A question of discipline

I hear the same story time and again from LPs: We want to work with private equity firms that have stable teams, clear and consistent investment theses and strong track records. It is not unusual for GPs in emerging Asia to seek ever increasing fund sizes - some LPs actively encourage it - but it throws up questions as to whether additional firepower means better returns or a slide toward undisciplined investing.

While funds may expand to capture evolving opportunities in growing markets, GPs must not expand beyond their means. Backed up by a young yet promising portfolio, it is all very well arguing that the returns of similar or greater magnitude can be generated from a larger corpus in the current cycle, but additional investment professionals are required to deploy this capital.

Is the GP able to do this without diluting the quality of the overall team? If the larger fund size represents a departure from tried and tested strategies, how prepared is the GP for this step into the unknown? And what happens if the approach doesn't turn out as expected?

Until recently, only two private equity firms in Asia had returned capital to LPs on the grounds that developments in the market since their vehicles closed had created a mismatch between corpus size and investment opportunities.

In 2009, The Carlyle Group announced that its second Japan buyout fund, which closed at JPY215.6 billion ($860 million) three years earlier, would be cut by JPY50 billion due to the sluggish post-financial crisis deal-making environment. In 2010, India-focused ChrysCapital Partners, citing limited investment opportunities over the previous year and the need to sustain an IRR of 15% or more, returned $300 million of its $1.26 billion fifth fund to investors.

A third GP has now been added to the list: India Value Fund Advisors (IVFA) has trimmed its fourth fund, which reached a final close of $725 million in 2009 after barely five months in the market, by approximately 15%. LPs were supportive of the decision (IVFA could have opted simply to extend the investment period) and have been refunded management fees on the $100 million that was returned.

As with the previous two cases, IVFA has responded to changes in the market dynamic. India's business cycle turned sharply in 2010-2011, lifting valuations significantly, but the private equity firm didn't believe the higher asking prices were justified based on the underlying economics. It held back, deploying only $100 million during the period.

Even if the environment turns significantly - unrealistic valuations are still responsible for IVFA walking away from seven deals so far in 2012 - it would be difficult to commit $625 million before the end of 2014, when the five-year investment phase comes to an end. The private equity firm decided to cut the fund size rather than move up from its $30-60 million equity check sweet spot.

Not all GPs would adopt a similar approach and that is why such decisions rarely play well in the wider market. Rival managers have to challenge the thesis or they will get phone calls from investors asking why they aren't considering a similar course of action. And the reality is that some aren't willing to forgo management fees in the interests of forging better long-term relationships with LPs.

The debate won't be settled in the newspapers or in chatter on the sidelines of conferences, but by whom LPs decide to re-up with and by how much. India is hardly flavor of the month among institutional investors. Many jumped in after being won over by the country's demographically-driven growth story but have since found themselves frustrated by a lack of strong exits.

Although the Indian economy remains fundamentally attractive, LPs are no longer throwing their money around. In this context, a disciplined manager is an attractive manager.

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• Topics
• Fundraising
• South Asia
• GPs
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• India
• India Value Fund Advisors
• GPs
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