LPs emphasize self-awareness in China GPs - AVCJ Forum

“If you are so excessively self-confident that you don’t have an awareness as to what your biases are, an awareness of where you have domain expertise and where you do not, and an awareness of the competitive environment, you are not going to be a success,” said Edward Grefenstette, president and CIO of The Dietrich Foundation. “We look for GPs that recognize the threats to their business model, the threats to their returns and actively try to combat that.”

The Dietrich Foundation has just under $1 billion in assets, of which 90% is allocated to PE and VC. China alone accounts for one-third of the overall portfolio, with seven VC players considered core to its exposure. During due diligence, Grefenstette regularly asks managers to name the most likely reason for future underperformance, assuming they stick to strategy and there are no damaging macro events. Many refuse to accept the premise of the question, insisting they will not fail.

“I would like to hear a GP say, ‘I’ll tell you exactly how it happens – it’s because we underestimated the competitive environment, it’s because we overpaid, it’s because we lost discipline and shifted strategy into another sector,’” Grefenstette added. “I would like to hear a GP articulate how their strategy might fail because as a result, they are less likely to trip up on those risks.”

Allstate Investments – asset manager to US-listed insurer Allstate, which has approximately $8 billion committed to private equity – conducts a version of this assessment internally. The team reviews the original memos for co-investments to establish whether they identified the possible cause of a sub-optimal outcome before going in. For example, prior to making an oilfield services investment in 2014, Allstate considered what might happen to the company if the price of oil fell from $100 a barrel to $70. It didn’t predict the events that led to a $40 a barrel scenario.

“The critical difference between a GP and an LP is that when things go wrong, as a GP you do have the opportunity to correct the situation. As an LP in a fund, things have to go really wrong before you have the opportunity to do anything,” said Peter Keehn, global head of private equity at Allstate. “It is very important for LPs and GPs to acknowledge the fact that things won’t always go perfectly.”

This self-awareness is seen as especially important in the context of changes in the Chinese investment environment that require managers to demonstrate different skillsets to those that have underpinned previous successes. Keehn identified two key areas: the gradual transition to control buyouts and moderating economic growth.

“Growth covered a multitude of inefficiencies in operating dynamics and structure,” he said of the latter. “In a slower growth economy, we are looking for managers to be able to demonstrate expertise that is less about the revenue line and more about the expense line. This is not a muscle that has necessarily been exercised by a lot of local GPs in the past.”

This view was echoed by Ralph Keitel, regional lead for East Asia in the International Finance Corporation’s (IFC) private equity funds division, who warned that the forces behind growth in China and other emerging markets could be weakening. “We’ve had 30 years of globalization, deregulation, liberalization, and trade that has lifted a lot of boats,” he said. “But in terms of geopolitics, we have seen shifts that might have significant implications in terms of how global supply chains are set up.”

IFC has a China portfolio of around 40 funds, most of them venture capital and growth equity vehicles in the $200-500 million range. It backs managers in less developed markets that might benefit from limited competition, but they also tend to be less proven, with a majority on their first or second funds. This means IFC must be extremely careful in manager selection. While Keitel believes the winners in China will be those that can create real value in a slower growth environment, above all he must be convinced of a team’s stability.

“When GPs are fundraising everyone is happy, putting on smiles, but in almost all cases, if something goes wrong it’s because team members leave or because the team doesn’t work as a team anymore,” he says. “The average marriage in the US lasts seven years. The average in our portfolio is 12-plus years. You are assuming that your team is going to work together for longer than the average marriage.”

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• Topics
• Greater China
• Fundraising
• Growth
• Venture
• GPs
• LPs
• China
• AVCJ Events
• Fundraising
• IFC
• The Dietrich Foundation
• Allstate