Asia fundraising: Size matters?

The availability of co-investment is not a deal breaker when Teachers' Private Capital is picking GPs in Asia, but is an important consideration. The PE unit of Ontario Teachers' Pension Plan (OTPP) has C$12 billion ($11.4 billion) deployed globally, split equally between fund and direct investments. As the group staffs up its Hong Kong office, so the capacity for co-investment in the region will increase.

But these deals must be done in the right way.

"There are two schools of thought on co-investment. We are of the co-underwriting school of thought - partnering with the GP from the very beginning on a particular opportunity and bringing in our own industry experts who have done lots of deals in that sector," Jane Rowe, senior vice president at OTPP, told AVCJ in a recent interview.

"At the other end of the spectrum are folks that have no desire to go deep into the due diligence or documentation. Maybe they go to two meetings decide they want to ride on the coattails of the GP."

OTPP belongs to a small group of LPs that possess the remit, resources and will to take this kind of proactive approach to co-investment. Marcus Simpson, head of global private equity at QIC, estimates there are 15-20 of these LPs globally, ranging from sovereign wealth funds through Canadian pension plans to QIC itself.

"A mega buyout manager I spoke to reached out to LPs around the world and 120 that said we are ready to co-invest. He had a deal with a fairly short fuse - about four weeks - and that 120 went down to about 20 who could actually do it," Simpson says. "There is a big difference between syndicating and underwriting, but syndication partners are starting the journey. A lot of people are trying to figure out where they sit on the spectrum and where they want to go."

Accommodating these large-scale LPs, whose priorities may differ from those of the mainstream, represents a challenge for GPs all varieties, either directly or indirectly.

For the larger managers, a $200 million check offers momentum in a difficult fundraising environment, with fee cuts and promises of co-invest frequently offered in return. Smaller players have little chance reeling in LPs of such size, but they are buffeted by a wider industry trend. As large institutions look to cut back on GP relationships, flocking to brand names that can take larger checks, it begs the question of whether risk aversion is denying them access to what might have been the next big thing.

"The big LPs are changing the market because they have deep pockets - but are they changing it in the right direction?" asks Fritz Becker, CEO and managing director, Harald Quandt Holding, a family office based in Germany. "Do large GPs really generate better returns? Some yes, but most no. In each region we started with brand name GPs but as our due diligence capacity has increased we have allocated more to mid-size and smaller GPs."

Add weight, shed bulk

Many investors have little choice because they are increasingly encumbered by their size. Thomas Kubr, executive chairman at Capital Dynamics, estimates that a mature PE program with $50 billion in assets needs to make new commitments of $10-12 billion each year to maintain its target allocation. If the LP is unable to account for more than 10% of a single fund then backing mid-market funds of $1 billion or below is challenging - two $500 million commitments are easier to monitor than 10 at $100 million apiece.

Yet at the same time the issue goes beyond size and becomes one of fund economics and ultimately performance. Institutional investors of all sizes are in recalibration mode, saying they will maintain or increase their overall allocation to private equity but focus on a smaller number of managers. What they have in common is depth.

"Many LPs with substantially diversified programs have come to realization that they have 10 people trying to manage over 100 GP relationships and this diversification hasn't delivered the returns they would have hoped," says Vincent Ng, a partner at Atlantic-Pacific Capital. "So focus on the top 15-20% performers, allocate another 5-10% for new relationships, and anyone else is run down or sold as a secondary."

The big getting bigger while the small get nothing at all is a brutal notion but one that is to a certain extent borne out by the fundraising data. According to AVCJ Research, Asia-focused PE funds have received commitments of $34.4 billion so far this year, nearly $20 billion short of the total for 2012 as a whole. It is likely to be the weakest fundraising performance in four years.

These numbers are based on funds that have reached a partial or final close. Take the final closes alone and the bifurcation in the market becomes clear.

At the top of the list sit three pan-regional vehicles, KKR Asian Fund II on $6 billion, RRJ Capital II on $3.5 billion and MBK Partners III on $2.7 billion. Discount funds with an element of government or strategic interest and there is nothing else until Anchor Equity Partners' debut Korea-focused fund on $500 million. There were eight more final closes above the $200 million mark by independent managers.

In 2012, 17 funds reached a final close of $500 million or more, with eight coming in at $1 billion and above, once again discounting government or strategic-backed vehicles. Another 15 raised in excess of $200 million. Placed against 2007 when Asia fundraising reached its pre-financial crisis peak of $62.9 billion - and the contrast becomes starker. Ten funds reached a final close of $1 billion or more, another 11 raised in excess of $500 million, and over 40 closed between $200 million and $500 million.

Large pan-Asian funds being raised by TPG Capital and The Carlyle Group, which launched after the likes of KKR, RRJ and MBK, have been in the market for more than 18 months. They are attracting capital but it remains to be seen whether they meet their targets by the previously stated year-end goal.

"The firms who have built up significant regional infrastructure and a strong investment track record across multiple markets are the ones who are attracting capital," says Joe Bae, head of KKR Asia, referring to the large-cap space. "The ones with fund sizes that are smaller than what was raised previously are those without a top-quartile track record or have seen major turnover on their teams or have different stories today as to the markets they can invest in."

KV Asia, a Southeast Asia-focused GP, is one of the lucky few in the region's hollowed-out mid-market, its debut fund closing at $263 million in August, more than two years after launch. Karam Butalia, KV Asia's executive chairman, notes that the process was made all the more challenging by LPs' wariness of backing first-time funds, even though the principals in this case are not newcomers to private equity.

"The big are indeed getting bigger. You look at these larger LPs, with tens of billions of dollars, they need to make a material impact, hence they need larger check sizes," he adds. "But there is a lot of money out there for private equity and small funds are still coming up. As the market becomes more seasoned you will get more specialized, smaller size funds that understand particular character traits and businesses."

Slim pickings

Plenty of industry participants are willing to plot a course towards greater GP specialization in the mid-market. Lorna Chen, a partner at Shearman & Sterling, is already seeing differentiation among smaller PE firms - to a large extent a matter of necessity given how the community has proliferated in recent years.

While it goes without saying that a pre-IPO manager who ran China deals out of Hong Kong must evolve if he is to stay competitive, there is some skepticism as to how deep the talent pool really is. Past experience also weighs on judgment calls, and the reality that far too many investors bought into the growth capital story and committed money to multiple GPs, often with overlapping strategies, that should never have been backed in the first place.

"In a China context, when LPs say they want to put more money to work in China but with fewer managers, they are saying that they previously gave money to 20 managers and 15 of them are sucking wind," one GP observes. "There is still a lot of money going into the market and it goes to those five managers - there really aren't many more - that are perceived to be differentiated."

This approach suggests deployment out of necessity rather than choice, which means the LP is always likely to opt for the most defensive option.

Similar attitudes are seen elsewhere in the region. First, there is a general unwillingness to embrace unproven managers and strategies, particularly among LPs who must run decisions past an investment committee that is based outside Asia. This is a classic safety play: the salaried investment manager is more incentivized to protect capital than take a risk on a GP who might deliver alpha but equally may well blow up.

Second, some LPs back the largest player in a particular space, despite having reservations about the manager, simply because there is a desire for exposure to a strategy of geography. "Their minimum check size is $75-100 million and there might be only one fund large enough to absorb that amount, so they have nowhere else to go," Ng says. "They are making decisions based on scarcity value rather than absolute returns."

One way an institutional investor can address this issue is by accessing smaller managers through a fund-of-funds. Indeed, the number of LPs who take Asia seriously is expected to grow exponentially over the next decade and many will follow the path taken by Harald Quandt and others, investing via a third-party manager until they are comfortable enough to go solo.

For those without the asset base to justify additional staff, a fund-of-funds or an advisory relationship might remain the logical way to access the asset class in Asia. At the other end of the spectrum, LPs with a passive remit are already moving towards customized solutions that typically offer more freedom and lower fees.

"We have clients with large amounts of capital to deploy but don't want a multitude of relationships in their PE program so we set up special purpose vehicles for them," says Michael Lukin, managing director and global head at Macquarie Investment Management's private markets division.

"There is flexibility in terms of being able to sell assets on the secondary market, not being locked into a co-mingled product and having control over the pace of deployment, but you can still access markets where there is $50 million of capacity available rather than $500 million."

When acting as a sounding board for smaller Australian funds seeking in the region of $200 million, Lukin advises against fundraising trips to Europe and the US in favor of Singapore and Hong Kong. Asian fund-of-funds are capable of writing $30-40 million checks and they are generally easier and cheaper to deal with than a far-flung US institution.

The momentum an anchor commitment from a fund-of-funds - or Temasek Holdings' Pavilion Capital - can give to a first-time fundraise shouldn't be underestimated, even though some industry participants warn that the terms demanded for performing this role can be egregious. Of the 2013 final closes, Anchor Equity and KV Asia are each said to have won early support from a trio of such institutions.

"Without an anchor investor it would have been a lot more difficult," KV Asia's Butalia notes. "They have the knowledge and the feet on the ground - many pension funds can't do that. Although the Canadians are taking a different route and it's interesting to see them setting up their own offices, by and large pension funds are understaffed and subject to a lot of regulation."

Higher standards

Regulation, or the imposition of minimum standards on GPs in terms of reporting and compliance, is another area in which larger managers are seen to hold an advantage. It also offers insight into the broader question of whether the big getting bigger is a function of the cycle or evidence of a more systemic shift.

The driving factors here are not specific to Asia but the outcome is. On one hand, the introduction of Institutional Limited Partners Association's (ILPA) set of principles for improving alignment of interest, governance and transparency in private equity has provided a strong starting point for LPs in their negotiations with GPs. On the other, the hawkish environment from which the principles emanated has turned the balance of power between GPs and LPs in favor of the latter.

Where they recognize fundraising is taking longer than anticipated, LPs are able to demand more concessions. Reductions in fees and access to co-investment are only one part of it. Wary of the opportunity cost of participating in private equity, institutional players want to benchmark the asset class against others. Hence the desire for more information, delivered more frequently, on a fund's holdings.

The willingness to make an exception for Asia in this respect is dissipating. A manager wanting to secure a commitment from one of these LPs must therefore invest in a back office to meet these requirements.

"A few years ago if you talked to a lot of European and US institutions they would say it's different in Asia. They understood they couldn't get the same standards as in the US and Europe," says Mario Giannini, CEO of Hamilton Lane. "But the lack of returns has made them say, ‘Well, it's different but not better, so why would I take that risk?' There's a view that they need institutional structures that make for a good fiduciary. That is an increasing issue for Asian GPs."

This poses something of an existential threat to a first-time smaller manager - he can't become institutionalized without funding but can't get funding unless he's institutionalized - but most accept that compliance is a cost of doing business. Furthermore, a fundraising process, while it may take longer than previously due to tighter due diligence, can be targeted to ensure time and cost efficiency.

"The key element we point to is targeting investors that are, at that particular time, focused on the right strategy, have capital and are willing to move," says Thomas Swain, Vice President with Credit Suisse's Private Fund Group in Hong Kong. "Unless the GP is in the camp where they can dictate terms and timing, they need to be sensitive to executing those steps to achieve and maintain fundraising momentum."

Finally, it remains to be seen whether the current - and general - trend whereby the big are getting bigger holds true.

Private equity globally has become increasingly focused on the largest pools of capital with the emergence of large-scale LPs and the retreat of high net worth individuals and family offices since the global financial crisis. At the same time, Giannini argues that bifurcation within the GP base - large players' scale advantage becoming entrenched and smaller players becoming more local and specialist - has been seen in other markets.

If these forces are preserving the status quo, two more seek to undermine it. First, foreign LPs' comfort and understanding of Asia will undoubtedly grow, leading to participation from a wider variety of institutions, in terms of size and strategy.

Second, capital seeks the best returns and if the mid-cap space is neglected now and managers thrive in the absence of significant competition, they will be oversubscribed next time around. Similarly, a GP that becomes too large and too dependent on management fees risks losing alignment of interest with investors.

"Some of these guys are small because they don't deserve to be bigger. Far fewer don't deserve it compared to five years ago, but the next cycle will throw up too much cash, people will start chasing returns and money will go to GPs who shouldn't get it," says Capital Dynamics' Kubr. "We will be having the same conversation in five years time and again in 12 years time."

SIDEBAR: Institutional platforms

It is difficult to talk about institutional platforms in private equity without someone bringing up David Swensen. The head of Yale University's endowment is known for developing an investment model that eschewed liquidity in favor of the higher returns available in asset classes such as private equity. He also has a reputation for backing the small guy.

"The David Swenson-type would say, ‘I like the guys who are entrepreneurial and great deal guys. I acknowledge that high returns may come at the expense of a less sophisticated back office,'" says Marcus Simpson, head of global private equity at QIC. "There is now a bifurcation in the market, some people are pushing away from those entrepreneurial roots in the belief that there will be big guys with global domination and then local specialized managers."

Anecdotal evidence suggests that larger institutional investors are asking more of GPs in terms of compliance and reporting standards, which in turn puts pressure on managers to ensure they have the appropriate infrastructure. Failure to do this may have an adverse affect on fundraising.

"It's about the operational capabilities you are trying to build, the government and regulatory work that needs to take place to be a good stakeholder in these countries," says Joe Bae, head of KKR Asia, describing an institutional platform. "A lot of the LP money coming into this part of the world is from investors who really care about governance, risk management, stability of the platform, training, and robust FCPA and ESG programs.

These things take a lot of effort to get right."
Few GPs in Asia can match KKR's global scale and resources when it comes to putting a platform in place, but the vast majority of industry participants are aware of the need to make LPs comfortable with the markets and opportunities to which they are exposed.

"From an LP perspective, it's ‘Okay, so I've backed these guys and they are great at deal sourcing but are they going to provide the reports I am looking for? Am I confident that the assets are being looked after in the appropriate way and I won't get involved in some kind of scandal?" says Marcus Thompson, CEO of Headland Capital Partners.

Derek Sulger, managing partner at Lunar Capital, adds that it is also an issue of sustainability and the LP being confident that a younger GP will last for 20 years or more, even though one or two key people may depart.

But does institutionalization come at the expense of the entrepreneurism that underpins private equity?

"An excellent GP should be allowed to focus on investment and returns, there shouldn't be too much LP influence," says Fritz Becker, CEO of Harald Quant Holdings, a Germany-based family office. "PE is still driven by a person's ability to find the right deals and do the right coaching of management teams. It might not be what is expected in the corporate governance department of an institutional pension fund."

However, Mario Giannini, CEO of Hamilton Lane, argues that institutional platforms have not damaged entrepreneurial thinking in the US - citing the venture capital industry as an example - and he doesn't see why Asia should be so different, despite being at an earlier stage of development.

"Being entrepreneurial and being in the Wild West is not the same thing," he adds.

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• Topics
• Fundraising
• Buyout
• Funds
• Performance
• Advisory
• LPs
• GPs
• Asia
• Fundraising
• buyout
• Growth capital
• KKR
• KV Asia
• OTPP
• Hamilton Lane
• QIC