LP interview: Allianz Capital Partners

Emerging markets offer significant growth opportunities tempered by a plethora of risks. What is currently happening in China’s technology sector isn’t necessarily dissimilar to the blips – some unexpected, others predictable – across multiple geographies, contends Qingru Li, a director at Allianz Capital Partners (ACP).

“Regulatory risk is part and parcel of investing in emerging markets. You must look not only at the private equity and business landscape, but also macro and regulatory factors,” he says. “In China, there is a crackdown on technology. In 2016, India had demonetization. Before that, in the early 2010s, infrastructure was hot. Everyone was investing in power plants in India, but then there was a crackdown on corruption and the opportunity disappeared.”

ACP has witnessed these twists and turns policy play out across Asia over the course of nearly two decades. As the group responsible for deploying capital from the balance sheet of global insurance firm Allianz into alternatives, it had EUR44.3 billion ($51.9 billion) in assets across private equity, infrastructure, and renewables as of the first quarter. The private equity portfolio amounted to EUR22 billion, of which approximately EUR5 billion was with Asia-based managers and co-investments.

The investment program is divided into two parts: a base manager program comprising funds of $1-3 billion and above, run by established GPs; and a spice program – it is spicier in nature, due to the different risk-return dynamic – for managers that are smaller, less proven, and typically country-focused. ACP commits of $150-200 million to base funds and $40-60 million to spice funds.

Accessing Asia

Asia is currently 40% base and 60% spice, with the latter program growing in stature as ACP became more familiar with the region. Investment activity kicked off in 2004 but it was run out of Munich. On opening an Asia office in Singapore three years later, ACP began to broaden its coverage from pan-regional buyout funds to country managers. There are now over 30 active relationships, out of approximately 100 globally.

The first China venture exposure came around this time, initially via managers that pursued a combination of early-stage and growth-stage deals. Gradually, the focus shifted earlier, but this has since been thrown into flux by broader developments. “Given the transition to new economy sectors, growth managers have moved towards VC, so there is a blurring of the line between venture capital and private equity,” Li explains.

To some extent, this convergence heightens the regulatory risk. An LP could have exposure to technology companies facing regulatory challenges or with uncertain IPO prospects – but multiple times through managers that invested at different points.

While Li observes that ACP has always been mindful of these risks, the group has learned to focus on longer-term outcomes in China. Regulatory turbulence is a feature of the Chinese investment environment, having touched on real estate and financial services, as well as technology. And then within technology, financial technology, social media, and gaming have faced scrutiny over the years.

While Li observes that ACP has always been mindful of these risks, the company has learned to focus on longer-term outcomes. Regulatory challenges are a feature of the Chinese investment environment, having touched on real estate and financial services, as well as technology. And then within technology, financial technology, social media, and gaming have faced scrutiny over the years.

“The current situation has been more severe in terms of impact on investor sentiment, probably because of the US-China trade tensions and the uncertainty over US listings,” he adds. “However, we have been investing in areas impacted by regulation for more than 10 years and the portfolio has been resilient. Unless you have a systemic targeting of all companies in an economy, at different times some sectors will grow and others will face challenges.”

ACP’s takeaway, based on its own analysis and feedback from portfolio managers, is that Hong Kong will become the focal point for companies pursuing offshore listings. But this doesn’t rule out the possibility of IPOs in the US for start-ups with no or low exposure to sensitive information.

Meanwhile, many of the VC managers in ACP’s portfolio were already reducing their consumer-technology exposure before the latest regulatory imbroglio – not so much prescience as a response to market dynamics, notably a flatlining in mobile internet penetration and saturation or consolidation of long-favored segments. Biotech and business services are the new sweet spots.

“You need to make sure the fund manager isn’t opportunistically targeting these areas,” says Li. “In China, investment opportunities come in waves and people jump on the bandwagon, which results in booms followed by corrections. We must be vigilant.”

For example, ACP took a deliberately conservative approach when first investing in China healthcare in 2015. It focused on managers with a presence in China and the US, reasoning that exposure to a developed market would help these GPs distinguish between sentiment and science-driven opportunities in an emerging market. ACP’s healthcare investments have escalated in recent years, though always to sector specialists. Much the same is expected of areas like business services.

“In the consumer-internet era, everyone was a generalist because it was all about platform companies and getting to a scale at which you could monetize,” Li explains. “Now there are funds that focus primarily on SaaS [software-as-a-service] or logistics, while generalists are organizing themselves into sector teams. It is a move towards specialized and more research and thesis-driven investment, whereas in the past it was more about following entrepreneurs.”

Regional spread

China accounts for the bulk of the regional portfolio – 60%, including exposure through pan-regional managers – followed by Australia and Korea on 10-15% apiece, with India, Southeast Asia, and Japan making up the rest. Historically, developed markets have delivered the most stable distributions.

India and Southeast Asia exposure is limited not just because of the standard emerging markets risks. In India, beyond the currency conversion issue, with rupee depreciation eating into US dollar-denominated returns, team churn is a longstanding issue. This is exacerbated by the pool of investable managers being shallower than in China, for example, but Li acknowledges that key man risk is a concern across both markets.

“I struggle to think of one manager that has 10 partners in an equal partnership, whereas that is common in the US and Europe. It is a cultural issue as well as a developmental phase,” he says. “As an LP, you can be a sounding board and an advisor, but in terms of execution, it is up to the GP.”

ACP’s take on Southeast Asia is influenced by the local business landscape, specifically the dominance of family-owned conglomerates. Some of the most successful investments have come from pan-regional managers aligning with these families and supporting spinouts.

“Given the markets are still relatively young, you can have a $500 million revenue company that is an industry leader, growing 20-30% a year, and owned by one of these family groups,” says Li. “We always ask, ‘What happens to the $20-30 million companies?’ From a risk-return perspective, it is more interesting to back the $500 million company than smaller players that have difficulty scaling.”

Venture capital in Southeast Asia is of more interest than small to midcap private equity. Technology is a younger sector, with no large family-owned incumbents. Moreover, the region is expected to benefit from US-China decoupling.

For the most part, though, ACP relies on pan-Asian managers in its base program to get exposure to India and Southeast Asia. The same can be said of Japan, where legacy performance issues tied to the global financial crisis period led to a wariness that is perhaps only now being overcome. It speaks to an inherent conservatism that is to be expected of an insurance company – a trait visible in approaches to secondaries and co-investment.

Secondaries are treated much like late primary opportunities. If ACP cannot get as much exposure as it would like to a certain manager, usually because a fund is oversubscribed, it may purchase interests from other LPs later. Co-investment, meanwhile, is restricted to portfolio managers, on a no fee, no carried interest basis, with a preference for prepackaged deals. Check sizes can be as small as $20 million but are usually in the $40-60 million range. Asia is not an especially active market.

“Our insurance sponsors tend to be prudently risk-averse; they want to invest more in mature companies with strong cash flows and profits," Li says. "In China’s technology and healthcare sectors, where there is a lot of deal flow, businesses are often unprofitable, and valuations are rich. This means we do more in developed markets.”

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