LPs push for value creation in Asia

Value creation may not necessarily be at the top of LPs’ wish-lists in Asia, but it’s starting to have an increasing influence on capital commitments to funds, writes Drew Wilson

“Value-add” – like “proprietary deal” and “top quartile” – is one of those hackneyed phrases that every firm in Asia likes to use for marketing purposes, but very few can actually back up.

“If you go by what people say, there’s an enormous amount of value-added work being done by GPs in Asia today,” says Doug Coulter, head of Asian private equity at LGT Capital Partners. “The unfortunate reality is, there’s relatively little being done.”

Some firms in the region do focus on operational value creation, i.e. working with a company to boost top and bottom line growth – PEI’s Operational Excellence Awards last year honoured the work of four Asia-based investments transformed by Headland Capital Partners, Hony Capital, Kohlberg Kravis Roberts and the Blackstone Group, while several industry sources also cited Bain Capital’s operational work as a standout. But the region still does not have enough GPs that can provide consistent and meaningful value creation. 

However, the maturing of economies and industries in Asia is creating a new reality in which operational change is being elevated to a higher level of importance, LP sources say. 

For example, listing candidates in the frozen IPO pipelines of China and India now have to show verifiable performance data to regulators and margin growth to investors. And as GDP growth slows in those markets, the wind is no longer blowing strong enough to make turkeys fly. Smart entrepreneur/owners focus tightly on business efficiency to bolster competitive advantage and thrive in a more difficult market. 

Private equity firms with operational expertise can play a key role here – and this is an argument that resonates with both entrepreneurs and limited partners. 

ACTIVISTS WANTED

“Entrepreneurs are looking for ways to transform their businesses,” says an LP at a US pension fund who spends time in China evaluating GPs. “They have a brand and want to learn how to run it. Even though the business can be cash generative and it doesn’t need capital, they want to bring in help.”

Equally, LPs are looking for sustainable returns – and investors are now more skeptical about the prospects of multiple arbitrage plays, which have been popular in China and India, because of their dependence on fickle public markets.

“When someone comes to us and pitches their fund, we would prefer it if they shared some examples of operational work they’ve done to increase the value of the company and make it more efficient,” says a source at one of Asia’s largest indigenous institutional investment firms, who requested anonymity. “Ideally we prefer an active manager with past experience improving a company.”

Steve Cowan, managing director of 57 Stars (formerly known as PCGI), which invests in private equity partnerships and does co-investments in emerging markets, agrees: “Operational improvement is a critical component of the value equation we look for in the GPs to whom we commit.”

If the fund is sector-focused, LP expectations on the operational side rise, adds David Nieuwendijk, senior investment officer at Netherlands-based development bank FMO. He says the bank would actually turn down an investment if it was clear the GP could not add value to portfolio companies.

“[Value creation] is how we have to defend our investment proposal internally. The committee asks, `How do you see the exit and where is the value creation coming from?’ The market may be growing, but a GP can also do a lot internally by changing management and cost-cutting. If that wouldn’t be the case, we wouldn’t invest in the company.”

There are many different ways for Asian GPs to create genuine value, sources point out. It may mean helping to recruit professional management. It may mean developing best practices in the supply chain. Or it may even just mean improving a company’s accounting practices so that it can go public (something that’s particularly important in China). 

“There are still opportunities in Asia where you can come in and do some basic help such as governance improvements,” says Coulter. “Ex-bankers can work on capital structure to improve profitability. You don’t necessarily have to go in and execute a 180-day plan.” 

In some cases, the most important value-added work may be bringing in international connections, says PEI’s US LP source. “The call for more operational intervention comes from the fact that capital markets [in China and India] are nearly shut down and investors see the need for alternative exit routes. To facilitate a trade sale, a global industry network is important in knowing the potential buyers’ names. That’s a handy value-add capability.”

INSIDE THE TENT

LPs also look at whether the value creation work is done in-house or outsourced. 
Coulter says that it’s better if team members have operational expertise and can go in and work with management, because that builds institutional knowledge. “We’d rather back a GP that is doing as much of the in-house work internally as possible. The knowledge can be useful in the next deal.”

But while an in-house team is preferable, it’s probably not realistic to expect smaller managers with a relatively modest AUM to have senior seasoned operating partners on the budget, he adds.

In Asia, operational input is also shaped by private equity’s dominant deal structure: minority stakes. If the GP is a minority investor, the entrepreneur, who is typically used to relying on his own judgment, may not welcome unsolicited advice.

However, Headland Capital (Asia’s overall winner in PEI’s Operational Excellence Awards last year) proved minority doesn’t necessarily mean passive. With a minority stake in China’s Yonghui Superstores, the firm was able to drive Yonghui’s expansion – from 58 stores in 2007 to 204 in 2011 – and leverage increased scale, striking better supply deals as the company moved into new Chinese markets. During the holding period, Yonghui experienced sales growth of 48 percent and EBITDA growth of 47 percent. 

Cowan accepts that a controlling stake is the best deal structure to promote value added work. However: “Certainly it’s possible to add value when you have a minority stake. And we do see situations where a minority investor is heavily involved in adding value to the business in which they are invested. It’s something we’re intensively focused on when we are considering investment opportunities.”

The US LP source adds: “A fundamental skill set for a minority investor will be living up to the art of being influential.”
One corollary of this is that as more control deals emerge in Asia, LPs expectations for operational work will rise. “If we consider an investment opportunity for a control buyout fund, we always think about whether they can add value for the company. It’s a key issue for us,” says Tomohiko Komada, head of private equity at Sumitomo Mitsui Trust. 

For majority shareholders, sources say, sector specialisation is crucial as industries in Asia grow more sophisticated, and that ratchets up the pressure for industry experts with the sort of insider skills to grow portfolio companies.

GPs have typically focused on broad industry themes, says the US LP source. But the size, scale and sophistication of some sectors in Asia today (the financial services industry in China, for example) means there’s a requirement for some specific expertise – i.e. knowing the key performance indicators in different industries and adjusting those indicators in different markets.

“Not everyone has those skill-sets. A lot of investors are still investing based on themes rather than a thorough understanding of the very basics of the business,” the US LP source says. “Sometimes LPs are more attuned to basics than some venture or growth equity investors, in China in particular. LPs from Canada, for example, know the energy sector very well, in some cases even better than the emerging market energy and mining managers.”

HARD QUESTIONS

The good news is that verifying claims of value creation contained in a fund’s marketing book is usually not too difficult, sources say. Probing with specific questions is a standard part of the due diligence process, and LPs have become good at it.

“If somebody is relatively junior and spent most of their career at an investment bank and are claiming they roll up their sleeves to help the company, you can poke holes in that pretty quickly,” Coulter says. “The number of people with deep operating experience who are partners at private equity firms is relatively small. Many GPs in Asia come from the financial services industry. They may be smart and talented at what they do, but may not understand company operations.”

All sources interviewed said they would supplement the GP’s claims by speaking to the entrepreneurs of exited companies as well as LPs from previous funds. 

SumiTrust first checks the financials against the claims, then discusses the GP’s value creation capability with existing investors and considers whether their explanation is consistent, says Komada. He also looks at a GP’s case studies and tries to generalise the approach. “We ask: is there a fundamental approach across the case studies that could be duplicated?”

Reporting is another matter. It varies by GP. Fund managers are typically not required to report on the operational aspects of their investments, and many GPs don’t. Some share experiences in annual meetings, highlighting how much value they added and how their contribution can be tangibly measured or translated into operating metrics, sources say. But most reporting tends to focus on the portfolio company’s financial metrics, without much extra detail. 

As Cowan puts it: “The challenge with reporting is that it doesn’t necessarily capture the essence of the questions you’re focused on, such as how was value created and who were the essential contributors to that creation?” 
Information on value creation needs to be collected more informally, which usually involves spending time at the company. Co-investment can be particularly useful in this regard. “If we’re already invested, we want to stay close to the portfolio,” says Coulter. “That’s why LPs like doing co-investments. It gets us closer to the portfolio companies and we can better assess management.”

Additionally, several LP sources say they focus on what actions the GP may have taken to fix a business when, say, the macro-environment slowed. “Particularly if things are not going well, a GP has to be hands-on and assist the company in making decisions,” Nieuwendijk says.

NOT THE ONLY MODEL

LP sources insist they don’t want GPs to fit a particular mould; they just want them to excel in their own right. After all, there are enough examples of funds in Asia that have delivered good returns while doing very little value creation, Coulter says. “If you’re not doing it, it doesn’t necessarily mean you’re not going to get our capital. The most important thing is: are you delivering good risk-adjusted returns to your LPs?”

But delivering those returns in the new environment of slower GDP growth and tougher competition is pressuring many GPs to examine what value they can offer to entrepreneurs. Jon-Erik Salata, founding partner of Baring Asia, said in a previous interview with PEI that value creation would be essential to generating desired returns in Asia over the next decade.

What’s more, says 57 Stars’ Cowan, as private equity matures across emerging markets and passive deals fade, “GPs that have the ability to create value in their investments are going to have a competitive advantage”. ?

A CULTURE THING

Developing in-house operational expertise involves a complete change of approach, sources say
A private equity firm aiming to add operational expertise must first develop a culture of involvement with portfolio companies, according to two firms that have been active in value creation for more than a decade in Asia. 
Shanghai-based Lunar Capital devoted years to culture and processes and only then added the people who naturally fitted in to that environment, explains Derek Sulger, managing partner.

Over time, the firm developed specific processes that are now applied to all investments. For example, Lunar has codified stages at many intervals pre-deal and during the holding period, which gives the team a framework for operational engagement. 

Lunar’s core team is 35 professionals, half of whom are full-time operations people.
“There’s a misguided view that you can hire someone, call them an operations person and your investment team can start shoving problems onto their desk,” says Sulger. “It’s a very reactive approach and in China it will likely fail, particularly because most investments are minority stakes. And the guy you hired for head of operations becomes a solver of impossible-to-solve tasks because he has little control or authority with company.”

Hong Kong-based Unitas Capital, which has several partners with operational experience on its team of 23 professionals, has a similar approach. “Throughout the firm, everybody here believes they’re a part of building and transforming businesses,” says John Lewis, chief executive.

Unitas is focused exclusively on industrial, consumer and retail sectors, and all operational professionals come from those industries. “They’re fully integrated with the rest of the team so we don’t distinguish between guys that come from deal or operational backgrounds. We’re all partners and everyone has carry across the fund. Operating guys work on deals from origination through to exit.”

Several operating partners were former CEOs, which Lewis says brings credibility with management teams. “They have been in that seat before, so they understand what the CEO is going through. They have a network of relationships, understanding of ownership of profit and loss and often experience making acquisitions.” 

A down-to-earth approach is also crucial, he says. “Rather than sitting on a throne and making pronouncements, people want to roll up their sleeves and walk the factory floor and examine detailed financial statements. We find that just makes management teams much more open to actually listening to them and working in partnership with them.”

Both firms use outside consultants, but only for targeted projects. “Bringing in outside consultants can work to analyse a very specific situation, but they can’t go in and add value on your behalf,” Sulger says.