Secondaries: A ticking clock

Four times in the last 20 or so years, Mahon China has been called in after - as one investor puts it - LPs "pressed the nuclear button." Since the global financial crisis, the firm has specialized in restructuring and rehabilitating stalled or distressed assets in China. In certain situations it is the GP, not the assets, that are stressed, and investors in the fund resolve to bring in a new team to manage a portfolio. 

The most recent case arose two years ago and concerned a GP that was suspected of misconduct. Mahon China advised the LPs as to whether they had leverage to replace the manager. They did, and the firm was duly appointed as the replacement GP.

"Essentially what we do is step in when trust has broken down between the investors and the manager," says David Mahon, managing director and CIO of Mahon China. 

Misconduct shatters this alignment of interest and limited partnership agreements (LPA) allow LPs to act upon it. In most cases, however, alignment gradually erodes over time as the GP fails to deliver on its promises. A fund might achieve "zombie" status when the manager is sitting on the assets purely for the fee income they generate, recognizing that a successor vehicle will not be raised. There is a reluctance to pursue exits because this reduces the assets under management and therefore the fees.

Removing the GP is a priority but LPs note that their powers can be limited. Situations are rarely as clear cut as the one outlined above and such drastic action requires the support of investors representing a comprehensive majority of the capital - in some cases up to 80%. Achieving consensus is difficult given each LP has its own objectives, priorities and competencies while the GP may actively resist change.

Mahon adds that LPs are sometimes reluctant to take action for fear of the questions that would be raised internally. "It is often better to replace the GP with people who are properly motivated, but it rarely happens because the LPs have to acknowledge that the GP is not performing," he says. "They don't want to admit that their decision to invest in the fund was flawed. This is the biggest barrier."

Kicking out the manager represents the sharp end of GP restructurings, yet several investors expect them to become a more common in Asia as frustration grows with GPs, notably in India and China, that have made minimal distributions. They are part of a much anticipated wave of restructurings in the region - so anticipated, in fact, that the phenomenon was being talked up two years ago.

While there are now hints of activity in India, it is premature to declare a panacea. The reality is that restructurings are tough to negotiate and really only work when every party involved believes it has something to gain.

"There was talk of a lot of restructurings globally but fewer deals than expected have actually closed," says Peter Kim, investment principal at Coller Capital. "These transactions are complex. In most deals there is a seller and a buyer, but in restructurings you have three parties: the seller or multiple sellers; the GP, which is very involved in the process; and the buyers, typically secondaries funds. You need a lot different interests to become aligned to make something happen."

Death by numbers

Asia has followed the global norm in recent years with private equity fundraising dropping off as LPs seek to consolidate their GP relationships. More capital is going to a smaller number of players: funds reaching a final close in 2014 raised the third highest annual total on record, but the number of vehicles crossing the finishing the line was the lowest in more than a decade

Look at India and China more closely and the picture becomes starker. Between 2006 and 2009, 112 India-focused vehicles achieved final closes, raising more than $19 billion. Over the five years that followed, $7.9 billion was raised by 71 funds. According to AVCJ Research, 90 private equity firms were responsible for the 112 final closes in 2006-2009 as some GPs raised multiple vehicles. Just 19 of these 90 managed final closes on successor vehicles between 2010 and 2014.

In China the phenomenon is similar, albeit less developed. The country's peak fundraising years were 2007-2011, when $41.7 billion went into 168 US dollar-denominated funds reaching a final close. (Renminbi vehicles have been excluded for the purposes of this analysis because they are still largely off limits to the leading secondary investors.) A total of 106 different GPs raised funds during this period, but only 37 of that number have completed a fundraise since then.

The classic GP restructuring would give these private equity firms more time to prove themselves. While some or all of the LPs want to their capital back, the management team still has faith in these assets and its ability to extract value from them. If it can identify some investors who think likewise, the portfolio can be acquired from the existing fund and housed in a new one with new LPs and different economics. The proceeds from the sale go to the LPs that wanted out.

However, these deals can come in all shapes and sizes, depending on the needs of the parties involved.

For example, the GP could simply amend the existing LPA to allow for the exit of existing investors and their replacement by new investors. This might be accompanied by stapled commitments to a new blind pool of capital. Alternatively, if the onus is on providing immediate liquidity, a slice could be carved out of the portfolio and placed into a new vehicle. The existing fund remains - it is run alongside the new vehicle, which may have a different investor base - and LPs have exposure to the remaining assets, but they also receive the sale proceeds as distributions. 

If GP removal falls towards the acrimonious end of the spectrum then spin-outs are at the other end: management is highly incentivized to get a restructuring done because they get to set up their own platform, often buoyed by a pool of primary capital to make new investments.

"Where you have key people on the ground who are motivated to do a deal, that is when things get done. They will coordinate, convince and make things happen," says Brooke Zhou, executive director for Asia Pacific private equity at LGT Capital Partners. "When a GP is sitting on a fund and wondering whether it is able to raise another, the motivation factor is not as clear, considering the potential risks they face."

It is no coincidence this is where Asia has seen activity, from NewQuest Capital Partners in 2012 to Lightbox last year. Both spin-outs were helped by the previous LP bases being small and the LPs keen to get out - and not necessarily due to underperformance. NewQuest was originally the Asia PE team at Bank of America Merrill Lynch, which left the asset class due to changing regulations. Kleiner Perkins Caufeild & Byers (KPCB) and Sherpalo Ventures, the original backers of the Lightbox team, exited for strategic reasons. 

Negotiating points

When dealing with a large group of LPs consensus is harder to find. Price is an obvious stumbling block. The seller doesn't want to be accused of offloading a position on the cheap while the buyer has certain return hurdles to meet. In the middle sits the GP, which may bridge the divide by giving up some of its own economics in order to secure a deal.

However, the negotiations go far deeper than this. If, for example, there is going to be a full restructuring and the selling entity will no longer exist, the buyers may be unhappy with the level of protection offered by the indemnities. A question mark over an audit of an individual portfolio company can therefore take on huge importance - if the buyer is not entirely comfortable with information presented this could derail any agreement or at least have a negative impact on price perception.

Jason Sambanju, head of Asia private equity secondaries at Deutsche Asset & Wealth Management, advocates care when engaging with LPs. "If you communicate too early you risk inertia; communicate too late and LPs might feel they are being forced into a corner," he says. "Managing the flow of information is very important."

This is arguably where what would have been Asia's highest-profile restructuring came up short. Australian GP Ironbridge Capital put forward a proposal whereby LPs in Funds I and II would exit their positions or roll over into a new vehicle holding the assets - and participate in a stapled secondary for a new vehicle. It was criticized by LPs, with some claiming that Ironbridge had no right to demand a primary commitment as a condition of rolling over.
The proposal was dropped and the transaction switched to a standard secondary sale as a number of investors took the opportunity to exit.

"There are so many factors that go into it and there is a lot of uncertainty," adds Adam Howarth, managing director and co-head of PE secondaries, Partners Group. "As a buyer you spend a lot of time and resources on negotiations without knowing the uptake. If you come across a $50 million interest in a fund, you know that if the reserve price is met the full amount will transact. With a restructuring you can't be sure if you will get the uptake."

Alternative routes

There are also methods through which a GP can extend its life, or at least its options, aside from a full restructuring. A number of private equity firms in Asia are understood to be operating on a deal-by-deal basis. They want more time to prove themselves on their existing funds or they recognize that performance is poor, and so taking potential investments to LPs on a speculative basis is a means of restating or rebuilding the track record.

Another course of action is to explore smaller, one-off stapled secondary arrangements. While the original Ironbridge proposal saw a tender offer put to all LPs, other private equity firms are opting for a more low-key approach. If it becomes clear that a couple of LPs are not going to re-up, the GP can facilitate their exit - provided they can be convinced to sell - from the existing vehicle and bring in investors who buy the position and also commit to the new fund. There is no fund restructuring, but the GP takes a step towards guaranteeing its future.

"If they were to consider something bigger like a GP restructuring then they do need to think about the type of headline risk they face," LGT's Zhou adds. "With these smaller deals, you don't have to disclose it to all the LPs - unless they are legally obligated to do so such as a right of first refusal to their existing LPs - and definitely not to the entire market."

A further option is to secure exits on a portfolio or single-asset level, selling assets directly to a GP that assumes the management role. NewQuest's current remit is to acquire such assets, leveraging the team's past experience of managing and exiting businesses. However, Darren Massara, managing partner at the firm, notes that the model may ultimately extend to serving as a replacement or supplemental GP for a fund where some of the original LPs remain in place.

"Either the LPs completely trust the GP and feel this is the right group to shepherd these assets to monetization or they want to bring in someone else to help them," he says. "There could, in theory, be a situation where they bring in a NewQuest. We could sit alongside the GP and help find resolutions to the assets they still have in their portfolios."

Size matters?

This is driven by a long-term view that more restructuring opportunities will emerge in time, just as they have in the US and Europe. What remains to be seen is how deal size impacts the frequency with which these transactions occur and the nature of the groups that pursue them.

In November 2014, Intermediate Capital Group and Goldman Sachs led a $860 million restructuring of US-based private equity firm Diamond Castle's 2006 vintage fourth fund. A number of existing investors achieved liquidity while the Diamond Castle team will continue to manage the assets. The Ironbridge deal, had it been completed as a restructuring, might have been of comparable size but Diamond Castle is several times larger than Lightbox.

Given the uncertainty involved in restructurings, investors in the US and Europe typically want to deploy a reasonable amount of capital. It begs the question as to whether there is a sufficient number of attractive candidates in Asia.

"There is a high risk-return profile in these deals and they are not going to want to go through the brain damage if only a small amount of dollars will be put to work," says Philip Tsai, managing director with UBS' private funds group in New York. "The larger deals that have been done in the US and Europe have generally been with managers that were somewhat tracked and known by the secondary buyer community."

The counterpoint is that the $200-300 million mid-market China and India funds from the 2006-2008 vintages might be more pliable. While funds like Diamond Castle will have dozens of LPs, these smaller players might have only one dozen. It is difficult to generalize on LP breakdowns, but fund-of-funds were particularly active in early vintage country-focused vehicles in Asia. Bearing in mind fund-of-funds are reasonably activist and many have a presence in Asia, NewQuest's Massara contends that they are well-positioned to nudge GPs in the direction of restructurings.

"These deals will still be GP-led but they might be a little more LP-initiated than in the US and Europe," he says. "They can be the ones who say, ‘This is what is happening in the US and Europe, it has worked for a few GPs. You guys might want to think about it.'"

The LP response to this is mixed. They see it as sound in theory but more complicated in practice. Potential conflicts of interest are a concern if the secondaries arm of a fund-of-funds approaches a GP in which the primaries team holds an interest. Beyond that, an LP can only suggest, not force a manager to take a particular course of action - at least in the absence of a misdemeanor or a no-fault divorce clause in the LPA.

Since setting up shop in Asia, several secondaries investors have run initiatives intended to educate the market on what restructurings and other secondary solutions can help GPs achieve. Pitching a concrete proposal to private equity firms, however, is a different matter. "We have approached a couple of GPs in China and India with ideas for restructuring," says one LP. "They aren't motivated enough. They are reluctant to do it because of the PR risk and they are unsure if it would be to their benefit."

Day of reckoning

It all comes back to the amount of pressure these GPs are under. There remain two well-represented constituencies in both India and China: the first remain convinced they can raise new funds, regardless of the feedback they might receive, and are therefore unwilling to consider a restructuring; the second accept their fate as zombie managers and see no upside in giving up the current trickle of fee income.

This status quo cannot last indefinitely. The realization that the capital-raising environment is challenging will sink in or funds will near the end of their 10-year lifespan and GPs will start asking for one-year extensions. It is then that the LPs leverage will really begin to tell and restructurings - alongside other secondary solutions - will appear on the agenda. Howarth of Partners Group says he is already seeing it, with some PE firms now exploring their options as a result of feedback from LPs.

Deutsche's Sambanju is similarly positive, noting that the momentum in India and predicting a "very interesting" next 36 months. However, he cautions that deal flow is likely to remain lumpy, simply because that is the nature of the business.

"Six months from now a $200 million fund restructuring might come out of the woodwork and everyone will say it's the beginning of a slew of deals," he says. "It won't work like that. Some years there will be none, other years there will be three or four. We just haven't reached a tipping point yet."

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• Topics
• Secondaries
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• UBS
• LGT Capital Partners
• LPs
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• Coller Capital
• NewQuest Capital Partners
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• Deutsche Bank