On the shoulders of giants: DFIs and first-time funds

When Mongolia Opportunity Partners (MOP) set out to raise its maiden fund in 2010, the challenge was two-fold. Not only did investing in Mongolia - whose chief industries are in mining and agriculture - carry with it the usual frontier market risks, putting off many potential LPs, but MOP also had no track record to speak of but for the experience of its founders.

"In Mongolia and other markets like it, no one is going to want to go in unless there's a mandate for it," says MandarJayawant, the PE firm's founder. "As such, development finance institutions (DFIs) are often the only ones who are going to anchor your fund."

For MOP, it was inevitable DFIs would play a significant role in the fund because Jayawant had previously acted as Asian Development Bank's (ADB) senior country economist and deputy country director for Mongolia from 2005 to 2008. He well understood the value of such partnerships and also knew what these institutions were looking for.

The fund eventually closed in June 2011 after receiving commitments from six different DFIs, including ADB, the World Bank's International Finance Corporation (IFC), German government-backed DEG, the European Bank for Reconstruction and Development (EBRD), Dutch development bank FMO and Obviam, a spin-out of the Swiss Investment Fund for Emerging Markets (SIFEM).

MOP is not the only GP to see the benefit of partnering with DFIs when mainstream LPs are reluctant to back first-time fund managers in largely unchartered geographies.

"Within the first three minutes of you walking into a meeting, a lot large LPs will say, ‘By the way, we don't invest in first-time funds, but we are happy to hear your story,'" recounts one emerging markets GP. "Everyone asks you the same questions: ‘How much have you raised? What are your soft commitments? Where have you reached?'"

As such, the presence of a DFI can be the difference between a successful fundraise and an unsuccessful one.

They offer not only capital, networks and experience, but also a seal approval that might encourage other LPs to come in. At the same time, working with a DFI means working within the constraints of its mandate, and so the challenge for private equity firms is how they can manage the relationship as it evolves.

Faith in first-timers

According to AVCJ Research, LP commitments by DFIs in Asia have amounted to $66 billion since 2003. IFC was the most active during this period, investing just under $3.5 billion. It is followed by CDC Group and the Overseas Private Investment Corporation (OPIC) - backed by the UK and US governments, respectively - which committed $2.6 billion and $1.5 billion.

Typically, DFIs look for three things in a GP. First, an ability to generate good commercial returns consummate the DFI's own investment targets. IFC, for example, dedicates around $3 billion - or 30% - of its investment program to private equity. Around $500 million of that is LP commitments, with $200 million deployed in Asia, and the target return is close to 20%.

Second, a DFI often prefers GPs with strategies that fit its developmental targets. For OPIC, focal points the touch points include job creation, infrastructure improvements, environmental and social impact, corporate social responsibility initiatives and technology and knowledge transfer in the GP's home country.

Third - and helping to ensure the first two requirements are met - there is a desire to play a pivotal role in the structure of the fund and the development of a GPs investment thesis. "Often where there is a large oversubscribed fund, there is no role for IFC to play but with a small fund we are able to make a difference and shape the fund structure," explains VikramRaju, senior global funds specialist with IFC.

This underscores the benefits to a DFI in backing a smaller vehicle, or even a first time fund. In the case of IFC, these make up for 50% of its LP commitments. Its more recent relationships include Indonesia-focused Falcon House Partners, which reached a final close of $212m on its debut fund last week after receiving an initial anchor investment of $25 million from IFC. Subsequent commitments came from OPIC, DEG and FMO.

Despite the risk involved in backing first-time funds, Raju points out that IFC has a good track record in this area, with these managers generating as much as 400 basis points of alpha. One of the reasons these funds perform so well is that the team behind a first-time vehicle invariably spends a lot of time thinking about the opportunity set. Without legacy funds to manage, they also tend to be more focused.

However the issue remains that - unless the fund is a spin-out - it can be challenging carrying out due diligence on a team that does not have track record. Rather than the comfort of knowing a team is more than the sum of its parts, a DFI must assess the experience of individual team members and make a call on their ability to work together.

"Investing in a fund is mainly about investing the people," explains Markus Bracht, vice president at DEG. "The integrity and in-depth experience of the GP is crucial and the alignment of interest between GP and LP is an integral part of our due diligence."

Given the role the DFI plays as an anchor investor, it is has a significant amount of leverage in ensuring alignment of interest is maintained.

Development demands

DFIs not only conform to their own investment mandate, but also to a number of global treaties regarding governance, regulation and transparency. Additionally, DFIs were among the first to endorse the Institutional Limited Partners Association's (ILPA) set of principles - launched in 2009 - that are intended to improve alignment of interest, governance and transparency in GP-LP relations.

"I would say DFIs are extremely sophisticated investors," says Abrar Mir, founder of Quadria, a GP that targets healthcare investments in South and Southeast Asia. It reached a $107 million first close on its debut fund last month, having received a $25 million commitment from IFC. "The threshold we have to cross to get a DFI over the line is extremely high, in some case higher than institutional investors."

In many cases, DFIs will often provide a list of industries GPs are restricted from investing in, such as alcohol, tobacco and gambling. In the case of MOP, one of these conditions of ADB and IFC's commitments to the fund was that it not do direct deals in mining.

One of the reasons for this is that many DFIs hesitate to give up the environmental and social custodianship of their involvement in sectors such as mining to a third party as the risks are deemed too great. ADB and IFC also needed to fulfill their mandate to help the Mongolian economy diversify beyond mining.

In any case, such restrictions can be immaterial when GPs are selected for the reason that conflicts of interest are unlikely to arise. MOP may not be able to make mining investments but as a small fund these capital intensive projects weren't really part of its original thesis.

Additional requirements DFIs place on GPs include supplementary reporting requirements that enable developmental outcomes to be measured. They may want, for example, information on a portfolio company's employment figures, with a particular interest in the number of female staff, or environmental data such as full breakdowns on emissions.

While requirements outlined by DFIs may initially appear onerous or restrictive, many GPs see the advantages of having a DFI as partner as substantially outweighing the cost.

First and foremost, the presence of a DFI on the LP roster gives confidence to other investors. MOP secured commitments from Japan‘s Orix Corp. and Mitsubishi Corp. prior to its final close, but only after receiving DFI money early on in the process. The same can be said of Falcon House, which closed above its $200 million target due to last-minute investments from undisclosed European institutional investors.

Another advantage GPs can leverage is a DFI's connections and experience. This is particularly valuable to a GP such as Quadria, whose specific sector focus could benefit from a DFI's network.

"Given that they have been in the market longer than most PE players, they have relationships not just at the commercial level but at the government level in many of the countries in which we operate," says Quadria's Mir. "So it is the government connection that would be useful to us."

In return, DFIs look to make investments alongside the fund managers they back. Indeed, the presence of co-investment opportunities is a large part of the reason they make commitments to the asset class in the first place.

There are two benefits of this kind of arrangement. First, many DFI will have offices in multiple geographies and are able to offer both on-the-ground presence and global expertise that other potential co-investor may lack. They may also be able to deploy additional capital in the form of debt and mezzanine financing to portfolio companies.

An example of this was IFC's $28 million investment last year in two Indian microfinance institutions, Equitas Microfinance and Ujjivan Financial Services. Equitas was backed by AavishkaarGoodwell and CLSA Capital Partners, both of which had received commitments from IFC, while IFC-backed Lok Capital had been among Ujjivan's shareholders.

"We find it very useful because we are not a very large fund and with the DFIs alongside we can increase the amount of money that is actually put in the companies," say MOP's Jayawant. "It always gives our transactions a bit of security because in these markets if you have a DFI as a shareholder your ability to solve problems is substantially greater than if you were operating by yourself."

On the other hand, given the challenges that go along with investing in certain emerging markets, DFIs are said to give more leeway as regards to management fees and carried interest. Anecdotal evidence suggests DFIs are reluctant to squeeze first time funds on fees where it would inhibit the formation of a strong team - the trade off being co-investment rights.

"When negotiating terms DFIs can be very generous with fees and carry because they understand we are a small fund and operating in markets that come high costs," says Jayawant.

Long-term relationships

Essentially, many DFIs are seeking to form relationships with the GPs they invest in with the hope of leveraging shared institutional knowledge and gaining access to future deals.

IFC, for example, was an early backer of Indonesia's Saratoga Capital, committing $35 million to Saratoga II, which held a final close at $152 million in 2009. IFC and CDC both declined to be LPs in the third fund - CDC was forced to sit out because Indonesia is no longer classified as a developing country - but IFC continues to work with its one-time investee.

Last year, it joined a Saratoga Capital-led consortium in purchasing a $112 million majority stake in Indonesian electricity producer Medco Power International.

"When we select a fund manager our main motivation is to establish long-term and trustworthy partnerships," says DEG's Bracht. "We want to cooperate with our partners to achieve our strategic goals, which are mainly the promotion of private entrepreneurship in emerging markets and the implementation of best practice social and environmental standards."

At the same time, while DFIs are looking to maintain ties with GPs they have previously backed, they are also looking to the next crop. Saratoga remains an informative example in this context. The private equity firm closed Fund III at $600 million after less than a year in the market, easily exceeding its target of $450 million. IFC, meanwhile, had moved on to Falcon House, a GP that has yet to achieve the same kind of institutional scale.

IFC's Raju describes many DFIs as having a "self-destruct button," where they will only back GPs until they become successful before putting their capital into the next generation of funds.

"As long as there is a need for us to be in a market where access to capital remains a problem and development goals need to be met, we think this is a way we can do it - by focusing on the newer, smaller funds even as the market gets more attractive," he says.

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• Topics
• Fundraising
• LPs
• GPs
• Fundraising
• Asia
• GPs
• LPs
• IFC
• German Investment and Development (DEG)
• CDC Group
• FMO
• Asian Development Bank
• Mongolia
• Southeast Asia