Limited partners: limited appetite

Last year’s fundraising volumes seemed to suggest Asia-focused private equity funds were on the up and up. Emerging Asia saw a record volume of funds raised, far exceeding any other emerging region  A mighty total of $39.7 billion was committed, representing a 38 percent increase from the $28.7 billion raised in 2007, according to statistics from the Emerging Markets Private Equity Association (EMPEA).

However, the EMPEA statistics from Q1 2009 tell a different story. In fact, of all the emerging markets Emerging Asia saw the biggest percentage decline in funds raised compared to the same period last year, although it still saw the greatest share of the capital. Fourteen Asia-focused funds raised $3.3 billion in 2009, compared to the 37 funds that raised $15.5 billion in Q1 2008; a 71 percent drop in capital raised.

Certainly the fundraising travails of many – even experienced fund managers – have been apparent. In the last six to eight months, a large number of Asia-focused private equity funds have either closed short of their fundraising targets, or continued to remain in the market for far longer than anticipated. North Asia-focused buyout firm MBK Partners, for instance, closed its second fund on $1.5 billion in July, well short of its reported initial target range of $2.5 billion to $3 billion. Elsewhere, Japanese private equity firm Unison Capital, which had raised ¥120 billion ($1.27 billion) for the second close of its third fund in October, was targeting a final close on ¥200 by the end of 2008, but is still in the market at time of press.

Fundraising has, of course, primarily been impacted by the liquidity problems of many of the globe’s large institutional investors. Battling plummeting listed equities portfolios, many large LPs, especially in the US, have seen the denominator effect paralyse their ability to commit to private equity.

This fact was documented by secondaries specialist Coller Capital’s most recent Global Private Equity Barometer (see last month’s issue), which registered the most pessimistic LP outlook on the asset class since it began the series of semi-annual surveys in 2004. According to the report, about 20 percent of LPs around the world plan to reduce their target allocation to private equity in the next year and they expect to see about 10 percent of LPs default on their commitments in the coming two years, highlighting the problems confronting institutional investors globally.

There is a view in the market that LPs will put more money into Asia if they believe Asian private equity may provide better returns than Western Europe or the US. However, while the period from 2005-07 was a good one in terms of returns, there remains a question mark over the sustainability of this performance. Enrique Cuan, the head of international distribution for Merrill Lynch’s Private Equity Fundraising Group, says Asia’s performance has been a bit of a mixed bag for investors globally, with a disappointing overall performance when viewed over the last 15 years. It has been a difficult place to invest, says Cuan, and is therefore under-weighted in many investors’ portfolios: “It’s not easy to convince people that they have to be in Asia,” he states. At the moment, many Western LPs may also feel there is more merit to be found in focusing on the distressed segment in their own backyards than emerging markets with higher risk profiles.

Further reducing the volume of fundraising is the fact many of the larger private equity funds raised their capital in 2007 and 2008, and the presence of a more cautious and slower investment pace, says Reto Schwager, a partner responsible for client activities in Asia at Zug-based alternative investment manager Partners Group. This slower pace of investment is again borne out by EMPEA statistics: investments in Emerging Asia dropped 66 percent in value terms, from $9.8 billion in Q1 2008 to $3.4 million in Q1 2009.

Fewer investments and fewer exits mean less capital being distributed to limited partners. As one placement agent pointed out, fundraising will not pick up again until investments and distributions increase, because investors will only have capital to invest once their committed capital is returned to them. Right now, he says, investors do not want to commit fresh capital to managers who will then compete with other managers already in their portfolio for the same scarce deals.

Large pension funds and insurance companies are also waiting for the public markets to recover and distributions to pick up, says Markus Ableitinger, Hong Kong-based director and head of investment management in Asia at Zug-headquartered fund of funds manager Capital Dynamics. If that happens, current restraints may disappear and the “same institutions that show reservation towards investing in Asia will re-enter the market”, he adds.

For now though, with institutional investors holding back on new commitments, the primary source of capital for Asia-focused private equity is the fund of funds industry. “There are over 30 Asia-focused funds of funds that have been raised in the last three years,” says Cuan.

While other institutional investors around the globe are faced with the denominator effect, over-allocation to certain regions, a scarcity of capital and other related issues, the pool of capital managed by funds of funds is ready to go into Asian private equity now – and in fact has to go into the market.

Playing hard to get

In this inert market, LPs are being incredibly selective about the investments they do make. For example, Toshiyuki Kumara, general manager of the private equity group at Tokio Marine Asset Management, which manages two pools of capital, one on behalf of parent company Tokio Marine and Nichido Fire Insurance (TMNF), and the second, a fund of funds product that invests in the US and Europe, says TMNF’s investment activity this year will consist mainly of re-ups to existing managers and very selective new relationships.

He expects TMNF to commit less capital to private equity this year because few of its existing managers are coming back to the market in 2009. The firm has invested in two Asia-focused private equity funds year and expects to make another commitment in the near future.

Nippon Life’s allocation to Asian investments (including Japan) has traditionally been less than 10 percent. The firm wants to increase this allocation to more than 15 percent, whilst being selective in its choice of managers. “We want to increase this percentage based on the thesis that we will see more attractive investment opportunities in Asia, especially those that harness growth in the region,” Sadanaga says.

Ableitinger says many investors with exposure to Asian private equity now acknowledge it is increasingly difficult to pick good fund managers in the region. As such, a flight to quality can be witnessed. Investors who continue to have an appetite for Asia and remain averse to risk are on the lookout for fund managers with experience. Consequently, for most of those managers without experience, things look pretty bleak.

“I would not want to be a first time fund manager in this environment,” one placement agent says, while Hideya Sadanaga, deputy general manager of the alternative investments division of Tokyo-based Nippon Life Insurance Company, states the best option for first time funds might be to be happy with the capital they’ve already managed to raise.

Also unpopular with LPs at the moment are the large pan-regional buyout funds. In the midst of a credit freeze – and therefore in effect a freeze on large deals – LPs say they are reluctant to commit to the strategy. Kumura, for instance, says that regional LBO funds have not been successful enough for his firm to want to invest in them.

Investing in growth capital is at the top of the agenda for most LPs, and the markets drawing the most attention are, unsurprisingly, China and India. Q1 2009 statistics from EMPEA show that of the $3.3 billion raised for Emerging Asia, $2.3 billion of this was destined for China – although this was slightly skewed by the $1.2 billion Shanghai Financial Industrial Fund – and $315 million was raised for India.

Precisely because of the level of interest in China, Ableitinger voices concern there is too much money targeting the market, and says Capital Dynamics is “very careful selecting managers there”.

India still poses questions for many investors. Although some investors really like the market, Ableitinger says others are more reluctant to invest there because of its poor infrastructure; the greater correlation between private equity and the public markets in India than in other markets; the fact that most GPs are corporate- or bank-affiliated; and finally, because investors think there will be more growth in China than in India.

Sadanaga says that since Nippon Life works from a Japanese balance sheet, Japan is the place it wants to be provided it can earn similar returns to elsewhere. The problem in Japan, in his opinion, is that there are not many GPs they would be comfortable working with, and that “Japan has had in place explicit and implicit obstacles that undermine private equity investment, making it less attractive for many managers to do deals here”. These include the ‘Shinsei tax’ (which was revoked earlier this year), a tax on capital gains made by private equity firms; a general cultural lack of acceptance and apprehension of Western-styled investing; the reluctance of large Japanese corporations to deal with foreign buyout shops; and a low tolerance for what is seen as “employee-unfriendly” behaviour in the country. However, he adds Japan has been an under-exploited private equity market and “corporate Japan’s back is pinned to the wall in many respects”.

Investors also view South Korea as a favourable investment destination. Schwager, for instance, says that from an investment point of view, Partners Group believes the current economic crisis in the country and the depreciation of the Korean Won present investors with a great opportunity to invest in Korea as entry multiples there are inexpensive.

There is consensus that the most important determinant for fundraising is the level of investment activity and the realisation of gains. Schwager says that a recent deal could bring some much needed good news: global buyout firm TPG’s exit from Shenzhen Development Bank. The deal is expected to fetch TPG somewhere between five to six times cost, which, says Schwager, is great news for private equity and great news for Asia. In generating a great IRR for one firm, it will hopefully stimulate an appetite for private equity among investors.

Placing Asia

The role placement agents have played in the Asian private equity industry has often gone unnoticed. When most Asian fund managers set out to raise their first funds, they were pitted against the odds. Not only were they inexperienced, they were also attempting to raise capital for a region very few (Western) institutional investors had exposure to or knew enough about.

As LPs have gained experience of investing in Asia, and the number of funds in the region has proliferated, the role of the placement agent has changed.

“When I was helping place an Indian fund in 2003, I had to explain why people should invest in India, why they should invest in India through private equity, and why they should invest in India at that time,” says Guy Eugene, managing partner at Verbier, Switzerland-based placement agent Legacy Finance.

“Now when you are helping raise a fund in India, LPs ask why they should be investing in one fund as opposed to another,” he says.

Eugene, who has helped place funds managed by leading Indian managers such as ICICI Venture and India Value Fund, says some LPs today are confused because there are so many funds in the market. As a consequence, managers are constantly grappling for the attention of potential LPs, who often receive between 30 and 50 PPMs a month.

The downturn has also added weight to the placement agents’ business case. According to Enrique Cuan, the head of international distribution for Merrill Lynch’s Private Equity Fundraising Group, the value of an agent is more compelling in this environment, “not only from a fundraising perspective, but also in helping managers build their brand”.

He says there is a lot of interest from Asian funds. “Many groups which thought they didn’t need an agent are now calling on us,” he says, adding that having a placement agent “gives people the comfort they need in an environment they haven’t lived in before”.