The US invasion: Competition rises among Asia PE legal counsel

Cadwalader is known for its long history, impeccable "white shoe" credentials and a US securitization business that hit unprecedented highs in 2006 only to come tumbling down in the wake of the global financial crisis. Private equity doesn't come into it. And, until about two years ago, neither did Asia.

Nevertheless, Cadwalader wants to have about 100 people in the region by 2015 and occupy a top three position across its private equity, M&A and financial institutions practices. Although the firm has been present in Beijing for more than six years, concerted expansion efforts only began in 2010, with the opening of a Hong Kong office. Regional headcount has grown from about six to around 30, the most recent addition being a Hong Kong and US equity capital markets team from Jones Day.

"We are not seen as a massive PE law firm but I think we can become a top three go-to player in Asia fairly quickly," says Rocky Lee, Cadwalader's Asia managing partner, who joined from DLA Piper two years ago where he was head of the PE and VC practice. "Many of the established PE-focused law firms don't have credible China experience so funds often come to me for a second opinion. Kirkland & Ellis, Ropes & Gray and Simpson Thacher are very good in the US and they are going to get that first call from their existing US clients. I expect that. But we are the ones getting the second call and in due course we expect to be getting that first call."

It is a remarkably ambitious target for an industry outlier. It also represents a gamble on two fronts: that Asia - and China in particular - will contribute an ever larger portion of global dealflow; and that local expertise can outmuscle the power of global legal brands, even as these brands move to strengthen their own capabilities in the region.

All together now

Cadwalader is not alone. As Hong Kong has established itself as one of the leading IPO centers globally, US law firms have rushed to set up local capital markets practices, posing a challenge to traditional UK dominance of the territory. A more recent lull in activity may have stemmed the tide of poaching individuals, carving out teams and opening new offices, but the long-term objectives remain unchanged.

"A lot of Chinese companies still need capital to grow and one of the first places they go to when capital markets are closed is private equity," says David Eich, founding partner of Kirkland & Ellis' Hong Kong office and the architect of a recruitment coup that last year saw eight high-profile partners join the firm from three rivals. "We look at private M&A, public M&A, US capital markets and Hong Kong capital markets as highly interrelated and we aspire to be market leaders in all of them."

Kirkland & Ellis arrived in Hong Kong in 2005 with a handful of lawyers focusing on M&A and fund formation. It now claims to be the biggest regional player in both areas. Other US players, ranging from generalists such as Akin Gump and Davis Polk to private equity specialists like Ropes & Gray and Simpson Thacher are less gung-ho but still expanding their regional footprints.

The fact that Cadwalader and Kirkland & Ellis' ambitions can co-exist in Asia is testament to the region's growth prospects and range of opportunities, but it is also an acknowledgement that relationships between law firms and their private equity clients are far less solid than in Europe or the US.

Business follows individuals over institutions - Lee claims to have taken 60% of his book from DLA Piper to Cadwalader, while Eich says that David Zhang and his corporate team have had strong client support since their move to Kirkland & Ellis - so there is a sense that Asia is still very much up for grabs.

"Firms that do private equity work in other parts of the world have realized that they need to have teams and capabilities on the ground in Asia," says Brian Schwarzwalder, a partner at Ropes & Gray. "If you are doing work for a PE firm in one geography but not another you are losing out on potential business and allowing another firm to develop a relationship with the client."

Incumbent's advantage?

Ropes & Gray arrived in Asia knowing that Bain Capital and TPG Capital were among its core clients in the US and decided to start by serving them. Rather than go on a hiring spree and pitch for large volumes of new business, it has brought in people with skill sets thought to meet the needs of Bain and TPG. Simpson Thacher can claim a longer tenure in the region, but its expansion strategy has been similar. Its cornerstone clients in the US are KKR and The Blackstone Group and, to a certain extent, the firm has managed to retain its business in Asia.

However, there are no guarantees. Firms entering the market to serve existing clients are relying on global stickiness - a private equity firm is going to use you in Asia because it knows you from elsewhere - but the same forces apply on a regional level. Some Asia deal teams have a high degree of autonomy when it comes to picking legal counsel.

Although teams may be implicitly encouraged by headquarters to use certain counsel, and this could give comfort to the investment committee in New York that has to sign off on deals, it isn't uniformly observed.

The most high-profile example is KKR. Simpson Thacher figures in the private equity firm's deals in most Asian markets apart from those in China. This is because KKR's core China team, including country head David Liu, joined from Morgan Stanley Private Equity Asia where they spent more than a decade working with Paul Weiss. That relationship has prevailed.

"In some respects the global firms are obliged to use certain legal counsel, but is it an expectation more than a rule," says Kathryn King Sudol, a partner with Simpson Thacher in Hong Kong. "Individual deal teams need to be comfortable with the counsel and usually have a lot of influence over the selection. We need to be mindful of providing superior service, rather than simply relying upon a global relationship."

Securing an exclusive relationship with a private equity firm in Asia is difficult if not impossible. In two more cases, there are signs that local deal teams are resisting pressure to use legal counsel that have strong ties to their global parent firms. Cleary Gottlieb relies on a steady stream of work from TPG in the US and Latham & Watkins often represents The Carlyle Group. According to market sources, the local deal teams are keen to broaden their scope.

These desires are not necessarily born of dissatisfaction with a law firm's overall performance, but rather whether its pockets of expertise are a good fit with the private equity investor's current focus. Hong Kong is the base for teams deploying capital across the region and they inevitably require advice on regulatory and other issues in different markets. Local counsel is often retained in each location and this may see the regional-level advisors relegated to supporting roles or squeezed out entirely, depending on the client's needs.

"We are horses for courses: we'll use one firm in Australia, another in Hong Kong because they are competent in China, and then another for Southeast Asia," one pan-Asia fund manager tells AVCJ. "I leave it up to the partner in the local office to decide who they are most comfortable using and will only step in if it's a lawyer who has really screwed us in the past. Global firms don't work like this. Some of these law firms are almost like in-house departments of the PE firms."

Know your market

This geographical expertise is not limited to Asia. While various firms have boosted their Hong Kong capital markets capabilities, the growing number of take-private transactions involving Chinese companies listed in the US requires different skill sets. In many cases, company management and their private equity backers want to exit the US bourse with a view to re-listing in Hong Kong, and this may involve a shift in incorporation jurisdiction from Nevada to the Cayman Islands.

It promises more work for law firms - provided they are familiar with US securities laws and public markets M&A. "US take-private deals are a relatively new product in this part of the world and only a handful of firms have the resources to work on such transactions," says Kirkland & Ellis' Zhang. "These are Chinese companies listed in the US and incorporated in the Cayman Islands."

Industry specialization is also a consideration, but arguably more in growth deals than big buyouts. Thomas Chou, co-chair of Morrison Foerster's Asia private equity practice, notes that while his firm operates in many industries, its particular experience in TMT and healthcare is a competitive advantage. In contrast, five years ago the industry focus of lawyers in China was much broader, with the same partners handling everything from online retail to natural resources.

Indeed, serving existing US clients with specific needs was a large part of the rationale behind Cooley setting up an office in Shanghai this year. The VC-focused firm has a strong life sciences practice and found that there was a demand for its expertise in terms of handling issues particular to deals in this industry, such as intellectual property and the likely involvement of global pharmaceuticals firms.

"If you know someone is very life sciences-focused then you better be experienced. It's easy to do the six documents that are finance-related but you need to understand the business and where it's going to go over time," says Patrick Loofbourrow, a partner at Cooley. "For a lot of our fund clients, we do fund formation and transaction work and then they want us to represent the companies once they have invested in them. They are comfortable with us."

Head to toe

A number of law firms aspire to recreate this head-to-toe service in Asia, which goes some way towards explaining the level of competition among fund formation teams. It's important to note that the bulk of the fund work for global private equity firms takes place in the US. While the M&A lawyers at Simpson Thacher or Weil are dealing with Blackstone or Silver Lake, their funds teams are pitching regional and local players for business. This is often done with the ultimate objective of securing more downstream work.

"We are quite targeted in terms of who we try to work with because we want to build long-term relationships with fund clients and hopefully this leads to more deal business," says Peter Feist, a partner at Weil. "We don't view our funds practice as a tool for doing as many funds as we can."

The battle for market share is forcing compromise in some quarters. All the law firms with active fund formation practices that spoke to AVCJ say they tend to target the high end of the market, creating bespoke structures for private equity clients willing to pay a premium for quality service. This is distinct from the mass market participants who work with all manner of private equity, mutual and hedge funds, producing more commoditized structures.

But they admit that the market has been disrupted by heavy discounting, with some law firms cutting fund formation fees by 50-60% in the name of goodwill. There is one report of a firm offering services for free in return for access to transaction work.

Even among the top tier players, there is a sense of kill or be killed. "I am fighting to starve the other practices," says one fund formation lawyer. "Some of the funds I am working on right now, I only took on to keep them from Kirkland & Ellis and the rest. Before all the new competition came in, I was never giving discounts."

The irony is that fundraising in general is becoming more expensive in Asia. A lot of GPs, including a fair number of first-time funds, are chasing capital at a time when LPs are becoming more wary about their allocations to the asset class. This results in more negotiation over terms, which means more billable hours for the fund formation lawyers.

The logic for inculcating relationships at the formation stage is inscrutable, economically and practically, and it is based on a model that has proven highly successful in the US.

According to market sources, fund formation in Asia costs anywhere between $500,000 and $1.5 million and a stable of repeat clients may come to market every 4-5 years. If a law firm is able to leverage its relationship with a GP to secure transactions arising from the fund, the potential pay-off is even more significant. A large buyout deal can generate work beyond the initial investment through debt refinancing, an IPO, high-yield bond issues and dividend re-caps.

Relationships built primarily on less complex minority deals can also deliver fringe benefits. "Having represented Warburg Pincus on other PE investments, we were awarded the buy-side advisory mandate when Warburg's portfolio company, Harbin Pharmaceutical, acquired Pfizer's swine vaccine business in China," says Morrison Foerster's Chou.

Institutional relationships

In practical terms, there are compelling arguments for a PE firm to use the same counsel for formation and transaction work. First, structural issues presented by the fund agreements have an impact on deals, particularly where different fund structures have been set up to accommodate different types of investors.

"The fund formation practice gives us an understanding of the structural issues and tax implications for the fund investors during the M&A process," says Simpson Thacher's Sudol. "These affect every deal in the sense that whenever the PE fund invests in a target company work has to be done with tax advisors, fund counsel and ERISA advisors."

Considerations include choosing vehicles with the appropriate tax treaty protection and ensuring that deal documents contain certain representations, warranties and covenants to cover fund-related issues.

Second, there is basic comfort and familiarity. If a legal service provider is working with a PE client in one area, it builds an awareness of what issues and processes are preferred, potentially making it easier to operate more widely. For a lot of firms, the onus is on establishing multiple relationships between different divisions - fund formation, M&A, financing, competition issues, restructuring - and the client.

"PE guys are generally sticky because of past history," says Andrew Ostrognai, a partner at Debevoise & Plimpton. "You might have done multiple sets of formation documents over the years or you've worked on deals and know what the hot points are. There is a wealth of institutional knowledge."

The problem is that PE players in Asia aren't nearly as institutionalized as the service providers would like. Just as an established relationship with private equity firm in the US will secure an initial meeting but not guaranteed dealflow, fund formation doesn't necessarily lead to downstream business.

Perhaps these conditions are to be expected of still immature markets. Asian private equity is barely two decades old and its development has been patchy, reflecting movements in individual markets. There are none of the 20-year relationships between law firms and their private equity clients that are characteristic of US and European markets.

Market outlook

It is possible that Asia may eventually follow a similar development path. Leading law firms say that all their practices are becoming incrementally more sophisticated. There is an expectation that as private equity investors reach their second and third funds, they will start to distinguish between top- and mid-tier practices and pay a premium for quality services. At the same time, the transactions these investors are involved in are likely to become more complex, creating a demand for more specialized advice.

Brad Peck, a partner with Cooley, describes the choice facing PE firms in blunt terms: "If you want to waste a lot of money, get a lawyer without domain experience who wants to take an academic rather than a practical view. Every transaction is ultimately a compromise and you have to find the best sort of compromise for your clients."

A more immediate question is whether the US law firms' expansion plans can be sustained in such a competitive environment, particularly if the current trough in capital markets activity continues into 2013. The appetite for Asian exposure is unabated - several lawyers say they regularly get calls from headhunters - and there are certainly a lot more funds in the region looking for business. However, it is unclear whether there is enough of the more lucrative work to go around.

Everyone wants to be doing later-stage, change-of-control deals but the reality is that these transactions will continue to be concentrated among a few leading practitioners as would-be rivals consume whatever they can in the hope of building momentum. Law firms that end up competing on price for generic Chinese growth deals against local players may find life difficult.

"Many of the non-Wall Street firms that are trying to open up don't necessarily have credible PE practices," says one industry participant. "You may be doing 80 deals a year but if you're only getting $35,000 a time, that doesn't add up to much."

One suggestion is that the bigger firms will consolidate over time and the number of lawyers currently serving the Hong Kong and China markets will remain the same or increase, but spread across 20 firms rather than 50. Others are more circumspect, warning that the US firms who brought in lawyers on big money won't underwrite their investments indefinitely if they aren't performing.

Kirkland & Ellis' Eich is unsurprisingly more bullish, noting that his firm's existing business from US and European clients entering Asia is increasingly complemented by work going in the other direction. "Just this morning our fund guys were working with some GPs who wanted to set up a fund to do real estate in the US, and we are building a team based on a group in New York and Hong Kong," says Eich. "We will see more of this - it is a function of the flattening world."

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