different set of skills around operational capabilities and a more value-added governance model, you are not going to get the PE-type returns you want," one fund manager observes. "There is going to be a lot more discipline about which GPs to back. LPs are going to ask tougher questions about what you do in terms of value-add. You can't just opportunistically arbitrage the public markets."

Asked how this line of questioning works in practice, Jonathan English, managing director at Portfolio Advisors, offers a selection of checkpoints designed to differentiate between those capable of executing operational change and those paying lip service to the strategy in order to raise a fund.

The central question is whether the manager's professional background fit the investment remit. If operational professionals have joined the roster, are they young tykes or experienced gray hairs? The latter are more likely to be taken seriously by entrepreneurs but at the same time it is not unknown for these people to depart after a couple of years, leading to another strategic repositioning. This is not black-and-white assessment and it requires step-by-step analysis of case studies.

Big means better?

Alluding to the upturn in performance recorded by Cambridge Associates' one-year returns, English notes that he has seen a tremendous amount of distribution and exit activity in Asia over the last 20 months, most of it from the pan-regional managers. The implication is that these GPs are better positioned to deliver in the current market conditions.

"LPs first entered the market with pan-regional managers but then they wanted to be more specific in looking for alpha generation and went with the single country guys, particularly in India and China," English says. "Now, though, people are seeing healthy returns coming out of the pan-Asian managers. Given their experience, networks and know-how in accessing global markets and M&A activity, they may be better suited to delivering returns when other capital markets slow down. As a result, you have seen more support for these managers from a fundraising perspective."

In the eyes of some LPs, many of these qualities are not possessed by pan-regional managers alone, but rather any private equity firm with the resources to build up silos of expertise in certain verticals.

For example, three of KKR's last four deals in China have been predicated on meeting growing Chinese consumer demand for high quality and safe food products. Building on a vertically-integrated farming thesis first developed for China Modern Dairy eight years ago, the private equity firm has set up a dairy farm venture and partnered with local players on pork and poultry production.

By a similar token, CDH and Hony Capital, the largest Chinese managers, have to some extent moved on from the transactions through which they made their name.

Hony has created two sector-focused teams to work on buyout opportunities in healthcare and restaurants. The healthcare group is led by the former vice principal of Beijing University's cancer hospital with 10 healthcare professionals working underneath him. A first investment came several weeks ago with the purchase of Shanghai Yangsi Hospital, the largest privately-owned hospital in Shanghai. This will serve as a platform for the acquisition of 10-15 hospitals in the next three years.

MPEP is among those backing the transformative powers of the larger manager in Asia, having decided three years ago that it would shift focus from the smaller end of the market to larger size funds.

Exits featuring strongly in the LP's thinking. First, if IPOs were going to remain a key exit route for Asian GPs, MPEP believed that public market investors would respond best to candidates from either end of the spectrum: VC-backed tech companies and larger, more mature businesses with strong corporate governance. Second, when multinationals examine M&A options they tend to go after one of the two top players in particular market. Bigger funds were seen as more likely backers of these top companies.

"Another part of the equation is we do believe this level of operational change and real impact in the portfolio companies will come over time, although maybe not in the same form as Europe or America," says MPEP's Morrison. "And it will be more towards the larger, more professionally run businesses. It will still be proportionally harder to do that in smaller companies."

With this in mind, MPEP is an LP in Hony's most recent fund, which closed at $2.36 billion in 2012. However, it is also backing BVCF, a China life sciences-focused GP currently investing its $200 million third fund. This represents a nod to the expected rise of specialist managers in Asia and the role they can play in a differentiated portfolio.

An evolving concept

As recently as three years ago, Asia growth managers would reject the notion of sector specialization on the grounds that they would miss out on a huge amount of potential deal flow. The more challenging fundraising environment prompted a change in strategy. Thinking more about marketing than reality, GPs emerged claiming to be specialists in the financial services, consumer and industrial sectors - a broad enough focus to cover the majority of deals available. While these players still exist, genuine specialists are also in the market.

"In the last 24 months quite a few healthcare-focused funds have emerged in Asia, as one example of sector specialization. In the US and Europe you see a lot of GPs that focus solely on one sector. We now see this sector focus starting to emerge in Asia, particularly for the healthcare and consumer sectors," says Pamela Fung, principal at Morgan Stanley Alternative Investment Management.

Some of these are spin-outs from established platforms. Kakar will be joined at Aequus by members of his healthcare team from Avenue Capital, which is expected to focus more on special situations for its next Asia fund. There are similarities between this and other situations in which executives have departed regional firms because fund sizes, and therefore equity checks, are getting larger. If these executives are seeing plenty of deals that no longer fit the firm's remit, there is a natural inclination to launch something mid-market and more focused.

There are also managers who start out agnostic but gradually become more concentrated. QIC, an asset manager owned by the Queensland government in Australia, gravitates towards funds of $300-500 million and has not participated in a fund larger than $1.1 billion in Asia. Some form of specialization, whether defined by sector or transaction type, is a given.

"If I look across a sample of our Asian our managers, one was generalist last fund but has now narrowed down to two sectors and is 60% of the way through investing the fund. Another is purely focused on one sector, while a third is a bit more agnostic but has other deep resources on the operational side and their ability to analyze markets. There is enough specialization available to find what we want," says Marcus Simpson, head of global private equity at QIC.

The advantages of specialist managers are clear - sophisticated industry knowledge, ability to add value, familiarity with potential partners and acquirers - but in an Asian context, so are the potential drawbacks. Chief among them is whether these GPs are able to generate enough deal flow in their formative years to keep their team of experts in place and build scale. Without a core base of LPs that are sufficiently convinced to overcome these reservations and back a specialist manager even though they have yet to see a large number of such funds perform in Asia, it can be difficult to get traction.

Vincent Ng, a partner at placement agent Atlantic Pacific Capital, suggests there is not a lack of supply of specialist funds, but a lack of demand.

"If I have a portfolio of 16 generalist GPs and I still need to put money to work, I might back a specialist," he says. "But if I'm making 2-3 bets in Asia each year, my risk-adjusted bet is probably safer with a generalist even if they don't have 15 PhDs evaluating healthcare opportunities. If healthcare is overpriced or extremely competitive, my generalist can look elsewhere."

Needs more discipline

Nevertheless, specialization is expected to continue to take root in Asia, among the large regional players and the smaller independents. In this respect, the evolutionary path is seen as no different from that of the US or Europe.

Using a nine-inning baseball analogy, Commonfund's Pascal says that Asia is still on its second or third inning, and maturing on a reasonably predictable course. He estimates that the region's managers could progress at a faster rate than the US pioneers, adopting 4-5 years' worth of industry best practices from other markets for every 2-3 years that passes.

But will specialization help Asian private equity deliver the risk-adjusted returns LPs want to see? Doug Coulter, head of Asia private equity at LGT Capital Partners is skeptical. He has yet to see any evidence that specialist funds outperform in the region, but at the same time, take all the outperformers as a group and it's a mixed bag in terms of size, strategy and geography.

With this in mind, it might be argued the evolution of the asset class in Asia should not be seen as a graduation from passive to active, or from stock flipping to company building, but from a frontier environment to a professional environment. LPs want to be presented a framework of discipline, governance and transparency through which they can trace consistent performance across deal sourcing, structuring, value creation and exit.

"While no clear evidence that good governance, transparency and institutionalization has been correlated to better returns in Asia, a lack of governance and institutionalization has often led to subpar returns," Coulter says.

Mounir Guen, CEO of placement agent MVision, is more bullish. He describes the ideal scenario as a GP that packages every deal into a 250-page report, detailing every aspect of their work on a company. He says such approaches are increasingly adopted by local managers in Asia.

"Institutionalization is very important. A GP must understand the power of their firm is to be able to synthesize and capture their DNA," he explains. "It is evolutionary. As markets develop, GPs understand how to formulate and structure their businesses. If you can take that discipline and put it on top of what is happening in Asia, you can have very successful results."

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