Offshore investors: Leap into the unknown

J-Star hopes that its carefully laid groundwork will come to fruition this year. The Japanese mid-cap private equity firm started reaching out to foreign investors in 2007 towards the end of fundraising for the firm's debut vehicle. The management team's plan was to build relationships with these LPs so they could put a face to a track record the next time they came calling in search of capital. That time is now.

J-Star raised JPY$12 billion ($153 million) for its first fund, all from domestic investors. In the ensuing five years, Japan has endured a global financial crisis and last year's earthquake, tsunami and nuclear crisis. For many of the large institutions previously active in the asset class, withdrawal has been a function of necessity: banks obliged to comply with the Volcker Rule and insurers dealing with the fallout of natural disaster. Others have benched themselves through choice, disillusioned by the performance of some of the larger domestic GPs that are struggling to deploy capital.

"Some of the major institutional investors have gone quiet so small- to mid-size PE firms that are able to demonstrate performance are trying to raise capital from overseas," says Gregory Hara, director and president of J-Star. "We have been communicating with some LPs for several years. Establishing direct relationships is the hard part for GPs going overseas for the first time."

J-Star is targeting around JPY15 billion for its second fund and expects foreign investors to account for more than 50% of the corpus. The PE firm now has a few overseas LPs in its first fund - stakes were picked up via the secondary market - and has co-invested in deals with several others. It is relying on their interest in the new vehicle translating into capital commitments.

Looking overseas

In a difficult fundraising environment globally, mid-market players across Asia are under pressure. Two other nations, however, find themselves in a similar quandary to Japan. For varying reasons and to varying degrees, domestic LPs in Australia and South Korea are scaling back commitments to local private equity firms, forcing these industry participants to look for support overseas.

These are not spin-outs or first-time managers; most are established players in their home markets, with a couple of funds and at least the semblance of a track record behind them. But how do these managers convince global investors who have the pick of GPs globally that their markets and their investment theses are a cut above the rest?

"Even if GPs aren't raising international capital right now, they are discussing it internally," says Vincent Ng, a partner at Atlantic-Pacific Capital. "Maybe they have decided to wait for cost reasons, or because they got a good RFP [request for proposal] from a local LP, or because they aren't confident of success in the current global economic environment. But they are waiting more out of necessity than desire."

The fundraising numbers imply as much. Australian GPs attracted just over $1 billion in the first half of 2012, down from about $2.2 billion in each of the two previous years. Capital-raising in Japan tumbled to $253 million in the first six months of the year, compared to $2.2 billion in 2011 and $1.5 billion in 2010. South Korea saw a similar level of retrenchment: 22 vehicles raised $653 million in the first half, down from $4.7 billion and $5.7 billion for the previous two years.

Australia, Japan and South Korea are Asia's most mature markets, offering buyout opportunities versus the growth deals that dominate China and India. Yet South Korea and Australia are in many respects polar opposites.

The former has LPs that are still very active in the asset class domestically, although the capital base is quite concentrated and tight on terms. Barely a handful of PE firms have succeeded in raising money overseas. The latter is seeing LPs become fussier about fund manager selections, driven by fee concerns and an increasing appetite for international GPs. However, there are stronger ties with foreign LPs among the small- and mid-cap players, arguably enhanced by a common language and familiar legal processes.

CHAMP Ventures closed its seventh fund at A$475 million ($485 million) in late June, with more than half of the capital coming from overseas investors, compared to less than 1% in its previous vehicles. Fellow lower mid-market investor Archer Capital Growth Funds still has 60% domestic investors in its recently raised A$300 million second fund, but the foreign share is up significantly from the predecessor vehicle.

Both GPs are part of larger groups that already have substantial international investors in their buyout funds and these relationships proved useful, but they guarantee a meeting, not a commitment.

"The process takes longer because you are competing for capital with all other PE firms globally and the investor base doesn't know you as well," says Gareth Banks, a director at CHAMP Ventures. "You have to explain about the merits of the Australian economy compared to other jurisdictions and the benefits of the segment in which you are investing."

Sing for your supper

Selling the virtues of one's domestic economy is easier for some than others. According to Craig Cartner, managing partner at Archer Growth, foreign investors were generally receptive to opportunities in Australia's small to mid-market buyout space, partly because it is a very clear investment thesis that has worked before.

Japanese mid-market firms, meanwhile, are in what one industry participant describes as a "scorched earth situation." They have to make the case why they can succeed where the larger buyout firms of the last vintage struggled, despite operating in a flat-iining economy.

"There are a lot of people out there raising money globally and so how do you stand out from the pack as a GP?" asks Andrew Thompson, head of private equity at KPMG Australia. "The overarching issue for the LP is: ‘If domestic LPs in your country are not investing, then why should we?' It takes a bit of explaining."

Given that most large North American pension funds are unwilling to write checks smaller than $50 million, they don't appear to be appropriate investors for Asian GPs seeking to raise less than $500 million. As such, mid-cap players must be more selective in targeting LPs.

Placement agents and fund formation lawyers can play a role here - the former actively matching GPs and LPs and the latter helping put together documents that meet international investors requirements, ranging from Institutional Limited Partners Association (ILPA) compliance to basic spelling and grammar.

However, industry participants who spoke to AVCJ offered mixed responses. Some see a trickle of business from certain markets, while others say the expected trend has yet to materialize.

Australian mid-market GPs that are looking to boost overseas investor numbers - such as CHAMP Ventures and Archer Growth - are readily named; so are their Japanese counterparts, including J-Star, Polaris and Valiant.

Few practitioners, though, could identify Korean PE players currently on the road with similar ambitions. Vogo Investment does want a substantial portion of its third fund, which has a target size of $650 million, to come from foreign investors, but the GP had 20% overseas money in its previous vehicle, so is hardly new to the game.

Anomalies might be explained by the kind of LPs mid-market private equity firms are targeting and how they are going about it. This in turn offers insights into the level of sophistication and international awareness behind such efforts.

Hara says J-Star has considered using a placement agent but so far hasn't gone through with it, in part because Japanese mandates haven't been popular of late and in part because J-Star isn't convinced by the value-add. Hara sees Asian fund-of-funds and family offices as the best fir for J-Star: the average ticket size is manageable and there is a genuine interest in Japan as part of a diversified regional portfolio. They are also easier to reach - most fund-of-funds are only too willing to come to him.

"We barely get any visits from domestic investors but these fund-of-funds regularly come to Japan, whether it's for fundraising or monitoring their current investments," Hara says. "I'd say 50-60% of the communication is them coming to visit J-Star."

However, there is a general appreciation that a balanced investor base is more sustainable. A North American LP with a private equity staff of four and just a handful of GP relationships in the region is inevitably a difficult sell. China, India and Southeast Asia have been the key areas of interest in recent years and even those may be accessed via pan-regional funds. Although fund-of-funds are friendlier to country-specific vehicles, they face their own pressures.

"Fund-of-funds are going to the market every 18-24 months and they have to demonstrate to investors an ability to find the next gems that can deliver absolute returns," says Atlantic-Pacific's Ng. "The macro issues in Japan and the long J-curve therefore create potential headwinds."

He adds that an increasing number of funds-of-funds are responding to these concerns by eschewing the blind pool for Japanese co-investments, in which the J-curve is shorter, the fees are lower and they have more influence on what happens with the target companies.

Diversity, at a price

The reality is that a truly diversified LP base comes at a price. Asia-based private equity firms must travel to the US, Europe and the Middle East to meet prospective investors and then employ international standard advisors and structures. CHAMP Ventures' Banks recalls making 5-10 trips to the US and Europe during the most recent fundraising period. "There are extra travel costs but it's more about the amount of time you spend on the road," he says.

Mid-market private equity firms tend to operate under reasonably tight economics and taking 3-4 senior professionals on the road for several months to raise a fund means less time is devoted to investments and divestments.

In terms of structure, it a case of replacing fund frameworks that were set up to meet domestic requirements with those that are acceptable to international investors.

Firstly, there may be incongruities on fees. Atlantic-Pacific's Ng cites Korea as an example. Domestic LPs remain active in the asset class and they have traditionally pushed for lower fees and a shorter fund life than are normally agreed for international GPs. If a PE firm wants to retain some of its existing domestic investor base as well as reaching out overseas, it must strike a balance on terms and conditions. "There is often a conflicting thesis," says Ng.

Secondly, the fund structure itself may need to be replicated offshore, and the legal and tax leakage issues vary by market.

The structures employed by Australian funds - a managed investment trust onshore and a limited partnership offshore - are generally clear to investors and GPs alike, but there have been changes in recent years. Belgium and Luxembourg entities, once placed in between the Australian target and Cayman Islands parent entity, are no longer used after the authorities decreed there wasn't sufficient substance to quality for tax treaty benefits. Now the Cayman fund normally invests directly and if the ultimate LPs come from treaty jurisdictions, they don't pay tax on the proceeds from investments.

For lower mid-market firms there is another structure, the venture capital limited partnership (VCLP), which is exempt from domestic tax. This could minimize the cost of bringing in foreign LPs - and assuage their tax concerns - but investments must fall within certain criteria.

Korean and Japanese GPs also tend to use separate domestic and offshore structures, even though regulators have introduced measures that allow all investors to be pooled together. Once again, it comes down to giving foreign LPs certainty about tax treatment.

"If a Japanese GP is trying to raise money overseas it is important for the structure and domicile of the fund to be familiar to the target investors. Accordingly, a Japanese limited partnership might not be the best route," says Alex Last, a partner at Mourant Ozannes. "You want people to focus on your strategy and your team, and not the domicile of the fund vehicle."

The status quo for both markets remains a Cayman fund routed through operational entities in secondary jurisdictions that offer tax treaty benefits - typically Singapore or Malta for Korea, and Ireland or perhaps Hong Kong for Japan. It is not unusual for GPs to employ several offshore structures to accommodate different LPs, and this adds to the cost. If the PE firm in question doesn't have a solid base of fee-generating assets already under management, scraping together the resources can be challenging.

"Japanese GPshave relatively small teams, so the administration is difficult," says Kazushige Kobayashi, managing director at Capital Dynamics. "It is a big burden."

In for the long haul

However, the burden won't dwindle as long as a private equity firm has foreign investors on board. A stable of domestic LPs will likely have similar IR requirements and a GP might be able to do face-to-face meetings with all of them in the space of an afternoon. Dealing with investors scattered across the globe means understanding individual requirements, which may involve delivering documents under four different reporting standards and in 12 different formats.

"Say you end up with 70 investors on the first close - each one is negotiated and each investor is represented by a different law firm," explains Paul Christopher, managing partner of MourantOzannes' Hong Kong office. "That's a significant amount of leg work."

He adds that some GPs are stepping up their expenditure, appointing advisory boards and international law firms that have credibility in the market. The initial outlay might dwarf previous budgets, but the pay-off could be significant - a 2% annual management fee on $100 million in commitments from overseas investors over a five-year investment period would easily outweigh additional fundraising costs incurred.

There is also the sense that failing to accommodate these LPs could see a PE franchise decay, as talented staff move on, portfolio companies struggle and funds underperform, leaving little hope of raising any new capital at all. "We want to have a more balanced investor base," says J-Star's Hara. "If something happens, then suddenly you might find capital is going away. Even though we are small and it's tedious and costly, we appreciate the difference it makes."

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• Topics
• LPs
• Fundraising
• Australasia
• North Asia
• LPs
• Offshore
• Australia
• Japan
• South Korea
• Fundraising
• CHAMP Ventures
• Archer Capital
• Capital Dynamics