Asian funds: arithmetic or geometry?

Concurrently, Asia Pacific is benefiting from another major consequence of the crisis: its growing relative strength and macroeconomic importance versus the hitherto dominant economies of the West. With low levels of fundraising and investor enthusiasm keeping up the pressure on fund structures in developed markets, many are wondering how the Asian industry is evolving to accommodate these opportunities and pressures, and what the optimum size, capabilities, and focus for Asia Pacific funds will be post-GFC.

Size matters

With $400 billion+ of excess capital in the industry, a growing debate over fund size is inevitable. Recently, David Rubenstein, Carlyle Group co-founder and MD, predicted that the largest firms will be compelled to evolve into multi-capability asset management platforms, as large, pure-play buyout vehicles become increasingly untenable. His predictions dovetailed with the long-running debate on the optimum size for PE firms investing in Asia Pacific – given fresh urgency by the apparent withdrawal of LP support for the larger buyout model.

In this debate, Jean Eric Salata, founder and CEO of Baring Private Equity Asia, predicts very few funds over the next few years in the $2 billion+ range for Asia, but many smaller funds. Ken Hao, MD with Silver Lake, feels there will be a wide range of sizes, “but clustered on the smaller end, with lots of fragmentation.” Derek Sulger, Partner at Lunar Capital, sees fund size increasing, “but not outrageously so. Funds are still modest in size by global standards. They will grow, as they should, and catch up to global-standards over the coming 10-20 years.”

Some do see an optimum size band emerging, though. Mark Qiu, CEO and MD of China Renaissance Capital Investment, puts a $300-500 million range as appropriate for Asia Pacific. Archana Hingorani, CEO & Executive Director at IL&FS Investment Managers, also sees $300-500 million as the optimal figure for emerging markets. “Typical growing Asian companies are still small as compared to developed countries, and deal sizes will typically range from $10-30 million in the growth equity space. Buyouts are still few in India, though we expect that they will pick up with the maturing of this generation of entrepreneurs.”

For China, meanwhile, Thomas Chou, Partner at Morrison & Foerster, expects, “all sizes. On the low end, there will remain a proliferation of RMB funds sponsored by local municipal governments. On the high end, LPs are generally increasing allocations towards China.”

The sentiment of certain types of LPs, though, could be skewing conclusions over size preferences, in terms of who they support for their own reasons. “What you do have in Asia is a lot of local funds of funds that can focus on small local groups,” notes Mounir Guen, CEO of MVision. “These fund-of-funds like the $200-300 million local groups… They pride themselves on being able to give you access.”

Given those opinions, what is actually happening in fundraising? AVCJ Research figures show an expected drop-off in buyout fundraising from almost $17.6 billion in 2008 to just over $4.6 billion in 2009 – but a recovery into 2010 of just over $5 billion at end 3Q10. The growth-oriented PE funds show a similar drop from just over $17.3 billion in 2008 to just over $6.5 billion in 2009 – then almost $9 billion to date in 2010. Pure VC funds, meanwhile, fell from over $7 billion in 2008 to just over $3.1 billion in 2009 – then down further through 2010 to just over $2.7 billion. So LP favor is shifting towards growth capital and smaller vehicles – but not exclusively, and buyout propositions show some signs of revival. Guen concludes that, “Both can cohabit, because the market is still very fresh.”

Single-country or pan-Asian?

Another aspect of the long-running debate now receiving fresh attention is the relative merits of single-country funds versus pan-Asian regional vehicles. Here, it’s worth remembering the obvious but very important point that a single-country platform for a major continental economy like India or China is a very different proposition to a single-country fund focused on a smaller Asian economy like Malaysia, or even Korea. China has been often compared to 32 countries trying to behave as a single state, so it’s unsurprising that such an investment environment can give a false gloss to the Asian single-country thesis that may not apply elsewhere. The recent INSEAD/AXA Private Equity survey of Asian private equity, indeed, could only find three representative divisions for returns by geography: pan-Asian funds, China and India.

Indeed, increased LP support for single-country funds in Asia is not reflected elsewhere. “Single-country funds in Europe are not flavor of the month. Most of the interest is focused on sub-regional,” remarks Guen. For this reason and others, many GPs are not so enamored of the single-country thesis. Jim Hildebrandt, MD with Bain Capital, feels the market is unlikely to see the winding down of the pan-regional fund proposition, especially for funds seeking to put larger amounts of capital to work.

“There will be both regional and country funds in future. The level of deal flow at the country level is too low to support many investment strategies, particularly with larger target deal sizes. Building a diversified portfolio of companies still requires a regional fund for the larger firms.”

Nick Bloy, Founder Partner and Director with Navis Capital Partners, also feels that both fund approaches will co-exist, but with some very specific qualifications about single-country vehicles. “There is an underappreciated inherent risk to single-country funds, which is that a single political, regulatory or taxation-related act, or civil unrest, can change the complexion of private equity in a single country for maybe a decade or more. In such circumstances… investment teams can fall apart. This does not happen with regional funds, where professionals and new deal generation can be redeployed.”

Australia, Korea and Japan have all arguably seen something of this at work, especially if one accepts the argument that Japan’s “Shinsei tax,” introduced in 2005 after Ripplewood Holdings realized a huge and visibly tax-free gain on its Shinsei Bank investment, helped retard private equity in that country.

Bloy also points out that for single-country funds, “portfolio construction is far less dynamic: 100% of the fund will be invested in that country over the subsequent five years, irrespective of whether the relative attractiveness of that country changes fundamentally or not.” Once again, Japan in particular has seen some fairly self-evident examples of funds that have raised major capital volumes for a market that can no longer support them post-GFC.

The INSEAD/AXA survey instanced above in fact found that pan-Asian funds offered the highest potential chance for outperformance when investing by geographical focus, with some 40% of funds outperforming. However, the same group also showed the greatest performance disparity, with less spectacular performers often not expected to even return money.

Fund focus and capabilities

The debate inevitably comes down to what approach best delivers returns to investors, and how firms should move to accommodate this. Obviously, prudent deployers of capital will diversify across approaches, and recent research suggests that the most successful LPs in Asia Pacific have profited by doing exactly that.

“The Asian private equity market is growing to a scale that supports funds targeting specific deal types,” asserts Hildebrandt. However, he adds, “there is no optimum target deal type. Type of deal is often driven by the country market of participation.” The INSEAD/AXA survey also found that the debate over returns drivers was mainly characterized by differences of opinions between GPs and LPs. GPs tended to stress results achieved by improvements in operating profits, while LPs emphasized multiples expansion and debt reduction.

Capabilities and specializations are also being driven by the changing returns drivers across the industry. As Melissa Ma, co-founder and Managing Partner of Asia Alternatives, points out, “there are really only three sources of value in private equity: leverage, multiples growth, and earnings expansion.” So long as the prevalent driver of returns across the industry remained leverage, GPs could afford to pay lip service to the mantra of operational improvement, while concentrating on the kind of deals and capabilities that best served leverage-driven theses. But post-GFC, when leverage is no longer so cheap and plentiful, and when LPs are dissociating themselves increasingly from propositions built around leverage-driven returns, the capability mix necessarily has to swing back towards earnings expansion and multiples growth – towards operations and conceivably consulting skills to improve and potentially reconfigure investee companies.

“We are rapidly migrating from an Asian private equity environment where sourcing was the primary skill for success to where deal selection and post-deal value-add are the critical capabilities,” says Hildebrandt. “This is a fundamental change to the market that will be very visible over the next five years, changing the size, team structure and roles of the best funds.”

Arguably, Asia has never been so leverage-driven in any event. All the same, local HR professionals are reporting that, even in Asia, demand from GPs is increasingly tilting towards experienced industry operations figures. This is not to discount financial skills completely, though. Many GPs admit that their core skill set is not in knowing the operational side of a business better than the entrepreneur. Rather it is frequently in finding solutions “all along the capital structure” to complement and help an investee’s operations. These financial skill sets and capabilities may remain in demand: the deal-focused skills of corralling high volumes of leverage to outbid competitors in LBO auctions likely will not.

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• Topics
• Performance
• Funds
• Fundraising
• Investments
• The Carlyle Group
• China Renaissance Capital Investment
• IL&FS Investment Managers
• Baring Private Equity Asia
• Archana Hingorani
• Bain Capital Asia
• Navis Management
• Nicholas Bloy
• Asia Alternatives Management
• Melissa J. Ma
• David M. Rubenstein