LPs see their money bloom?

Their views and shifts in opinion en masse may be as disparate and unpredictable as the weather, but cannot be ignored. So what is their state of mind two years on from the Lehman collapse, and what does that presage for Asia Pacific private equity?

In PE’s corner: the macro perspective

Asian GPs, especially in China, facing an apparent tidal wave of LP interest and money might question whether they really need to concern themselves with their competitive position relative to other regions and asset classes.

As Sarah Alexander, founding president of EMPEA, reminds us, “The global economic downturn undermined the assumption that investing in developed markets was risk-free, while additionally highlighting the importance of a well-diversified portfolio.” But for many Western LPs, this means just the start of a wholesale readjustment process, with every danger of making mistakes and seeing lower returns, rather than enhanced performance, along the way.

The broader picture gives them little room to hesitate, however. Post the GFC, investors across all asset classes are seeing greater unpredictability around returns as the smoothing effect of leverage recedes. “In a more regulated and less levered global economy, you’ve got lower average asset returns, more dispersion around the mean, and more positive and negative fat tail outcomes,” cautions Brian Baker, President and Director of PIMCO Asia, speaking at the recent PPI Asian Pension Fund 2010 Roundtable in Hong Kong. Many investors are consequently chasing pure yield and accepting higher risks, when even more conservative asset classes have lost their historic safe harbor status and promise only more volatility going forward.

In Asia, meanwhile, the macro outlook could not be better, according to Varel Freeman, First VP at the European Bank for Reconstruction and Development (EBRD). “There’s a great uplift going on in investment, productivity, emergence of the middle class, and all of the factors that would make many of these markets much the same as the US appeared in the boom years of the 1950s and 1960s.”

Furthermore, the global economy’s growth drivers over the past few decades appear to be dropping away, compelling global institutional investors to look to new sources of returns. Baker points to the move away from the “three powerful forces that have been working together” over the past three decades to generate world growth. One is deregulation; another is globalization, “which brought a large pool of capital and labor into the global economy”; and the third was financial innovation, a product of deregulation. “Those are all unwinding,” he warns, as governments re-regulate their economic institutions, back-pedal on globalization, and legislate away financial innovation. “That’s a significant change to what we’ve all been doing over the past 30 years,” Baker cautions.

Risk and returns

As this suggests, a wholesale transition in global asset allocation and growth drivers is hardly likely to be easy or risk-free for LPs, however unavoidable. As Mark Delaney, Deputy Chief Executive and CIO at AustralianSuper, remarks, “If half of the world’s GDP growth is coming from emerging markets and half of world’s future corporate profit growth will come from emerging markets, but only 14% of the MSCI and market capitalization is in emerging markets, what happens if half of the world’s capital flows try to get into 14% of world capital markets?” He sees the transition as “inevitable,” but anything but smooth.

Some LPs are comfortable with the re-rating of Asian market risk. “The risk premium for the emerging markets has been reduced substantially to reflect the perception of the current global macro situation,” asserts Maninder Saluja, Co-Head of the Emerging Markets Private Equity Program at Quilvest Group. But others see many LPs, drawn by the macro story, coming to Asia and then hesitating on the doorstep when they find far fewer investment-grade GPs than they had hoped. “The significant amount of capital that wants to go [into Asia] is still there, but it can’t find a home,” points out Mounir Guen, CEO of MVision Private Equity Advisers.

Lack of available investment-grade options tends to exacerbate diversification risk, and hence reduces the benefits in diversifying out of developed markets. Though Freeman welcomes the strengths of emerging markets, he adds, “For me, the biggest risk is the insufficient room to diversify the risk you take … For those investing in emerging markets, you don’t have a lot of choice. That means a great deal of returns correlation.”

PV Wang, Partner at Adams Street Partners, asserts that diversification is “no longer the main reason or driver” for investing in Asian markets. “Once you have seen the structural changes that are happening in emerging markets, the urbanization and the emergence of the middle class, what happened post-GFC just shows that those changes continue regardless of the destruction of the crisis.”

However, diversification into emerging markets, or various alternatives, needs to be looked at carefully in terms of how it is done and what the ultimate goal is. Baker cites the once-lauded university endowments as an example of what can go wrong. “People became very enamored with the endowment model, where they had multiple asset class exposures. But if you look at the endowments, they had a very difficult 2008,” he cautions. “We’ve looked at the correlation of the endowments to the MSCI and it’s about 98%. They had asset allocation diversification but they didn’t have risk diversification.”

And although Asia Pacific private equity may have long appeared short on quality investment-grade propositions, for Freeman at least, the asset class as a whole still offers a valuable opportunity for diversification away from the region’s similarly narrow listed markets. “I would put in a plug for private equity and unlisted investment opportunities as a very important entry point for you to differentiate yourselves from the herd of investors.”

Also, underweighting in private equity towards Asia may be proportionately more significant than in the public bourses. “Asia is an indispensible part of global allocation,” avers Wang. “Private equity in a sense is just catching up with the public markets.”

Alison Nankivell, Principal for the Asia region with EDC Equity, also maintains that, “in relative terms, we believe that PE is a more useful financial product in emerging markets, where the capital and debt markets are not as developed. Private equity allows you to get access to emerging players. That’s what we’re interested in.”

For Delaney, there is still one overriding risk going forward in Asian economies. “The most obvious thing that can go wrong is that they overheat. With fixed exchange rates they’re importing US monetary policy. The economies will be run too hard; and that’ll generate inflation. And that’ll undermine the growth engine for the entire world. For me that’s the most material risk on the investment horizon.”

Does Asia deliver?

Despite the irrepressible excitement among LPs and the irrefutable macro rationale for moves into Asia, there is still the outstanding question of whether the region is going to make money for them. As Nanvikell cautions, “like most regions, everything gravitates towards the mean,” and Asia’s macro vigor does not grant it immunity from that simple principle.

Exactly what is the right investment balance towards Asia now remains a ticklish question. “For our segregated clients, we manage 15-30% allocations to Asia, depending on their appetite,” notes Lynsey Register, Principal at Hermes Global Private Equity. However, she adds, “the fine balance is whether there are enough experienced and credible managers to fulfill this requirement and whether increasing allocations and therefore capital flows to the region will impede future returns.”

Some are optimistic. “PE can make money,” Freeman affirms. “Over a 20 year period, we have done very well as a sponsor of PE in the 20+ countries where we operate. The asset has returned, net of fees and expenses, very close to what we have achieved in our equity program.” Quilvest’s Saluja asserts that “inherent growth in underlying businesses is leading to true returns,” although he also concedes that, “valuations are limiting the overall upside.”

Others are still cautious. “As yet, Asia is still to demonstrate its true performance, with only a handful of managers that have delivered material cash to LPs,” warns Register. According to Wang, on a relative basis, Asia Pacific private equity “has significantly outperformed the rest of the world. But I would make the proposition that the downside from investing in the wrong fund is still very high. The dispersion of returns in Asia is much higher.”

Freeman admits readily that the EBRD’s experience may reflect its unique position and capabilities, as well as a determined focus on active portfolio management, but he also points out that, “our returns include the people who have washed out from the process as well as the more successful managers, with who we have done four or five funds now. It’s a blended average of the winners and the losers.”

Delaney sees Asia’s immaturity as still likely to defer returns, despite or even because of all the momentum from global LPs. “The fact that markets grow bigger is no consolation: I like markets that grow up,” he says. “I’m suspicious that the capital might come in before the markets broaden.” However, LPs may simply have to take a chance to obtain what they want. “If you want to get access to high-potential, high-growth mid-market companies in emerging markets, you’ve really got to do it through PE,” Nankivell concludes. “And that’s our target.”

“Investors in Asian private equity expect higher returns compared to Europe or the US,” concludes Dr. Fritz Becker, CEO and MD of Harald Quandt Holding. “The next three to five years will prove if the GPs are able to deliver these returns in real cash flows.” 

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• Topics
• Fundraising
• LPs
• Funds
• Performance
• Adams Street Partners
• Piau Voon Wang