China fundraising: What LPs want

Trade tensions with the US represent one of multiple reasons why an LP might pass on a China-focused fund. As previously noted, those with no direct exposure to China might be inclined to wait-and-see whether the current climate mellows before making their first commitment. Those that approach the country with an experienced eye and existing portfolio of single-country managers do not appear to be holding back. Indeed, some are bullish – citing the long-term opportunities presented by an economy in transition and the short-term benefits of a moderation in valuations.

This does not mean fundraising is easy. New LP relationships are hard-won, given a tendency among institutional investors to prune portfolios and allocate more money to the managers they regard as top performers. Meanwhile, new GPs often struggle to get traction with an investor community that is preoccupied with re-ups or wary of unproven franchises. These dynamics are largely responsible for the widening gap between haves and have nots.

LPs speaking at the recent AVCJ China Forum offered some insights into what they want to see from China managers, beyond meeting performance and governance criteria…

Self-awareness: “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. During due diligence, he 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 do not accept the premise of the question, insisting they will not fail. But Grefenstette wants to hear GPs articulate how their strategy might fail because it suggests thought has gone into combatting threats.

Bottom line competencies: Structural reforms in China’s economy mean the days of double-digit growth are past. In the absence of strong macro tailwinds, private equity investors must rely on operational expertise to drive returns. “Growth covered a multitude of inefficiencies in operating dynamics and structure,” said Peter Keehn, global head of private equity at Allstate Investments. “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.”

Domain expertise: There is already evidence of this taking root among China GPs as completely sector-agnostic strategies have been replaced by a focus on a handful of areas. Sector specialists have also emerged. The gradual transition to control buyouts means domain expertise will become ever more important. “Being a good growth investor is different from being a good control investor,” Keehn said, adding that Allstate is changing its manager selection criteria.

Team stability: “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,” said Ralph Keitel, regional lead for East Asia in the International Finance Corporation’s private equity funds division. “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.” Recognizing that dynamics change over time is a key aspect of maintaining stability. Few Chinese GPs are old enough to run into succession-planning issues, but the importance of keeping mid-level talent engaged and incentivized – with a nod to the long-term health of the firm – can be overlooked.

Alignment of interests: In-demand Chinese private equity firms have been able to achieve significant increases in fund size with each vintage. This raises the question of how much is too much. Grefenstette has started asking managers how big their next fund should be if the goal is to maximize returns for LPs. “If they’ve put $1.2 billion on the cover, the immediate answer should be, ‘It’s $1.2 billion.’ But it’s amazing how often that isn’t the answer.”

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• Topics
• Greater China
• Fundraising
• LPs
• Performance
• China
• Allstate
• The Dietrich Foundation
• IFC