Gatekeepers to Asian private equity

From a decade ago, when Asia had only a couple of private equity fund of funds in operation, the region has come a long way: even by conservative estimates, at least 35 funds of funds managers are active in the region today.

On the face of it, the proliferation would seem easily explained. After all, Asia is the fastest growing economic region in the world; a large number of companies are on the cusp of making the transition from being small domestic heavyweights to bigger regional, if not global players; consumption expenditures are on the rise. All of this has created immense potential for private equity investments to generate high returns.

In the circumstances, the increase in the number of funds of funds is not surprising. Many institutional investors in Asia are for the first time exploring private equity in search of returns that could potentially outstrip returns generated from more traditional asset classes. Insurance companies, financial groups and national pension schemes are all looking to diversify their portfolios which until recently were made up mainly of investments in bonds and listed equities. Simultaneously, there is also an increasing influx of capital from investors in other parts of the world who are beginning to buy into the Asian growth story and are keen to become a part of it.

“There has been an evolution in the manager universe, and the range of investment opportunities has also increased.”

Chris Meads, a Hong Kong-based partner at Pantheon Ventures, which is currently committing capital out of its fifth Asia-dedicated funds of funds, says: “When our first Asian fund was raised, Asia was a sideshow. Today investors regard Asia as a core part of their investment portfolio. The luxury of being able to ignore Asia is not available anymore.”

As a result, a multitude of fund investment teams have launched Asia-focused funds of funds in recent years. The capital they have channeled into the region has contributed to a significant increase in fund formation activity.

In recent times, Asia has seen some very large funds close. Fund sizes have multiplied by a factor of three and sometimes even four. And the number of GPs has been rising rapidly as well. Market participants estimate that there are at least 400 private equity funds in the region today.

Research conducted by SCM Strategic Capital Management, a Zurich-based investment group specialising in private equity, real estate and infrastructure, which recently opened an office in Hong Kong, shows that more than $33 billion was raised for the Asian market last year alone, a 30 percent increase over 2006. In total, 149 private equity funds were raised in Asia.

Markus Ableitinger, director and head of investment management Asia at international fund of funds manager Capital Dynamics, says: “The Asian market is on the global scene and private equity exposure in Asia has become a really important part of any global private equity portfolio. The Asian economies are still largely under-penetrated in terms of private equity as compared with the US and Europe, so there is scope for inherent growth. Finally, inefficiencies in Asian companies are usually greater, and that is attractive for private equity investors.”

Capital Dynamics has invested more than $730 million in Asia in the last three years and has started marketing an Asia-dedicated fund of funds, the group's first such product.

HUGE CHOICE
The sheer size and diversity of Asia's private equity markets is one of the main factors that explain the prevalence of funds of funds in the region. David Pierce, chief executive officer of Squadron Capital in Hong Kong: “There are now many Asian funds of funds, most created in the very recent past, with or raising large sums. It is natural to wonder: why so much money so rapidly? We see considerable demand among investors globally, who feel it is time to invest in Asia and that a fund of funds is the best way to address markets where they lack the experience, language skills and networks to select managers.”

From emerging markets such as India and China, to developed markets like Australia, Singapore and Japan, to frontier markets of the likes of Pakistan, Cambodia and the Central Asian countries, the choices available to limited partners are huge. Often, limited partners just cannot cover this diverse range of managers effectively.

Pierce says: “Our LPs are quite sophisticated. They realise that they don't have the human resources in-house to cover properly such a large and diverse part of the world. This is true even of our Asian LPs. Even LPs who normally go direct find a fund of funds managed by a large and experienced team to be the best way to access Asian private equity.”

A recent survey conducted by Epiven, a specialist private equity advisor on China, revealed just how important a role funds of funds are playing in providing access to the country's private equity market. According to the study, 66 percent of European funds of funds are committed to Chinese private equity, as compared to 33 percent of non-funds of funds limited partners. (Interestingly, 28 percent of European funds of funds even said that they would be interested in investing in China through other funds of funds. Such a strategy may help plug gaps in terms of market knowledge and penetration, but it would also result in higher fees.) Dominic McGlinchey, a managing partner at Epiven, says: “I think one advantage of funds of funds to investors is that [they] can help them resolve issues regarding transparency. Of course, it is important to work with a fund of funds that specialises in Chinese private equity and has a track record. Another route is to invest directly by working with a specialist that knows the market.”

HOMEGROWN GROUPS AND INNOVATORS
A direct result of the increasing popularity of the asset class in Asia is the emergence of local funds of funds managers investing in the region.

Firms such as Asia Alternatives, which has offices in Hong Kong, Beijing and San Francisco, and Axiom Asia Private Capital in Singapore have been active in the region for a couple of years now. Eagle Capital and IDFC Global Alternatives in Singapore, and ICICI Bank in Mumbai, are also raising funds of funds.

A key aspect drawing limited partners towards investing in private equity through local fund of funds is their knowledge of fund managers in the region. Fund of funds professionals spend a lot of time on the ground and get to know new GPs, giving them the advantage of knowing their investment teams, deal sourcing processes and investment management capabilities. For an institutional investor sitting in another part of the world, this is much harder to achieve. As such, finding an experienced fund of funds manager that specialises in the evaluation of Asian GPs and the conduct of due diligence on their funds is an attractive proposition for many.

Homegrown funds of funds that focus either on the region as a whole or on certain pockets tend to develop a deep understanding of the markets in the region, and the prospects of private equity within them. In conversations with fund of funds managers, the importance of networks, relationships and trust come to the fore time and time again. Most importantly, there is a view that there is space for homegrown fund of funds managers to compete alongside the international houses, primarily because the region offers such a wide spectrum in terms of diversity of markets and investment strategies.

As the private equity market in Asia continues to develop, a number of funds of funds concentrating on individual countries, specifically China and India, have also been created. Examples are Evolvence India, which is based in Dubai, and China-focused Jade Invest, which has offices in Beijing and Shanghai.

An untested proposition, the jury is still out on whether single-country funds of funds will be able to match the returns of more conventional fund of funds managers with a pan-regional focus over sustained periods of time. The question is whether individual markets in Asia are deep enough to sustain country-focused strategies, and it is no surprise that with China and India, it is two very large and rapidly growing economies that have attracted single-country FoFs.

Another innovative strategy now being put to the test is fund of funds offerings targeting Asia's growing private equity real estate segment. Composition Capital Partners, headquartered in Amsterdam, is among the first real estate funds of funds to set up shop in the region with an office in Hong Kong. William Shaw, director for Asia at the firm, which launched its first Asia-dedicated real estate funds of in April 2005, says that there is a “very strong growth” in the number of real estate funds in the Asia Pacific region. Tapping this growth, Composition Capital Asia Fund I closed in July 2006 on $175 million, and was fully committed by November last year. The firm is currently raising capital for a second Asia-focused product.

CONSEQUENCES OF THE DOWNTURN
Amid increasing competition for both investor capital and access to Asia's best GPs, funds of funds are working hard to position themselves for future growth. Meads says: “Our Asian investment strategy has definitely changed. From the time we raised our first Asian vehicle in 1994, we have seen the Asian financial crisis, the opening up of markets such as South Korea and the emergence of buyouts in Asia. There has been an evolution in the manager universe, and the range of investment opportunities has also increased.”

All funds of funds interviewed for this article spoke about a change in investment strategy, and the increased pace of investment in the region. They also referenced the dramatic change in financial markets sentiment that has occurred recently.

Up until last year, the stock market boom in the region, especially in India and China, provided exceptional returns to growth capital funds and other types of private equity investor who exited their portfolio companies through IPOs. Now however, stock markets have come down sharply, and the IPO window has closed. In additions, the Asian economies have shown signs of a slowdown as well, and leverage, although still available for most transactions in Asia, has become more expensive.

In short, life now seems a fair bit tougher than it did a year ago. Asia's fund of funds professionals are obviously cognisant of this change.

Meads says: “The 2003-2006 vintages for Asia are among the best performing funds of all time. I think it's going to be more challenging for the 2007 Asian vintage funds. It is unlikely we will see IRRs as high as what we saw between 2003 and 2006.”

“[The change] hasn't affected us at all really,” Ableitinger says. “The thing with funds of funds is that from an investment strategy point of view, timing the market is difficult. In distressed times when economic parameters are down, funds of these vintage years usually perform well.”

However, he adds: “In terms of the transformation of businesses that fund managers invest in, the current environment is not good. And if economic parameters continue this way for another four to five years, then exit conditions aren't going to be great either.” He says that recent funds that raised a lot of money and have invested a lot of it quickly will face challenges. But he also notes that conditions in emerging markets tend to change quite quickly, so that an overly pessimistic forecast might well be outdated before long.

One redeeming feature of Asian private equity may be that the use of leverage in regional transactions has not been as aggressive as it has been in Western markets. Pierce says that even where leverage has been used in Asia, it wasn't the sort of leverage that was common in the US and Europe prior to the credit crunch. He insists: “The impact on transactions to date has been relatively modest, more psychological than actual.”

HOLDING BACK
Nevertheless, the pace of deal-making has undoubtedly come off since last year. As Meads points out, “I think we're going into a period of slower activity. 2007 was frenetic in terms of fundraising by underlying Asian funds. This was because managers were making quick deals and also possibly because managers knew tougher times lay ahead.”

The fact that plenty of capital raised for Asian private equity remains to be invested is also a concern. “How will these managers deploy their funds?”, asks Pierce. “Some have raised more money than they initially sought and several seem to have more than they have the ability to sensibly deploy, which has led to some unwise, over-priced deals.” He adds that less experienced managers have a tendency to invest very quickly, which is always a concern for limited partners.

Even though new capital continues to be raised, it seems inevitable that private equity fund formation in Asia is going to slow down in the coming months, enabling a period of reflection and consolidation for the industry. Funds of funds with money to invest are likely to make new commitments selectively. They will also keep a close eye on their existing portfolios in the hope that the underlying funds will continue to deliver the returns that the boom-times promised.