Analysis: Flight to (poorer) quality

Asia is more popular than ever with LPs, but many only want to invest with a small number of proven ‘quality’ GPs. What does this mean for fund sizes and performance in the region?

Asia’s quick bounce-back from the global financial crisis has ensured its place on the allocation wish list of global LPs.

April’s Emerging markets private equity survey 2010 from Coller Capital and the Emerging Markets Private Equity Association, for example, found the percentage of LPs planning to either begin or increase investment in China, India and other emerging Asian markets was 53 percent, 40 percent, and 34 percent respectively. This compares to the 6 percent each of respondents who planned to decrease commitments to India and China, and the 4 percent who planned to lessen their commitments to other emerging Asian markets.

Despite continuing institutional constraints that mean these plans have in many cases yet to translate into action, it is clear more private equity money is targeting select parts of the Asian region than ever before. So much so that Enrique Cuan, managing partner at London-based placement firm Mercury Capital Advisors, worries there may not be enough quality managers to “absorb the wave of capital that will inevitably flow into the region” over the coming years.

The flight to quality has already been reflected in some of the fundraising stories to come out of Asia in the past months. While on the one hand, a number of fund managers have been compelled to re-evaluate the sizes of their funds and lower their targets; on the other hand, there have been several cases of funds being oversubscribed.

These include China-focused CDH Investments, which received subscriptions greatly in excess of its $1.4 billion hard cap for CDH Fund IV and could, according to one source, have raised twice the amount; Capital Today, which was targeting $300 million for its second fund and closed on $400 million; CITIC Capital, which closed CITIC Capital China Partners II on $925 million, easily exceeding its $750 million target; and India’s Ascent Capital, which was oversubscribed but closed on its $350 million target as LPs believed that to be optimal fund size for the Indian growth capital segment.

It is a situation that could potentially widen the gulf between established managers and those that are in the market to raise either their maiden or second funds. However, it could also be a situation detrimental to the proven “quality” managers themselves.

Hugh Dyus, Hong Kong-based head of Asian private equity at fund of funds manager Macquarie Funds Group, points out there is a tendency in the private equity media to define success in terms of fundraising, although investment success is what matters to LPs.

In his view, there could well be an inverse correlation between the two factors. “If you have a good investment track record, it helps in fundraising. But often, fund managers push the envelope too far and raise too much money, to the point where their investment performance is undermined by the size of the funds they need to deploy,” he says. As a result, GPs may end up with poor investment performance because their fundraising was too successful.

Market chatter suggests this may be what is happening in the pan-Asian buyout industry, for which several multi-billion dollar funds were raised just before the onset of the financial crisis.

Though there are many who voice skepticism about the ability of these funds to first successfully deploy all of their dry powder, and second generate decent returns from these investments, it is too soon to judge. It will also be some time yet before we can gauge properly the appetite LPs have for large pan-Asian buyout funds going forward, as there are very few in the market today.

Christopher Yang, general partner and China-head for Boston-based gatekeeper Grove Street Advisors, agrees there are drawbacks to larger fund sizes, saying the larger the funds become, the more you tend to see experienced managers competing for a smaller set of opportunities. On the other hand, he adds, while smaller funds can obviously generate higher returns, there is a need to consider the risk-return tradeoff.

“I don’t think there is necessarily an optimal fund size in Asia, but there needs to be a balance between experienced teams and fund sizes,” he says.

With the rapid rise in popularity of certain Asian regions, like China and India, it seems that balance is in danger of being lost and with it, the potential for standout returns.

This article is an excerpt of a longer feature on Asian fundraising, which appears in the September edition sister magazine PEI Asia.