Asia fundraising: Emerging LPs

The great and the good of the institutional investment world gathered in Quebec in 2010 to look at ways in which they could collaborate. Disintermediation was inevitably a key theme: How could these institutions cut out the middlemen in order to reduce fee expenditure and focus on direct deals tailored to their long-term horizons rather than a seven-year fund cycle?

China Investment Corporation (CIC), Beijing's $409 billion sovereign wealth fund, was in attendance and the executives liked what they heard. "CIC subsequently set up its own round table with a view to uniting LPs - the ultimate capital providers, not fund-of-funds - and talking about new ideas and investment products. There was a very strong response," says one industry participant who attended the meetings. "Gradually, more and more LPs are thinking about how they can work together."

Infrastructure is the classic example of where a large institutional investor - perhaps an Asian sovereign fund with a relatively young alternatives program, limited short-term liabilities and lots of liquidity - would seek to commit capital for long periods. However, real estate, up-size private equity deals and venture capital, particularly in the context of new energy, are also cited as areas of interest.

CIC doubled its exposure to "long-term holdings," understood to include private equity and direct investments and hedge funds, in 2011 to 31% as it extended its investment horizon from five to 10 years. Direct transactions in the last 12 months are dominated by energy and infrastructure plays, such as France's GDF Suez and Thames Water Utilities and Heathrow Airport Holdings. However, it also acquired a $2 billion interest stake in Alibaba Group in support of the firm's repurchase of a stake in itself from Yahoo.

Strategic imperatives

This change in strategy on the part of Asian sovereign wealth funds has been long anticipated and the motivations widely analyzed. But what does it mean for GPs that see these institutions as potential fund investors? They will certainly have to alter the way in which they approach the likes of CIC, Korea Investment Corporation (KIC), Malaysia's Employees Provident Fund, Temasek Holdings and Government of Singapore Investment Corp. (GIC), but it doesn't mean they can't do business with them.

"These large institutional investors are starting to do more on their own, in order to reduce overall costs and capture more premium, but they still need good partners. They can't do everything on their own" says Scot Kalb, former chief investment officer at KIC who now runs his own institutional investment consultancy, KLTI Advisors. "The watchword for GPs is partnership. -It's not just about returns, it's about working together."

CIC's Alibaba deal is instructive in this respect. The sovereign fund had been in negotiations with the e-commerce platform for more than a year about participating in the $7.6 billion Yahoo buyback, partly due to uncertainty about the timing of the transaction. The equity portion came out at $3.9 billion and, after CIC took its cut, the remainder was divided up between Boyu Capital, CITIC Capital and CDB Capital as well as existing investors Silver Lake, DST and Temasek.

It was a fairly typical club deal with no shortage of interest from the private equity community. However, Boyu was involved from the outset, advising CIC and helping facilitate the transaction. "Boyu was instrumental in negotiating the terms on behalf of CIC," says one source familiar with both the sovereign fund and this deal. "Particularly when negotiating with domestic guys, CIC is too bossy and talks often break down. So they needed an intermediary."

Put simply, Boyu got a piece of the action thanks to its familiarity with CIC and by delivering a value-added service that few in the market could realistically provide. It is a strategy that other GPs would do well to emulate with any of Asia's emerging LPs, but it requires an understanding of how these institutions operate.

Motivating factors

Two thirds of sovereign wealth funds in existence today globally weren't around 10 years ago, so their alternatives programs are still immature. The desire for exposure to the asset class arises from a need to counterbalance much weightier public equities holdings. Stock market investors pay an embedded premium that reflects the liquidity such assets offer; an institution happy to hold on to assets for decades see no reason for paying this premium across its portfolio.

While alternatives offer better returns, these come with a higher price tag in the form of management and performance fees and other costs, which can alter the risk-adjusted return profile of the investment. Kalb preaches a disciplined approach - a 750-basis point premium might easily be whittled down to 250 without proper cost controls - and careful manager selection.

"With public markets you can diversify managers without much portfolio construction risk, but in the alternatives space, the disparity in performance between first and fourth quartile managers is enormous. If you diversify too much it can undermine performance," he says. "Poor program construction is not easily fixed because of the length of commitments. If you have 300 managers and want to get it down to 75, it could take 10-15 years."

The real danger is when sovereign funds stipulate that alternatives must account for a certain portion of overall assets and managers respond by allocating to a growing number of GPs as the capital at their disposal increases.

Doug Coulter, head of Asian private equity at LGT Capital Advisors, observes that the biggest mistake is trying to build an investment platform too quickly. "A new CIO comes in and says we need to increase PE exposure and next thing you know they have put lots of money into the worst vintage funds in the market," Coulter says. He adds that certain institutions have learned from the rash direct commitments that characterized their early days and have since focused on expanding organically and slowly.

It is worth noting that managers are under enormous pressure to put capital to work once an investment platform is set up. When Kalb arrived at KIC in 2009 private equity activity was virtually zero and he had to create an entire alternatives program. In just under three years, KIC invested about $10 billion on a committed capital basis across a broad spectrum of alternatives.

With this in mind, he stresses the need for nascent Asian LPs to target private equity firms that are capable of scaling up in terms of fund size and infrastructure. These institutions have to deploy considerable amounts of capital each year and so a $50 million allocation to a mid-market manager isn't going to move the needle. Furthermore, if that allocation is going into a fund with a corpus of $200 million, sizeable co-investment opportunities might also be limited.

Going smaller

Other industry participants have a different take. "We are seeing some of the Asian sovereign funds make smaller commitments and become more nimble," says Sebastiaan van den Berg, managing director at HabourVest Partners in Hong Kong. "They started their investment programs making big commitments to buyout funds and now they are looking to go lower, using fund-of-funds but also going in directly."

The source familiar with CIC's strategy confirms that a shift is underway from global to regional to country managers, ostensibly to get closer to expertise in individual markets. In some cases, a sovereign fund will take a stake in the GP in addition to anchoring the fund, but there is no hard and fast rule. "It's not just about saving fees and carry but getting a better variety of investment options that are most customizable and suit the sovereign fund's needs," the source says. "Direct investment has always been a focus."

In this sense, even though LPs are keen on pursuing direct investment opportunities, total allocations to GPs are unlikely to decrease. Rather, they might be redistributed to focus on different funds based on issues such as the size and nature of co-investment opportunities.

Some sovereign funds are already set up for this. Temasek's north Asia subsidiary Pavilion Capital is known for backing smaller regional GPs.

It goes without saying that co-investment opportunities should feature prominently in any pitch a mid-market Asian GP makes to one of the region's sovereign wealth funds. According to one placement agent, a US or European GP is unlikely to get a face-to-face meeting with a large Asian LP unless their fund is $3.5 billion or more and therefore classified as large cap in global terms. Anyone beneath this threshold is referred to gatekeepers who advise the LP on asset allocation in developed markets. Asian allocations, however, are handled in house.

But it isn't as simple as setting up a single meeting and sharing the investment pipeline. These LPs want to establish real partnerships with managers and making the breakthrough requires persistence. One GP recalls the origination process taking 12-18 months from the first discussion to closing the document. During this period, the GP met with the prospective Asian investor six times and the investor made two site visits to conduct due diligence.

Indeed, it is advisable to establish relationships well before the official fundraising process begins. "Approaching people from a fundraising perspective alone is not as fruitful as it used to be," says Vincent Ng, a partner at placement agent Atlantic-Pacific Capital. "A lot of Asian LPs want to build relationships early on - not when you need the money but when you don't need the money."

To build familiarity, fund managers will talk LPs through their portfolios, explaining the good times and the bad, and also put forward co-investment opportunities. Although some institutions split up the primary and co-investment functions, in many cases it is the same group of people running the business for a particular geography. Therefore they might be responsive to this kind of value-add.

KLTI's Kalb stresses that co-investment shouldn't come with a fee attached. His view is that GPs in general must be prepared to give more ground on upfront and hidden costs, including the introduction of hurdles so that investors aren't paying performance fees on beta.

Share the knowledge

When dealing with Asian LPs that have less experience with the asset class or limited resources, GPs are also expected to offer training, information and even technology. Ng says that placement agents go in and try to act as a conduit, sharing market knowledge - even if they are in the process of marketing a buyout fund, they will offer views on the venture capital environment if the LP expresses an interest in the area. Broadly speaking, fund managers can do much the same.

"If you help them think through concepts and follow the learning curve, they will see you as transparent and as a good source of information - and you find that the next time they are in your city they ask to come by the office and meet the team," he says. "As a GP you are not going to identify your main competitors during these meetings, although some of the more confident managers have been known to do this."

How far a GP is willing to go in the name of generating goodwill - and potential fund commitments - from sovereign wealth funds and other large institutions is ultimately a function of the fundraising environment. It reflects the wider GP-LP power dynamic and the negotiations that take place on fees and terms and conditions: a manager in demand can give less away.

However, Kalb sees it as part of a much-needed realignment of interest. "GPs have forgotten that the private equity industry was not created so that PE professionals could become rich; it was created to help LPs diversify their portfolios and invest in illiquid asset classes to generate greater returns for their constituents," he says. "This business is all about GPs helping LPs to be better at investing."

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• Fundraising
• LPs
• Greater China
• North Asia
• Southeast Asia
• Fundraising
• China
• Asia
• LPs
• South Korea
• Singapore
• Sovereign wealth fund
• CIC
• KIC
• Temasek Holdings
• GIC Private