Fund concessions: A tailored fit

Picture a typical first-time fund in Europe. The three founders would come from Apax Partners, Permira and BC Partners, respectively. Each would have around 20 years of experience, an impressive contacts book and enough personal wealth to give the new vehicle a top-up if the going got tough.

Contrast that with the description of a first-time fund in Asia, offered by one industry participant: "It's likely to be made up of the head of Southeast Asia for Merrill Lynch, the head of south China for PwC, and some kind of junior PE executive who's spent three years in New York."

For that reason - namely that nascent Asian GPs often lack the human infrastructure required to properly implement investment strategies - fund managers on this side of the globe seem to have excused themselves from the fees debate which continues to rage in Europe. "It's much less of a topic here," says Michael Prahl, a senior researcher at INSEAD's Global Private Equity Initiative. "LPs understand that local GPs need to charge sufficient fees to build up their infrastructure and pay salaries."

While LPs have generally accepted this as the status quo in Asia, fees are a contentious issue in Europe and the US, where fundraising remains labored. Economic uncertainty has led many investors to retreat from the market while those who do choose to participate are demanding more from their GPs. As a result, management fees are on a downward spiral in Europe in particular. The average GP currently commands around 1.5%, while early bird discounts have cropped up on several occasions, prompted by BC Partners' 2-3% discount on fees for those signing up at first close. BC also offered to re-pay LPs' transaction fees.

Staking a claim

Concessions in Asia tend to follow a different route, notably regional LPs - predominantly sovereign wealth funds - requesting a stake in the management company of a GP in exchange for putting up a large chunk of the capital.

The standout example of this globally was China Investment Corporation (CIC) picking up 2.3% of Apax's operating company in 2009 while simultaneously buying EUR800 million of commitments to the firm's seventh European fund. Anecdotal evidence suggests there is a similar practice at many first-time funds in Asia.

For the first-time GP, these concessions are counterbalanced by the promise of large commitments from established LPs. Those who qualify for such privileges are typically cornerstone investors, who play a far more important role in Asian than in more mature markets. By putting in capital early on, and effectively placing the weight of their reputation behind the fund manager, a cornerstone investor offers the momentum to get a new vehicle off the ground. Crucially, their presence reduces the risk proposition of the fund in the eyes of other prospective LPs.

The practice of bringing cornerstones on board is particularly widespread in India. A number of family offices are believed to hold shares of 25% or more in local private equity funds, as well as a stake in the associated management company.

The benefit of this arrangement to the LP in question is that it allows it to take a share of the management fee and carry - rather than merely reaping returns on a deal-by-deal basis. "It's a way of capturing some of the economics associated with the underlying funds on a pro-rata basis," explains Josh Kahn, a director in the Hong Kong office of Hamilton Lane, a private equity asset management firm.

What's unknown, however, is whether these advantages are enough to outweigh the potential inevitable negatives of the situation - such as the GP becoming a quasi-captive fund manager under the control of an all-powerful LP. "GPs will do it to encourage a strategic relationship with that LP," continues Kahn. "As the lifeblood of any GP is continued access to capital for its funds, cementing a relationship with a large sovereign wealth fund, for example, provides a measure of greater funding stability by creating a closer alignment of interests."

I want to hold your hand

Another popular request among Asia-focused LPs is the right to co-invest on deals. Indonesia's Northstar Pacific, for example, relied heavily on TPG Capital as an LP in its early funds and has since co-invested with the private equity firm and Government of Singapore Investment Corp. (GIC) on several occasions. Temasek Holdings is also well known for backing first-time fund managers and then investing alongside them. Hopu Investment Management may not have lasted long, but Temasek was a significant LP and leveraged this position to participate in a string of deals, including China Construction Bank, Asian Citrus, Iron Mining and Chesapeake Energy.

Meanwhile, HarbourVest Partners' relationship with Australia's Archer Capital is of much longer standing, but it still facilitated a lucrative co-investment in accounting software company MYOB. They exited the firm this year for A$1.3 billion, having paid just $296 million for it in 2008.

Unlike stakes in fund managers, though, these concessions tend to be granted on a more informal basis. The norm is for indications to be made that if there's an opportunity for LPs to participate and they will be invited to join the share structure - suggesting that in this area, the GP is calling the shots. And while more LPs are seeking co-investment in the region than previously, this may have more to say about LPs' relative appetite for Asia than the attractiveness of co-investment per se.

"Clearly some of the global LPs are looking at Asia more for co-investments, but that's because they've got more confidence in local markets than other markets," points out Bob Partridge, Managing Partner of Ernst & Young's Greater China transaction advisory team. He adds that the main candidates for co-investment are LPs that have long engaged in direct investments, such as sovereign wealth funds.

Hamilton Lane's Kahn, however, maintains that even LPs who are relatively new to private equity are also seeking co-investment opportunities, as they want to use the dealflow to help establish their portfolios. "Co-investing brings a lot of attractive features for nascent programs," he says. "It allows them to average down fees, to control their capital exposures a bit more and to potentially help mitigate the J-curve their programs face in early stages of formation."

Another pro for more established LPs is that it allows them to test-drive a specific GP before deciding whether to make a primary fund commitment to them. The LP might also want to invest more than the fund is able to put in on its own, while any profits accrued wouldn't come after deductions for fees.

Capital call

Two other, slightly less common areas of concession are secondary sales and separate accounts. In the former, GPs have started to facilitate LP exits from mature fund interests through the secondary market. In return, they secure investments into their latest vehicles.

"GPs are normally very worried about the secondary market, because it's not a free trading environment - they don't want their shares flying around," says Prahl. "But they're being helpful because fundamentally that's the only way for them to get big new allocations from certain investors." Even big-name brands, such as EQT - which received almost a quarter of contributions from its new buyout fund from Asian LPs - helped existing investors to re-up in this way.

As for separate accounts, these are pools of capital structured apart from a main fund and usually afford the account holder special conditions, such as reduced fees. A number of Hamilton Lane's larger Asian clients to negotiate such accounts with GPs and Kahn attributes their success to "the scale that institutions in this part of the world represent."

Fans of this arrangement include CIC, which is one of two separate account holders attached to Lexington Partners' seventh secondary fund. The sovereign wealth fund contributed $500 million to the $7 billion vehicle, providing much-needed dry powder in the early stages. According to a person familiar with the situation, in addition to capital, CIC is expected to leverage its network to give the fund access to a wider variety of deals.

Unsurprisingly, the larger the LP, the more likely concessions will be requested. When it comes to taking stakes in the large buyout fund managers, for example, the sovereign wealth funds and national pension funds - from the Middle East and more recently from China and Singapore - are leading the way.

Prahl was a principal at Apax Partners when the firm sold off a stake in its management company to CIC. In his view, it's the sheer size of these state-owned vehicles that prompts GPs to offer such opportunities. "Holding a stake in the GP only makes sense if you can write a big check for every subsequent fund," he says. "Sovereign wealth funds have the capacity to re-up again and again - they write the biggest checks."

Ernst & Young's Partridge adds that another reason for the sovereigns' increased co-investment activity may simply be their increasing familiarity with the asset class.

For all the momentum a cornerstone investor can provide, offering special treatment to one LP can create conflicts within the fund as well as with other investors. If a sovereign wealth fund has a stake in the GP, a smaller portion of the carry ends up in the pockets of the individuals doing deals, potentially eroding motivation and loyalty to the fund. "I know that many of the US and European institutional LPs are very much against the practice," says Prahl.

On the LP side, there might be resentment if a slice of everyone's fees ends up with a single cornerstone investor. GPs may also struggle to share co-investment opportunities among LPs. How do you assess the demands of a new LP who has committed a large amount of capital to one fund against those of a smaller contributor who has been a loyal investor for more than a decade? Separately, fund-of-funds have the issue of being in competition with their clients in getting the pick of the bunch.

Mario Giannini, CEO of Hamilton Lane, predicts that LPs across the board will end up competing with one another to co-invest in the future. "It's going to become LP versus LP," he says. "If I'm an LP and I know that you're essentially getting a fee break because you are cherry-picking certain investments, how do I feel about that? Some LPs might say they don't want anyone to have right of first refusal on deals."

The dynamics of this concession-based fundraising environment have yet to be played out, but GPs must strike a careful balance between enduring some inconveniences to get a fund off the ground and handing over too much control. Any disputes which do arise with LPs may be easier to bear for first-time Asian GPs than their European counterparts as, in many cases, LPs have ruled the show here from day one.

"It's potentially win-win for everyone involved," says Darren Bowdern, a private equity partner at KPMG China. "It's good for the private equity houses, because it allows them to develop relationships with key investors, and for the other LPs, as having heavyweight LPs on board can generate new opportunities for the fund."

While there are certainly positives to be drawn from the situation, GPs may ultimately find there is a fine line between a potential and an actual win-win.

 

 

SIDEBAR: Co-investment allocations - How much is too much?

With major fund-of-fund managers HarbourVest Partners, Capital Dynamics and Hamilton Lane each allocating 5-10% of their assets under management to co-investment, investing alongside a GP is clearly a popular practice among global LPs focused on Asia. But what are the risks associated with co-investing too much?

Over-allocation to any asset class can be risky business, and LP co-investment is no exception. As such, when Hermes GPE recently revealed that it allocates half its assets under management to co-investment programs, several of its LPs peers balked at the thought. "Their entire fund could be wiped out with just one or two bad deals," said one.

The best way to play the co-investment game is on a highly selective basis, believes Claudio Siniscalco, principal at HarbourVest, which rejects up to 19 in every 20 opportunities it sees. "If as much as 50% of your assets under management are in co-investments, you're being less selective by definition", he says.

Siniscalco points out that GPs' first priority is always customers in their blind pool funds, so co-investors can end up unbalancing things if they keep most of their capital outside of the traditional GP-LP arrangement. "At the end of the day it can lead to a less healthy relationship between the two parties."

Hermes, which opened an office in Singapore this year, maintains that having a large co-investment allocation has generated value for the firm. "We've had really strong returns and our clients like us doing it, so we have no reason to reduce it," insists Head of Europe Simon Moss. "The co-investment portfolio is actually one of our best performing."

The firm claims that it stays selective by having flexibility in the composition of its investments. So if it gets to the end of the year and finds it's only invested 20% because of a lack of deal opportunities, it can either increase its allocation to funds or simply invest less that year.

 

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• LPs
• Fundraising
• Investments
• Investor relations
• LPs
• Fundraising
• Co-investment
• Asia