Asia fundraising: How much is too much?

It took Australian GP Quadrant Private Equity just over a month to close its seventh fund at A$850 million ($758 million) earlier this year. Although the new vehicle was two times oversubscribed, there was no substantial increase in fund size on Fund VI, worth A$750 million.

The big jump came in the two previous vintages, 2007 and 2010, when in each case the fund expanded by close to 50%. Fund V was driven by pre-global financial crisis brio, while Fund VI was the first to include offshore investors. Parallels can be drawn with the strong demand for Archer Capital's fifth fund, which closed in late 2011 at A$1.5 billion, but represented a relatively small increase in size on its predecessor. For Archer, the leap was from Fund III to Fund IV, when the corpus grew threefold.

This reset in expectations inevitably followed a bout of exuberance. Australasian managers raised nearly $21 billion between 2005 and 2007 - sums not matched before or since - and performance suffered.

Speaking at last year's AVCJ Australia Forum, Peter Wiggs, managing partner at Archer, blamed the industry outgrowing its space. "The LPs gave the money to the GPs and the GPs spent it on dodgy deals and then we all lost it. What do you do? What I do is I size my market. I reckon I can spend this much money in four years sensibly. The fact that the market might want to give me twice that amount is irrelevant," he said.

It is a lesson that many managers Asia's emerging markets have yet to learn, or perhaps are only on the cusp of doing so. The region experienced its own pre-financial crisis boom and in the flight to quality that followed, LPs flocked to the relatively small number of managers with track records and brand names alongside their strong investment theses.

An escalation in fund size across vintages is not a new phenomenon in Asia but the fact it continues does beg the question of how much is too much. Is a manager responding to changing opportunity set or is he simply being greedy?

Thomas Kubr, executive chairman at Capital Dynamics, observes that ambition is not necessarily a bad thing. LPs want alignment of interest with GPs - the manager isn't going to make money unless his investors get their cash back. Discipline comes with time.

"If you offer them twice the money, some say they have the ability to scale their strategy and take twice the money," he says. "There are exceptions, particularly in more developed private equity markets. In North America and Europe the quality guys got that message a long time ago. In Australia it's the same; there are a few managers who have been out there for several generations now. They know how big their market is and what they can do."

Recipe for a fundraise

Numerous considerations are woven into the sizing of a fund. There are three primary market-based reasons why a fund might be larger than its predecessor: economies and companies are growing, so the average deal size is likely to go up; existing team members are more experienced and new investment professionals have been hired, which means the sourcing net is denser and wider; and the GP has identified an addressable gap in the market that requires additional financial firepower.

The above are factored in, to whatever degree they may apply to the situation, and ongoing deal flow mapping is used to establish what there is to invest in over the next five years and how much capital is needed. There may be other extenuating circumstances, ranging from pure ego to pushing above a certain size threshold so the major LPs consider the fund directly rather than referring it to an advisor.

Asian private equity fundraising stands at $49.7 billion so far this year (including incremental as well as final closes) after nosing ahead of the 2013 total of $49.4 billion. The 2012 figure of $55.3 billion possibly within reach; neutralize the distorting impact that renminbi-denominated vehicles had on the industry in 2011 and Asia could be on course for its best year since before the global financial crisis.

However, the number of funds that have attracted capital in 2014 is barely more than 200, compared to over 350 in each of 2013 and 2012. Average vehicle sizes have been on a general upward trend since 2009, but this year the figure has rocketed to $243 million, up from $135 million in 2013. For successfully raised funds only, the gap increases.

The flight to quality operates differently for pan-regional versus single country vehicles, largely driven by the perceived opportunities within individual markets. Capital-raising for funds targeting China or India has slowed from the peak years and the money is flowing to the relatively few managers seen as actual or potential outperformers.

In the recent years, a couple of Indian GPs have reduced their fund sizes in response to a changing investment environment. Those currently in the market or about to enter it are generally seeking to raise roughly the same or only modestly more than in the previous vintage. The leading China-focused managers, however, are not necessarily being squeezed.

"The global trend among institutional LPs is to be increasingly selective in choosing fund managers," says Chris Churl-Min Lee, a Beijing-based associate with Cleary Gottlieb's fund formation practice.

"And when the LPs look at China, they are presented with an increasing number of fund managers that are looking to raise offshore funds. While a number of experienced managers with strong track records have been able to successfully raise large funds relatively quickly, first time managers and managers with weaker track records can face a rather long and difficult fundraising process."

CDH Investments closed its fifth US dollar-denominated China fund earlier this year at $2.55 billion after raising the hard cap slightly to accommodate investor demand. The process took about 16 months and the fund is $1 billion larger than its predecessor. Hony Capital, operating in a friendlier fundraising environment, closed its fifth China fund at $2.36 billion in early 2012, also $1 billion larger than its predecessor.

Meanwhile, Boyu Capital and FountainVest Partners upped the size of their second China funds by 50% and 40%, respectively, although both are in the $1-1.5 billion range.

John Morrison, managing director at Munich Private Equity Partners, compares the situation to a "Darwinian land grab." Firms are seeking to take advantage of their market position in order to ensure their place among the dominant players for years to come.

He accepts that PE firms are under pressure to meet the ambitions and financial expectations of its investment professionals. Increasing fund size is one way of achieving this, but the question LPs must answer is: Does this change the nature of the proposition?

"Every time you invest in a fund you can dwell quite a long time on the past but you also have to ask yourself who is best positioned to capitalize on whatever opportunities exist in the market over the next cycle. In a market that develops as rapidly as Asia, the players at the top end of the market have that depth of cross-border experience, that wherewithal to bring in true operational capability."

MPEP has found itself in 2-3 situations where the final consideration was whether it really wants to invest in a fund targeting substantially more than the previous vintage. In one case it ended up committing, convinced by the quality of the group and the efforts made to built out investment infrastructure; but there have also been situations in which it said no.

A couple of LPs told AVCJ that getting comfortable with larger China funds in part depends on being convinced the managers can execute the kind of larger cross-border transactions they say they have in their pipeline. Jonathan English, managing director at Portfolio Advisors, puts it in the broader context of GPs having institutionalized platforms capable of sourcing and dealing with challenging investments, while simultaneously meeting the reporting issues that come with running a fund.

"There are other groups in the region that would be attempting to make pretty big step-ups from their predecessor funds but I don't think have gone through the institutionalization process," he says.

Such assessments can equally well be made of the pan-regional managers. Between July 2012 and September 2014, nearly all of the largest global and Asia-based PE firms closed the first regional vehicles they have raised since the global financial crisis. Eight GPs collectively raised $27.2 billion. This is $5.3 billion more than the same firms raised for their previous vehicles, and in a difficult fundraising environment.

Bigger Baring

The missing member from this group - although its previous fund was raised post-crisis - is Baring Private Equity Asia, which is expected to close its sixth pan-regional vehicle at the hard cap of $3.85 billion.

Baring Asia is an interesting case study in that the firm has accelerated through the fund sizes over the last 10 years. Fund III closed at $490 million in 2006 and has since become one of the best-performing funds for its vintage in Asia and globally. This gave momentum to the next two vehicles, both of which came in substantially above target at $1.52 billion (2007) and $2.46 billion (2011).

According to separate disclosures by LPs, Fund IV had delivered a net IRR of 10.2% and a multiple of 1.6x as of March, while Fund V was on an IRR of 9.9% and a total value multiple of 1.19x as of June.

"Fund III made LPs interested, so they raised Fund IV. LPs are still clamoring to get in off the back of Fund III but the verdict is still out on realized performance," says one industry source familiar with the firm. "Fund IV is predicated on Nord Anglia [a school operator that went public in March]. Fund V is still very early in its life cycle and Fund VI will be a fresh pot of capital. We will see how history plays out and whether they have managed the evolution properly."

The formula that served Baring Asia so well in Fund III - middle-market growth equity and buyout deals sourced on a proprietary basis, involving companies that want to scale up - has at least been modified. Fund IV targeted fast-growing companies with enterprise values of $100-300 million; for Fund VI, the equity check range is $50-300 million. The plan is for a diversified portfolio of 20-25 companies, but there may be more buyouts at the upper end of the scale.

These could be the same kinds of companies Baring Asia was backing in 2005, but they have grown in line with the economic opportunity in the region. Nevertheless, the strategy begs two questions. First, can the PE firm continue its existing approach to sourcing or will it increasingly end up in auctions against the large global and pan-regional players? Second, does Baring Asia have the operational capabilities to deal with the complexities facing larger and more international companies?

AVCJ spoke with several LPs, each of whom discussed concerns about Baring Asia's fund size internally before deciding to commit.

"In these situations, we have to ask if the manager has built the infrastructure, created the approach and established the processes prior to raising the fund or has it raised the fund and then tried to reinvest in itself," one LP explains. "Baring has built a highly professional structure, a multi-office environment we thought worked. They have the systems and processes to handle a growth in fund size."

Another LP points to the efforts made in creating operations, financing and country-focused teams, as well as developing internship and training programs intended to ensure deep bench strength.

While Baring Asia can still point to a 17-year track record in the region and a core group of partners with experience of multiple business cycles, it has certainly brought in fresh talent. When raising Fund IV, the firm had 23 investment professionals across offices in Hong Kong, Shanghai, Singapore, Tokyo and San Francisco. Headcount is now 100, of which 51 are investment professionals, and offices have been added in Beijing, Jakarta, Mumbai and Singapore, although the San Francisco presence has gone.

There are no guarantees of performance and a number of industry participants claim that Baring Asia is raising too much capital and will struggle. Even if Fund VI performs well, others in the $3 billion-plus fund size space - that now also includes Affinity Equity Partners, The Carlyle Group, CVC Capital Partners, KKR, RRJ Capital and TPG Capital - may not.

"It's not like it doesn't still cause concern when CVC, Carlyle and everyone else has raised a sizeable fund around the same time," observes one North American LP. "There is a lot of capital at that high end of the market."

Expansion plans

Much like Baring Asia, other pan-regional players have expanded their footprint since the last cycle. Affinity closed its fourth fund at $3.8 billion earlier this year, having raised $2.8 billion for its 2006 vintage predecessor. The firm decided against expanding its geographic remit to include Japan and India, but increased headcount by 50% and opened offices in Beijing and Jakarta, for a total of six.

Ahead of closing its second Asian fund at $6 billion in July 2013, KKR opened its seventh regional base in Singapore and also brought in additional talent, creating a localized operational presence to complement its already localized investment team. Asked whether $6 billion was too big, Joe Bae, KKR's regional head, told AVCJ last year that the target was based on the encouraging returns generated by the more than $5.5 billion it had deployed in Asia over the previous 6-7 years, as well as the increasing resources being put on the ground.

Portfolio Advisors' English questions how easy it is to turn $6 billion into $12 billion and what cost of capital is incurred by each investment platform. "I would say there is a varying cost of capital at play in terms of what are realistic return expectations, what the GP is happy with, and what the LP base is happy with," he says. "When you start getting to $3.5 billion plus funds in Asia the verdict is still out."

Another issue that must be factored into this debate is co-investment. For example, it has been estimated that the $3.3 billion TPG Capital raised for its most recent pan-Asian fund could translate into $4.5 billion in firepower given LP appetite for additional direct exposure to deals.

One regional buyout fund manager tells AVCJ that ticket sizes at the top end of the market are growing even faster than fund sizes - perhaps a reflection of the level of competition this segment.

The largest pure private equity buyout in 2014 to date is The Carlyle Group's $1.9 billion acquisition of security services business ADT Korea. With debt financing said to be around $1.2 billion and equity participation from two Carlyle funds, there was likely still ample room for co-investment. The big minority deal of the year, which saw 25 investors commit $17 billion to Sinopec's retail business, also featured individual check sizes substantial enough for sharing.

While co-investment tends to be limited to a handful of large and sophisticated LPs, the level of interest expressed could ultimately tempt a GP - already on course to raise a larger fund than before - to push the strategy even further. It is a reminder that ambition or greed on the part of the manager is not the only force driving fund sizes ever higher.

The slicing and dicing of allocations towards the end of a popular fundraise is usually done to accommodate LPs.

"You can always package a larger fund as the economic opportunity evolving," says Vincent Ng, a partner at placement agent Atlantic-Pacific Capital. "And there are always two sides to the coin: a supposedly greedy GP milking as much as he can, and also an LP that is perhaps putting money in thoughtlessly."

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• Topics
• Fundraising
• GPs
• LPs
• Asia
• Fundraising
• GPs
• LPs
• China
• India
• Capital Dynamics
• Munich Private Equity Partners
• Portfolio Advisors
• Baring Private Equity Asia