Caution: Lower returns ahead?

Out of 151 LPs polled, 77% expected 16%+ annual returns near-term, and 17% were banking on 25%+ net returns in the next three to five years.

AVCJ was launched some 20+ years ago as a platform to promote and project Asia Pacific private equity, so it’s always hard to rain on the industry’s parade. Nonetheless, feedback from investors and advisors alike suggests that those expectations are going to have to be disappointed – even if this is for the ultimate good of the industry.

This is not to discount Asia’s recent performance. As sources observe, the region has broadly outperformed Europe and the US in realizations through the hard times of 2009, paying back investors comparatively well. Concurrently, deal volume dropped off significantly less than in Western markets. Both these factors, plus the inherent macro growth story in the region, should be enough in themselves to keep LPs keen on Asia Pacific. In fact, AVCJ’s sources posit an industry-wide rebalancing towards something like a 25% allocation to Asia Pacific in private equity portfolios – well up on the single-digit norms of the past.

However, the increasing weight of investor interest – and money – coming in to the region is in itself likely to depress returns. Industry sources continue to emphasize the shortage of quality GPs to absorb all that capital, meaning that some LPs are inevitably going to make sub-optimal allocations and receive sub-optimal returns. Furthermore, even the solid realizations of 2009 saw lower multiples, closer to 2x money than 3x money, with returns heading more towards standard international levels. Also, the rebound in public markets has meant that GPs are facing valuation challenges on deals, with the inherent growth already factored in at entry. Essentially, the market knows its value, and expects people to pay for it.

None of this should put LPs off investing in the region. Asia ultimately has the capacity to absorb far more private equity capital than it does now. And the GFC has shown the benefits of strong geographical diversification, with pre-crisis exposure to Asia reaping dividends for the investors smart and lucky enough to be out here in the first place. But LPs may have to learn to accept that they will no longer be able to get wild frontier-style premium returns from the region.

Some LPs may ask: What about our risk-adjusted returns, and the premium we expect for taking the risk of investing in a new market? Well, as other sources point out, returns are an objective measure, but risk is entirely subjective. The adjustment any investor makes to account for risk is both individual and heavily conditioned by that investor’s capabilities. Asian investors, for instance, just do not need to account so far for risk, since they presumably have the market knowledge and local ties to help mitigate their risks. And international LPs are often paying a risk premium, not so much for the immaturity of the market, as for their distance from, and ignorance of, it.

Relative risk/return ratios in any case have been largely overturned post the GFC. As the infrastructure article in this week’s issue explains, some of the most accepted investment models developed in the West have turned out to have inbuilt flaws that reduce returns over the long term. So global LPs would be wise to think globally and hope realistically – for good returns from an increasingly mature market, rather than outstanding returns from a flaky and immature one. Part of the price of growing up.

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• Performance
• LPs
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