Asian fund-of-funds: In the balance

As the largest public pension fund in America's most ethnically and culturally diverse state, the California Public Employees Retirement System (CalPERS) is obliged to employ a diverse investment philosophy. As of 2002, CalPERS had committed just over $1 billion to private equity firms that are majority-owned by women and minorities. By mid-2008 this had risen to $3.4 billion, a threefold increase.

In a 2009 presentation, CalPERS identified 44 private equity firms that had benefited from its commitment to diversity. They included Asia Alternatives, an independent fund-of-funds manager set up six years ago by three Asian women, Melissa Ma, Laure Wang and Rebecca Xu.

According to CalPERS, the firm hasn't received capital as part of a particular diversity program, but it has certainly ridden a helpful trend. The pension fund's commitments to women and minority-owned players rose by half in 2007 alone, the year Asia Alternatives closed its $515 million debut fund. CalPERS also participated in the second fund, which closed just over a year later on a bumper $950 million.

To suggest that Asia Alternatives' fundraising success is built on race and gender would be unfair. At a time when US institutional investors were still wary of Asia, the founders could point to their CVs, which included Hellman & Friedman, Goldman Sachs, International Finance Corp.(IFC) and Harvard Business School, as well as considerable on-the-ground experience.

"They had the right combination of blue chip backgrounds and a local footprint - and they understood that a US public pension fund has to allocate a certain amount to funds backed by minorities," says a senior executive with a global gatekeeper firm. "They sold Asia in 2006 and the pension funds and endowments loved them."

Asia Alternatives returned to the market in January of last year, seeking to raise around $1 billion for fund three. As of September, it had attracted commitments of $375 million. By all accounts, Ma and Xu are as tenacious as they were when they started out, but the question being asked is whether the compelling investment narrative of 2006-2007 - a polished VC, a grasp of Asia and access to off-the-radar GPs - still holds true today.

Consolidation coming?

LPs are increasingly familiar with the region and its primary movers, while the fund-of-funds market is more competitive than ever as global fund-of-funds, gatekeepers and consultants all pursue capital allocations. Do Asia's independent players have sufficient momentum to continue or is a period of consolidation likely to ensue, with smaller fund-of-funds destined to be consumed by larger organizations or fade away?

"We would expect some consolidation," says Doug Coulter, head of Asia Pacific private equity at LGT Capital Partners. "If you do not have the scale to be able to afford best in class back- and middle-office functions, your business could be at risk long term. In addition, PE is a resource intensive business that requires significant bottom-up due diligence. Without this, it is difficult to see how you are going to navigate what is a confusing and fast-changing landscape."

Representatives of HarbourVest Partners and Pantheon offer a similar view. This is unsurprising given that, as global players, one of their principal selling points is an ability to handle most or all of the fundraising and investment process in house.

It is also a reflection of the particular market segment in which these firms operate. Haide Lui, a Hong Kong-based vice president with HarbourVest, cites a client's study carried out over a year ago that found there were 60-70 fund-of-funds in Asia. As of the second half of 2011, this number had fallen to 40-50 - and of these only about 20 target global institutional investors.

The fund-of-funds industry can be broadly divided into several categories: global or emerging markets players that invest out of single worldwide vehicles (Adams Street Partners, Siguler Guff); global fund-of-funds with Asia-specific products (LGT, Pantheon, HarbourVest, Partners Group); and wholly or partly independent regional or national-focused operators, most of which emerged from 2005 onwards (Asia Alternatives, Emerald Hill, Axiom Asia, Squadron Capital, Eagle Asia Partners, Jade Invest). Investment banks and consulting firms also operate pools of discretionary capital in Asia and then there is any number of lesser known or less formal outfits that have some - or aspire to have some - third-party money.

A variety of interpretations of the fund-of-funds business model as recognized in the West, based on the varying demands of a widening LP base, could emerge in this space.

"Compared with 2006-2007, competition among Asian fund-of-funds has gone up enormously, but private equity is still underpenetrated here relative to the US and Europe," says Marc Lau, managing director of Axiom Asia. "There are 10-20 firms going after institutional investors, but within that it is quite diversified. Some target big pension funds while others go after smaller institutional names."

Size matters

To anyone pursuing the pure fund-of-funds model, and regardless of the target client base, size matters. A firm needs to reach a critical mass of assets under management in order to make operations economically sustainable. Europe is a case in point: For every Partners Group, which has grown to have more than $30 billion under management across a range of private investment programs, there is at least one Alliance Trust Equity Partners, the private equity arm of Alliance Trust that closed its doors in 2011, having failed to gain traction after five years in the market.

"Funds-of-funds are a great business but if you want to be really global they are expensive as well because you need to hire teams. There is only one way to keep them and that is to feed them by raising more capital and selling more products," says Juan Delgado-Moreira, Asia managing director for Hamilton Lane.

He notes that low entry barriers have seen Europe's $1-2 billion fund-of-funds space become well populated, with local asset management firms launching new vehicles as fast as old ones disappear.

As with standard GPs, the performance of a fund-of-funds' second vehicle is often the making or breaking of it. Several of the independent players in Asia closed their second funds around 2007-2008 and are now looking to raise more money. Besides Asia Alternatives, Axiom is working on the follow-up fund to the $950 million vehicle it raised last time around, while Squadron has once again targeted $400 million. Eagle and Jade are both seeking capital for their second funds.

Axiom's Lau admits that the industry has moved on from theoretical discussions about experience and knowledge to scrutiny of track records, now that some data on previous funds is available, and questions about access to specific GPs.

For Axiom and Asia Alternatives, a successful fundraise - with plenty of re-ups from existing investors - would take their respective assets under management comfortably beyond $2 billion, allowing them to further consolidate their platforms.

The global capital-raising environment is challenging for all private equity vehicles at present, although LPs are generally less inclined to pull back from Asia than other markets. Progress for the bigger names may be bumpy but they are unlikely to be derailed. As for the firms that fill out the 40-50 thought to be in operation, those that can't count on a sponsor face an uncertain future. "At least half of them will have trouble raising money in the next cycle," says Vincent Huang, a partner at Pantheon.

Diverging strategies

Throughout the industry there is already evidence of business plan fragmentation as participants seek to cater to investors' needs, with the fault lines following geography and product scope. While local level issues such as team size and experience play an important role, some tie change to wider concerns about the fund-of-funds model in general. Ludvig Nilsson, managing director of Jade Invest, argues that fund-of-funds in the West have become so commoditized and over-marketed, and actual evidence of an ability to pick superior managers is so scant that LPs are looking for more specialization. As a result, attitudes toward Asia are also in flux.

"People are ramping up their exposure to Asia so they are breaking it down into smaller segments and looking at who can really add value," he says. "It has dawned on people that you can go wrong with brand names and that there are very few synergies between the different markets in Asia."

This situation is exacerbated by the distance, language barriers, relatively small staff and sheer on-the-ground opacity that leave LPs feeling far removed from a market like China. Asia tends to account for a small portion of the average US pension fund's overall commitment to alternative assets. These funds are therefore unlikely to have the time and resources to piece together financial statements of portfolio companies held by GPs in which fund-of-funds managers invest. And some Chinese GPs' commitment to investor reporting leaves a lot to be desired.

The natural inclination is to go for the player with most local expertise, but opinion is divided as to who is best of breed. Coulter's view that bigger is ultimately better, with the likes of LGT destined to win out because their greater resources prevail in an increasingly large and complex market, gets short shrift from Nilsson. He argues that LPs can get most value by using a clutch of fund-of-funds that cover different countries or regions within Asia.

"In a few years the big players could build up huge databases and strong teams but so far they have not felt the need to do so," Nilsson says, adding that in some cases team stability in China isn't helped by mainland staff being underpaid and under-empowered.

The current fundraising cycle should go some way toward establishing the extent to which Asia can accommodate smaller independent fund-of-funds alongside global players. However, their product offerings are not uniform. Pantheon's Huang contrasts his firm's preference for the comingled fund approach to Asian fund-of-funds' willingness to compromise on fees and separate accounts in order to secure commitments.

"Some fund-of-funds take multiple separate accounts and offer free allocations - they deploy $20 million for the standard fee and another $30 million for no fee," Huang says. "The problem is that your access to the best quality funds is always limited so you may have to bet on first-time funds to satisfy LPs' allocation needs. Plus, it is hard to avoid conflicts managing several large LPs who all want special treatment."
Room for compromise

The term "standard fee" is open to interpretation. Industry participants put it at zero to 1.5% in annual management fees plus zero to 10% of carried interest, depending on track record and experience, but agreements tend to be heavily negotiated. Volume-based discounts are not unusual and neither are separate accounts. For many large pension funds, a separate account may makes more economic sense than a fund-of-funds: fees are lower, the investment period is more flexible, and there is greater autonomy on GP selection.

In pursuing this business, though, Asian fund-of-funds come up against another competitor in consultancy firms.

Consultancy services range from basic advice - a shortlist of GPs that the LP might like to consider - to managing pools of discretionary capital. The likes of Capital Dynamics, StepStone and Hamilton Lane are well known for directly handling investment portfolios but consultants that have traditionally only operated in an advisory capacity are trying to broaden their scope. Rather than suggesting the LP invests in two of seven funds, a consultant might advocate taking responsibility for allocations to all seven.

Several sources tell AVCJ they have heard from clients that Mercer and Towers Watson are among those seeking pools of discretionary capital. Luba Nikulina, head of private markets at Towers Watson, denies this, saying that her firm remains focused on advisory services "starting from one-off due diligence projects and ending with the implementation of comprehensive alternative investment solutions."

Regardless, one Asia-based executive with a gatekeeper firm insists that consultants will continue to try to enter the management space. "The consultants are getting $100,000 for their services and they see these people walk in with different products and getting more money for fund picking," he says. "They think it looks easy, it's a high-margin business, so they want in."

Given how segmented the PE consultancy business has become in the US, not all market participants in Asia will be able to - or want to - follow this path. LPs might be uncomfortable at the prospect of a consultant becoming directly involved in the asset class. Similarly, they might conclude that a fund-of-funds doesn't have the capability to develop customized portfolios and client management operations

In some cases, strategies are already well established. Axiom is sticking with the comingled fund approach, while Asia Alternatives, Emerald Hill and Eagle have all been successful in securing separate account mandates from institutional investors. And for every large LP that decides to opt out of fund-of-funds, there may be several smaller institutions that want greater exposure to Asia but don't have the resources to do it alone.

With their smaller peers destined to have trouble raising new funds, the future of independent Asian fund-of-funds that do gain traction in the market might be governed by internal pressures more than anything else. Marketing and distribution is an issue for all participants. The long fundraising process of fund-of-funds means some people must spend protracted periods on the road. For an independent Asian fund-of-funds that doesn't have the investor relations muscle of a larger player, it may become too much of a strain.

Acquisition targets?

"A GP raises money every three years or so but we are in the market all the time - you finish raising your last fund and there's not much time before you start again," says one Hong Kong-based fund-of-funds manager. "If you are two guys that have raised a couple of billion and somebody comes along and offers a large sum then you might sell out."

Several firms have raised a couple of billion for Asia, but who would want to buy them? The aforementioned Asia-based gatekeeper claims to get calls every day from people acting for local players who are tired of fundraising and want to sell out. He turns down every one, arguing that Asian fund-of-funds are of little value to his business: Clients are paying for his investment judgment and access to quirky funds is of little significance in this context.

Clearly, not everyone shares this view. It is suggested that some fund-of-funds might link up - as a sponsorship arrangement or a full acquisition - with larger organizations that help them market their business in a more systematic way. Potential partners fall into two categories: consultancy firms that are trying to move from private equity advisory into discretionary funds management; and global asset managers, such as Swiss Re and Neuberger Berman, who are also real or aspiring entrants to the fund-of-funds space.

Whatever the outcome, no one is under any illusion that the industry hasn't changed. If these independent fund-of-funds were starting out today, they would be unlikely to survive without a sponsor, and if they are to prevail, they must find ways to differentiate products and services.

"There are a lot more fund-of-funds now so it's more challenging to break into the market," says Axiom's Lau, "but I do believe there are niches to be pursued."

SIDEBAR: Fund-of-funds selection - Global or local?

If a US institutional investor has only six people responsible for private equity globally, it might make sense to enter Asia through a fund-of-funds that has twice as many people covering this region alone. But is it better to invest in a global player with a regional platform or an Asia specialist? Industry participants tell AVCJ that there is a tendency toward the latter.

"There is a preference for local expertise," says Haide Lui, a Hong Kong-based vice president with HarbourVest Partners. "But local has many different looks and expertise takes time to develop. For example, last year marked our team's 15th year in Asia. Back then we were one of the only fund-of-funds the region."

Executives from other global fund-of-funds echo this frustration. Their teams comprise just as many Asians and local language speakers as the regional competition. They can also offer considerable back office resources and the capacity to benchmark what is going on in Asia against other parts of the world. And for GPs, there is the credibility that comes with having a big name on the investor roster, which may bring in other LPs.

So what is the problem? First, investors might decide that Asia is sufficiently complex and diverse that a group dedicated to the region offers the most value. Second, they may be concerned about a lack of alignment of interest with a global fund-of-funds, because as they have so many different products, a manager might be distracted by other portfolios.

"There are some very good teams in Asia as part of a global fund-of-funds group but it might be argued that they are more interested in the performance of funds elsewhere," says David Pierce, CEO of Squadron Capital. "With a local player, there may be a greater alignment of interests."

The debate will ultimately be settled by performance. While there is certainly some crossover in the GPs backed by fund-of-funds, weightings will vary - based to a certain extent on a fund manager's conviction - and this will impact returns. "The gap between first quartile and fourth quartile will widen, just as it will with the GPs," says LGT's Coulter.

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• Topics
• Fund-of-funds
• Fundraising
• GPs
• LPs
• LGT Capital Partners
• California Public Employees' Retirement System (CalPERS)
• Pantheon
• Squadron Capital Advisors
• Jade Alternative Investment Advisors
• HarbourVest Partners
• Asia Alternatives Management
• Axiom Asia Private Capital
• Fundraising
• Asia
• Fund-of-funds