Asia fundraising: In Volcker's shadow

"There is definitely an extinction event underway" confides one Asian GP. Not long ago this manager had to completely reconstruct his LP base after the US financial institutions that had previously been such enthusiastic investors were unable to re-up for a new vehicle. Private equity firms globally are facing a new fundraising reality in the light of recent regulatory reforms. Casualties are expected.

"After the global financial crisis, banks started looking at illiquid assets in a different way and private equity became a bit harder to stomach," he continues. "Dodd Frank has been the nail in the coffin in terms of making it prohibitively difficult for banks to be strong in the assets class."

The Dodd-Frank Wall Street Reform and Consumer Protection Act, to give the legislation its full name, was signed into law in 2010 and represents the most significant redrawing of US financial regulation since the Great Depression. The general idea is prevent banking system collapse and a key tenet of the policy is restricting balance sheet exposure to alternative assets.

For private equity, the key section is the Volcker Rule, which came into effect in July. It prohibits any banking entity from engaging in proprietary trading or acquiring, or retaining, any kind of ownership interest in a private equity fund or hedge fund. More specifically, the rule imposes a 3% cap on the amount of tier-one capital banks can invest in such vehicles. They are also unable to account for more than 3% of any single fund.

Factor in the increased capital adequacy requirements imposed on large financial institutions under the Basel III standards, and banks' alternatives ambitions have been more or less neutered. GPs in need of primary capital find their options are limited.

Taking the strain

Asia-focused private equity firms feel the impact in different ways. The global buyout funds, busy raising their latest regional vehicles, have sufficiently large investor bases that they can manage the fallout by targeting LP classes more aggressively. Some smaller funds might not have any US financial institutions on the roster at all.

Two mid-market GPs that reached final closes in recent months despite upheaval in their LP bases are Indonesia's Saratoga Capital and The Longreach Group. A US financial institution was one of three anchor investors in Saratoga's $150 million second fund, which closed in 2009. When the GP returned to the market late last year, the LP was unable to participate, citing the Volcker Rule. Riding on a wave of interest in Indonesian managers, Saratoga still accumulated $600 million in a matter of months.

Longreach, reliant on a larger number of US financial institutions in its previous vehicle and seeking to raise capital for the currently unfashionable Japanese market, faced a much tougher proposition. The fundraising period lasted two years and the initial target of $750 million was scaled back to $400 million.

According to Preqin, banks account for 6% of LPs globally. Among US LPs that proportion is lower - 1% compared to 2% in 2008. Though the percentage change is small, the impact on Asian funds is pronounced as even those institutions able to retain private equity interests in the region have had to limit their exposure.

The extent to which US banks have shed existing private equity programs in recent years is evidenced by the booming secondaries market. Speaking to AVCJ last month, Bryon Sheets, a US-based partner with secondaries specialist Paul Capital, said that current deal flow is 1.5 times what the firm was working on even two years ago. A little over half of our deal flow is coming from banks and significantly more than half in terms of dollars.

To put the shift into perspective, 3% of the cumulative tier-one asset pool of the largest banks in the US is estimated at between $2 billion and $5 billion.

"In light of this change GPs have turned to new sources of funds such as sovereign wealth funds, insurance companies and private banking clients" says Phill Smith, a partner at law firm Mayer Brown. "Furthermore, some GPs have turned away from collective investment schemes completely and now focus on tailor-made managed accounts for large institutional investors."

Rebuilding job

Longreach didn't have to do anything as extreme as abandoning limited partnership model, but the LP base required significant recalibration. According to market sources, 70% of the capital committed to the GP's $1 billion debut fund, raised between 2004 and 2006, came from US-based investors. Japanese LPs accounted for the rest of the corpus.

In the recently-closed second fund, the US portion plunged to around one third, Japan's share stayed more or less the same, and a final third came from Asia ex-Japan investors. Sovereign wealth funds from South Korea, Singapore and Malaysia are thought to feature prominently in the final portion.

In Asia, where banks have typically formed a much larger chunk of the LP base by number of institutions, there have been some significant changes over the past four years. In 2008, 20% of LPs were banks; by 2012 the share had fallen to 15%. Government agencies now account for 10% of the region's LPs, up from 7% in 2008. Pension funds are unchanged on 4%. The changes suggest that not only US banks are seeing their private equity investments curtailed by the Volcker rule.

"The Volcker Rule will affect non-US financial Institutions," confirms Jay Baris, a partner at MorrisonFoerster in New York. "To what extent is still not clear - the rules have been proposed but not yet finalized, but it could affect their ability to remain in the business"

The rule states that Asian banks, or any foreign banking organization with US subsidiaries, are prevented from proprietary trading in a similar way to US banks. The only banking groups exempted are those that conduct their business solely outside the US on the provision that no ownership interest in a fund is offered or sold in the US. As a result, Asian banks are forced to choose between maintaining a US presence and holding on to a private equity portfolio in their own countries.

"You have to make a decision on whether you want to promote business development in the US, and cooperation between the two countries, or focus on your domestic development - currently the legislation is unclear," says MounirGuen, CEO of placement agent MVision. "It captures you under its guidelines the same way as if you are a US domestic entity. So you are put in a position where you have to decide what is most important to you."

The legislation has already attracted criticisms from Asian institutions who believe they have being unduly constrained. Earlier this year the Association of Banks in Singapore submitted a position paper to US authorities, requesting an exemption from rule.

A new world

With the prospect of a smaller pool of international banks willing or able to commit to private equity, both GPs large and small must adapt to a new climate. Some anticipate a trend towards investments in larger, more established GPs. Where the larger banks were once more willing to take a risk in backing smaller private equity firms, it is doubtful whether more risk-averse LPs - government agencies or fund-of-funds, for example - would be willing to invest in a manager without a solid track record.

It is suggested that younger, more independent firms might differentiate themselves by focusing on more contrarian markets. In this way they might be able to offer LPs a kind of exposure they can't get elsewhere and at the same time avoid like-for-like comparisons to more experienced counterparts.

"Smart managers will always come up with ways and new strategies to attract investors," says Lorna Chen, a Hong Kong-based partner with Shearman & Sterling. "I wouldn't think that small GPs will become extinct because of the Volcker Rule and compliance burdens."

However, it remains to be seen where these managers are prepared to draw the line. According to anecdotal evidence, a number of smaller GPs have agreed to give up stakes in themselves in return for a sovereign wealth funds providing seed capital to vehicles that otherwise might not be raised.

"I think as a result of regulation, smaller firms will be more desperate and willing to do things they may not want to do, such as sell equity in themselves," says one Asia-focused GP.

SIDEBAR: SEC registration - The compliance burden

"Our By restricting the extent to which banks can invest in private equity, the Volcker Rule has narrowed the investor universe for private equity firms. But fundraising isn't the only facet of PE targeted by the Dodd-Frank Act, of which the Volcker Rule is part. GPs, including certain Asia-based managers, are now obliged to register with the US Securities and Exchange Commission (SEC). can restrict the way they approach their potential investors.

"It is a game changer," explains Jay Baris, a New York-based partner with Morrison Foerster, "Dodd-Frank has removed some of the exemptions from the registration requirement that many advisors, including advisers to VC and PE funds, relied on. The effects will be felt overseas because the reach of US law is long and wide, while GPs may not realize they are subject to these registration requirements."

For the last six months, all GPs with US investors have been required to file with the SEC as either registered investment advisors (RIA) or exempt reporting advisors (ERA).

For those that file as RIAs - i.e. those that have US investors in their funds - the provisions require, among other things, adopting and implementing written policies and procedures, designating a chief compliance officer, maintaining books and records and implementing a code of ethics. They must also disclose conflicts of interest and other information and ensure that advertising and performance reporting complies with regulatory rules.

"It is definitely a big compliance burden, especially for mid- to large-size GPs, but from a fundraising perspective it is not necessarily bad," says Lorna Chen, a partner at Shearman & Sterling. "It means they can tell investors during the due diligence process that they are in compliance with SEC rules by being fully registered. In this kind of environment they are finding it is a good thing to be linked to a regulator."

However, GPs should also consider that any information they disclose to the SEC as part of the registration application - and there is still some uncertainty among industry participants as to exactly how much detail must be included - will be posted on the SEC website.

"In general they are living with more scrutiny, so I think GPs that are RIAs are being much more cautious about how they present their track record." says Ian O'Donnell of law firm Cooley. "They are spending more time reviewing all LP communications than they used to. GPs are feeling more limited in what they can say, which can impact how much punch the marketing message have. That probably puts more importance on face-to-face meetings."

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• Topics
• Fundraising
• Regulation
• North America
• regulation
• Fundraising
• Asia
• USA
• The Longreach Group Limited
• Saratoga Capital Group