US LPs and Asian GPs: Survival of the fittest

The California Public Employees' Retirement System (CalPERS) is every bit the heavyweight GP. It is the second-largest public pension fund in the US and the biggest contributor to PE. Of its $304.5 billion in assets, $28.8 billion is devoted to the asset class.

While CalPERS has no plans to dramatically reduce this allocation, it will be shared among a smaller number of managers - commitments to individual GPs will fall from 98 to 30 over the next five years. For CalPERS alone to engage in a major refocusing would be troubling enough. But the pension fund serves as a bellwether for LP attitudes, and its move has highlighted a problem that has been apparent some time now.

"A lot of people have distributed more of their attention and resources on a domestic basis," says Heidi Poon, senior vice president at advisory firm TorreyCove Capital Partners. "It doesn't mean that people completely ignore it, but there are definitely more questions along the lines of, ‘Why do I need to fly over to China to look at this fund, when they haven't delivered the same returns?'"

As more investors join the so-called "CalPERS cull," the ensuing ripples are expected to hit emerging markets especially hard, with investors retreating from small, emerging funds and entrusting their money to larger players or even taking it home to domestic GPs. Unless they can find replacement capital, many less established firms may be swept away.

However, like all evolutionary thresholds, this trimming of GP relationships is not a universal negative. While some pain will come in the short term, the overall effect should be to strengthen the market and reinforce the best tendencies among those who are able to weather the storm.

Out of the comfort zone

Doing business in Asia can be frustrating for a US investor. It involves difficulties that are not present at home, including differences in time zones, language and culture. These additional challenges are factored into the risk-reward ratio, leading LPs to expect returns that funds don't always deliver.

An additional challenge to expectations is the relative novelty of private equity in Asia. While GPs in the region have made great strides in building their business savvy, they are still significantly behind their US counterparts. The latter have more experience and know more techniques for adding value to their portfolio companies - all in the context of conforming to the traditional buyout model. This gives LPs more confidence in these managers' ability to deliver strong returns.

"Where the US GPs are approaching 40 years old, in Asia they're just coming out of the first cycle," says Mounir Guen, CEO of MVision. "That's more the frontier type of exposure than it is the settlers, or a modern kind of environment. The US is in that urban, modern look. It's all slick, it's really clever, the guys really know what they're doing."

EMPEA's 2015 survey of global LPs supports these claims of skepticism. While the number of LPs expecting returns of 16% or more from their developed markets portfolios has risen slightly since 2012, expectations for similar returns from emerging markets, including Asia, have dropped from 72% in 2012 to just over half this year.

Moreover, the number of LPs planning to increase their allocations to emerging markets dropped from 64% in 2011 to 45% in 2015; the number planning to decrease allocations increased from 2% to 22%. While the survey did not track US LPs specifically, it is nonetheless useful for examining overall attitudes.

Not all funds are suffering from LPs' refocus on the US. In 2014, Asia private equity exits reached a record $65.3 billion, buoyed the $5.8 billion sale of Oriental Brewery and Alibaba Group's $25 billion IPO - respectively the largest trade sale and the largest public offering ever seen in the region.

The beneficiaries of Oriental Brewery, KKR and Affinity Equity Partners, are among those generalist, pan-regional GPs that continue to receive ample funding from investors. Silver Lake, one of the biggest winners on Alibaba, invests out of a well-supported global fund.

Smaller vehicles, with a country- or sector-specific focus, have a harder time attracting interest in this environment.

It's tough for these guys to write checks much under $50 million. It's just not worth their effort and the diligence and everything they have to go through in order to get there - Justin Dolling

There are several reasons for this trend. Reputation plays a part; large, regional GPs tend to have a longer history than recently established specialist funds. Investors who have already seen Asian markets hit several speed bumps may also see bigger funds as a safer bet, capable of generating reliable returns with less risk attached, in part because they are not tied to the fortunes of single market.

Furthermore, consolidating investments into a few large funds helps LPs economize their GP relationships. Each fund, no matter the size, requires the same due diligence work. All else being equal, there is a clear advantage for investors to maximize the return that can be generated by the time spent.

"For a pension fund in the US, with relatively little staff and a quite sizable portfolio, it's easier to evaluate a dozen or so funds in the $1 billion-plus space than to try to evaluate closer to 100 funds that operate in the $500 million to $1 billion fund space in Asia," says Javad Movsoumov, executive director of the Asia-Pacific private funds group at UBS.

AVCJ Research bears out these reports of consolidation. While the number of country-specific and regional funds receiving commitments has fallen from 2011 to 2014, the average size of each fund, of both types, actually increased from 2012 to 2014.

Tougher on terms

Another disadvantage for smaller funds has to do with some common restrictions imposed by LPs. Often an investor will be unable to account for more than 10% of the total fund size. However, larger investors also are reluctant to commit small amounts, given the burden of due diligence and because the sheer size of their asset pools requires a substantial annual commitment to the asset class.

"It's tough for these guys to write checks much under $50 million. It's just not worth their effort and the diligence and everything they have to go through in order to get there," says Justin Dolling, a partner at Kirkland & Ellis. "It's difficult for a large institutional investor to justify going through all the necessary work and relationship building until a fund hits at least $500 million, because then they can write a $50 million check and still be below 10% of the fund."

LP expectations are not limited to fund size. Over the last several years there has been a marked trend for investors to add increasingly strict conditions to a fund commitment. These demands, in the form of side letters, can encompass a range of issues, from governance or transparency issues to special fee arrangements.

Extra conditions have grown rapidly; while GPs were describing side letters as an unfair imposition as recently as three years ago, today industry veterans say they have become an accepted part of doing business in the Asia market.

One important note, however, is that LPs are less likely to require additional guarantees from managers with whom they have established relationships. This means that, once again, the burden falls on smaller, still-growing GPs to meet a standard that their larger or better-known colleagues do not have to face.

The difficulty that comes along with increased demands can be seen in the case of India's Multiples Alternative Asset Management, which is currently raising its second India-focused fund. Canada Pension Plan Investment Board (CPPIB) anchored the debut vehicle and industry sources say that Multiples' willingness to grant the requests of the LP in return for a re-up may have backfired.

"The deal that they have with CPPIB means that other larger investors want the same deal, which CPPIB doesn't want to give other investors, and therefore now people aren't really looking at it," says one executive familiar with the fundraising market.

Not everyone sees the well drying up for smaller funds in Asia. While some LPs are becoming more reluctant to commit to funds directly, there are alternative paths. Advisors and funds-of-funds, for instance, have long been seen as a way for foreign LPs to gain Asia exposure without taking on too much risk, since investors can commit to a single manager that then spreads its money around.

While this approach results in a double layer of fees, the peace of mind may be seen as worth the increased costs. Committing to a fund-of-funds also involves giving up some control, which means the money of a skeptical investor can still end up with a smaller GP in the end.

"If you look at some recent fundraises in China, they still get quite an amazing amount from the fund-of-funds community," says Conrad Yan, a partner at placement agent Campbell Lutyens. "There is obviously a time lag, because while a lot of investors have declining interest in China, they have already deployed the capital with the fund-of-funds. These fund-of-funds are probably less cynical about China than the direct capital owners."

However, this environment too is changing, and some of the old assumptions do not apply anymore. Funds-of-funds themselves are finding it harder to raise money, as outside LPs become more familiar with the local scene and more confident in their ability to deal with local funds themselves.

"It has become less complicated to evaluate funds in Asia over the last few years and that is what prompted us to expand our regional portfolio," Andy Hayes, private equity investor officer at Oregon State Treasury, told AVCJ last year. "The winners have begun to prove themselves, more GPs have started to return capital and we are seeing who can do this job in Asia."

It should be noted this does not apply to all LPs, many of which remain comfortable working through intermediaries that are familiar with the target markets. Neither does this trend necessarily mean less money is available for smaller players. "If the funds-of-funds are no longer doing the larger funds, they have to differentiate themselves, so they will have more time and attention to devote to the smaller funds," says TorreyCove's Poon.

Alternative sources

In addition to exploring fund-of-fund relationships, there are other LPs beyond the bigger-pocket public pension funds. One fund manager in Hong Kong sees family offices and endowments as willing to take bigger risks; a pension fund might not participate in a manager's fundraise until the third or fourth fund, but an endowment or a family office might come in as early as Fund II.

While risk-averse LPs such as pension funds may see Asia as too risky for their money, there are still plenty of opportunities around the region for those willing to take bigger leaps.

"Even though the Southeast Asian countries are smaller, and the funds are smaller as well, those funds are still very suitable for some adventurous LPs, like endowments," says Campbell Lutyens' Yan. "Vietnam would be a good example. Because Vietnam still has a lot of growth, it's a country that can be seen as a China-plus-one strategy, and there are some state-owned enterprise privatization plays that can still be seen as low-hanging fruits."

Asian managers may also be too devoted to certain types of investors from a prestige standpoint, passing over LPs who are more appropriate for them or more likely to commit. In the new environment, GPs that chase after pension funds because they have the biggest pockets could be outmaneuvered by those who are willing to accept money from other sources.

"Historically it's always been, ‘I want US endowments and foundations.' That was the thing that everybody wanted, to have Harvard as an investor," says Niklas Amundsson, managing director at placement agent Monument Group. "Today it's more, ‘I want US public pension money, because that's sticky capital, and it's always going to be there.' Just because something is trending at the moment, it doesn't mean it is right for you."

Positive forces

Perhaps the most troubling implication of the "CalPERS cull" is that of a general retreat from Asia for US investors. The headline numbers do not suggest this to be the case, or at least not yet. Private equity fundraising reached a record $68.3 billion last year, the highest level since 2011, which coincided with the height of the renminbi-denominated fundraising boom. What is unclear is where the money is coming from.

Even among the larger managers, while they may not have seen a retreat, the balance has shifted from the US and Europe to Asian and Middle East investors. In Affinity's fourth fund, which closed at $3.8 billion last year, LPs from these regions accounted for 39% of the total corpus, compared to 15% in the previous vintage. The North American share dropped from 50% to 38%. This is not unusual for Affinity's peer group.

I think the trend is definitely for emerging markets, and specifically the biggest markets, such as China, to take more of a place in private equity portfolios - Javad Movsoumov

However, UBS' Movsoumov argues that, if there has been a drop off in the US contribution, it is more of a realignment than a permanent withdrawal. "If you rewind back 8-10 years ago, there were a lot of LPs that had no emerging markets pocket at all," he says. "But I think the trend is definitely for emerging markets, and specifically the biggest markets, such as China, to take more of a place in private equity portfolios."

It is clear that the refocusing of larger LPs will create a harsher environment for smaller GPs, and one in which many managers could find themselves unable to cope. However, as industry professionals point out, a more challenging environment is exactly the circumstance that creates evolutionary pressure and forces adaptation.

For one thing, while Asian managers lack the experience of their US rivals, they also have the advantage of being able to learn from the history of the US market. With the global economy growing more interconnected, US and Asian GPs have increasingly similar backgrounds. In many cases, senior executives at indigenous Asian firms started out working in private equity firms in the US, before returning to their home countries.

This bank of knowledge and experience may allow the Asian private equity market to develop faster than others at a similar point in their cycles. GPs can build business models intended to avoid the pitfalls that those markets faced early on.

"Sector-specific is very hard to find in Europe. It's still very much regional, while in Asia, sector-specific is quite healthily growing. And the US is virtually all sector-specific now," says MVision's Guen. "They're all defined, and they're all differentiated. And you can see that coming already in Asia, in the way that GPs present themselves."

In the case of side letters, these too have a welcome herd-thinning effect. GPs that can meet the demands of skeptical LPs will quickly earn themselves a reputation for discipline and professionalism. Although established firms have an unfair advantage in this space - a well-known GP can always dictate its own terms - in the long run GPs that can meet these requirements may find themselves better-equipped for hostile conditions than those currently making it by on their reputations.

Industry watchers agree that small GPs have tough seas ahead, but they see this as a feature of any healthy market. Instead of bemoaning their bad luck, managers should get to work planning their course and making their plans for survival. The reward for a good approach will be to stay afloat after the storm recedes, and to be better prepared for the next one.

"Market crashes and market downturns are always good for filtering out the weak, and those who should not be raising money in the first place," says TorreyCove's Poon. "So then the strong get stronger, and eventually you'll be on a par with the global players that have, basically, international standards."

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• Topics
• Fundraising
• LPs
• GPs
• North America
• Fundraising
• LPs
• GPs
• USA
• California Public Employees' Retirement System (CalPERS)
• Asia