Rising to the challenges

Accessing the huge growth story that is Chinese private equity is not an easy task. Mind you, committing to Europe- and US-based funds is not getting any easier, according to one influential European LP.

When Danish pension fund ATP – which has always been coy about the size of its assets under management – began committing capital to private equity funds in 2002, it instantly become one of Europe’s largest investors in private equity. Nowadays through its subsidiary fund of funds platform ATP Private Equity Partners it commits around €500 million to private equity managers per year.

“We developed our portfolio of GPs internationally from the outset,” Klaus Bjørn Rühne, a partner at ATP PEP, tells PEI over a breakfast meeting in early June. He is referring to the fact that to generate the best returns for his group’s sole financial sponsor, ATP PEP sought out the best managers with the best track records, leaving it with a fairly even split between US and European GPs.

But the ability to build a global portfolio of private equity relationships may soon be stunted for European limited partners. If and when the EU’s Directive on Alternative Investment Fund Managers becomes law, which is expected to be confirmed in July, managers based outside the EU will find it much more difficult – and in some cases impossible – to raise money from European institutions.

FORTRESS EUROPE

Rühne is unequivocal in his criticism of the directive. “If European LPs cannot address GPs on a global scale it will be very harmful for pension funds in Europe,” he says. If GPs based in the US were to require a “passport” to market their funds in the EU (“hopefully this will not happen”, says Rühne), then you could argue the best GPs in the states would just jump over “Fortress Europe” and find their money in Middle East and Asia, he says.

Many of the flaws in the AIFM Directive, Rühne continues, stem from the fact that its main objective is “investor protection”, when sophisticated institutional investors are quite capable of protecting themselves. “It is amazing that a directive is being formed that does not see the GP and LP as partners,” he says. “It is being created as if GPs have to market themselves to LPs. Our experience tells us that we seek each other; we proactively seek GPs and they seek us. We are here as professional investors, and we should be able to take care of ourselves as professional investors.”

Rühne’s focus on pending regulatory threats is driven by more than just a sense of responsibility as a member of the European LP community. In his new position as chairman of the LP platform at the European Private Equity & Venture Capital Association, he – along with several European peers – is tasked with giving LPs a unified voice and getting it heard on matters such as the Directive.

The newly formed platform is due to convene for the first time in early July in order to finalise an agenda – or “action plan” – for the group. To date this has been relatively reactive, driven by the need to mobilise the “LP voice” to add weight to the debate around proposed new legislation. Arguably, this voice was not mobilised early enough to really steer the debate on AIFM, but there are numerous other matters for the platform to focus on.

RETURNS AT RISK

Pending rules governing how expensive it is for banks and insurance companies to hold private equity interests risk squeezing out two of continental Europe’s most active groups of LPs. Solvency II, risk-focused legislation which is designed to prevent insurance companies carrying too many “risky” assets, and Basel III, which applies similar objectives to the banking sector, have not yet received the same attention as the AIFM directive, but represent a significant headache for many investors. “The LP community is telling us that the Solvency II directive is a very hot topic,” says Rühne. “The point of course is that if you are an insurance company, you are more cautious about investing in private equity right now because of the uncertainty.”

To address these issues EVCA set up a risk management working group at the beginning of the year. It is currently finalising the first draft of some risk management guidelines before starting a consultation process with various stakeholders. “Risk profiles and benchmarking are very poorly understood areas,” says Rühne. “This is a real concern for pension funds and insurance companies wishing to make private equity commitments today.”

There is room on EVCA’s seven-strong LP platform for two more members, says Rühne, adding that it still needs a family office as these represent a “very important element of the LP base in Europe”. Among the current members are Pantheon Ventures, Greenpark Capital and the European Investment Fund. There are no solely US members – although Rühne says their interests on matters such as “passporting” rules are well represented on the panel by the likes of HarbourVest Partners, which has strong US links.

Rühne describes the platform as the first LP working group set up within a predominantly GP-focused organisation. This gives it a valuable perspective when tackling another of its major agenda items: the creation of a set of LP-orientated best practice guidelines.

DEFINING BEST PRACTICE

Like the Institutional Limited Partners Association “Private Equity Principles” launched last year, EVCA’s guidelines will chart best practices for LPs across a broad range of topics, although these topics are as yet still “fluid”, an EVCA spokesman tells PEI.

When ILPA launched its guidelines on terms and conditions for private equity funds, the reaction from GPs was mixed. Some offered full and public support, while others outwardly criticised the guidelines as representing LP collusion. A report from Switzerland-based investment consultant Strategic Capital Management concluded that the guidelines were too numerous and too prescriptive. “It’s very valuable, but LPs run the risk of being too detailed, and by doing so they’re watering down the impact,” said Stefan Hepp, a partner with SCM, at the time.

EVCA has already “reached out” to ILPA in developing its guidelines, says Rühne, but the EVCA guidelines will most likely take a more “middle road” approach to fund terms than ILPA’s guidelines, reflecting EVCA’s mix of LP and GP members.

“ILPA is a pure pension fund-oriented LP platform and they have produced some very interesting guidelines that in many regards make sense,” he says. “It would be fair to say, however, that there can be discussions around some of these guidelines to find a middle road more collaboratively.”

ILPA’s membership comprises 220 of the most influential private equity investors in the world, controlling around $1 trillion in private equity commitments.

“We have a lot of sympathy for the ILPA guidelines. Given that we as an LP platform are partners with the GPs in EVCA, we want to form a view together with the GPs so that guidelines make sense for all involved.” Rühne declines to go into potential areas of difference with ILPA on guidelines, as the EVCA platform has yet to formally discuss them.

EASTERN EYE-OPENING

When asked to remove his EVCA hat and discuss the world as he sees it through the lens of an established private equity investor, Rühne shifts his focus away from Europe to the emerging markets. For while ATP has built up its track record for the most part through its commitments to Europe- and US-focused managers, the appeal of the Chinese growth story is too much to resist.

Rühne describes his first trip to China 18 months ago as “an unbelievable eye-opener”, comparable to spending time in India two years ago. “You can understand why the more competitive LPs have opened offices in Hong Kong. Private equity has to some extent been institutionalised very quickly.”

A permanent ATP office in Asia is, however, not currently on the agenda, but “things change fast”.  In 2007 the group opened an office in New York to better access and monitor the US market, “so you never know”, mulls Rühne.

While Rühne won’t be moving his family to Beijing any time soon, he is sold on the “fantastic” macro drivers and “good growth stories” of the Chinese market. An appreciation of the Tiger economies no doubt has a bearing on ATP’s decision to double its exposure to the emerging markets to 10 percent up from 5 percent when it raises its next fund later this year.

ATP PEP has recently committed to funds in Latin America and India, but accessing the Chinese growth story is proving a little more complicated. Corporate governance concerns make it “very difficult to see through whether set-ups are real or not,” says Rühne. “From a due diligence perspective you need to feel you have full transparency, even from a language perspective. From the top it looks great, but when you get down, it can be a difficult process.”

REVISING THE APPROACH

Such barriers have pushed ATP to consider accessing the region via funds of funds. Such a move would break ground for the group as it has never done so before. “That’s why we opened in New York,” says Rühne, “Because we feel we can do it best ourselves. We have done secondary funds and secondary investments ourselves. But for Asia there is still discussion about whether we should do it ourselves or use funds of funds.”

Rühne elaborates that if ATP does go down the fund of funds route, it would seek to leverage the relationship with the manager, getting full access to due diligence processes and making primary commitments alongside the fund of funds manager. “We’re looking at it but haven’t made a decision.”

The desire to tap into China’s growth puts ATP PEP in a boat with many other private equity investors around the world. This raises the question of whether too much money poured into the country’s private equity market will create a bubble and produce disappointing returns. “Of course I am somewhat worried,” responds Rühne, who allays fears by comparing it to the US market, which has for many years been home to “lots of money” and a competitive private equity landscape. “Our history has shown that if you find the best managers you can outperform. And we think either on our own or with a fund of funds we can do the same in China.”