Emerging markets embracing value-add approach

A Hong Kong-based limited partner recently highlighted a “kind of evolution” among Indian private equity GPs: the recruitment of operating partners.

Mumbai-headquartered Blue River Capital, currently in the market with its second fund, and Mumbai- and Silicon Valley-based Nexus Venture Partners, which has two funds under its belt, are among the firms that have appointed operating partners in the past year. But they aren’t alone.

Vikram Raju, a senior global funds specialist at the International Finance Corporation (IFC), recently put it: “It’s rare that we come across a new fund in India without an ‘operating partner’ type of person.”

In China meanwhile, a similar trend is developing. One Beijing-based management consultant told sister publication PE Asia that throughout 2010 he saw a steady stream of local GPs come to him for advice on how to add operational expertise.

In markets where almost all private equity activity tends to fall under the broad banner of “growth”, it is not always easy to read an industry-wide shift in strategy behind the structural changes taking place at the individual GP level.

Nonetheless, this is exactly what appears to be going on: growth capital is growing up. Or, as Raju puts it: “Among the larger firms, the smart ones have been re-configuring their skill sets to ensure they are positioned for strong performance in a changing landscape.”

For GPs in China and India, one of the “changes in landscape” he referred to was simply the level of competition. Estimates put the number of self-labelled private equity funds in China at around 1,000 and in India at 400 to 600 – with new entrants sprouting up all the time.

In February, for example, Reuters reported that the China Securities Regulatory Commission was planning to allow asset management arms of select brokerages to enter private equity as early as this year. In India and China meanwhile, the constant stream of “spin-outs” seen has meant the market is flooded with first-time funds, all of which are seeking to build a franchise.

Compounding the need to stand out in an increasingly crowded market is the fact that, according to LPs, many of Asia’s well-known GPs fell into private equity almost accidentally, building their reputation and track records through a hybrid mix of medium-term private and public investments, early mover advantage and the luck of being in the right place at the right time. As that early mover advantage fades – and with it the window of opportunity that built their track record – they have realised they will need to change tack to stay in the game.

“There are funds that have made it past levels 1 and 2 and have been able to raise a lot of money now. Their challenge is generating the same kind of returns – under very different circumstances – that made them successful in the first place,” states Raju.

One such window of opportunity that will “eventually go away” is the pre-IPO play in China, says Vincent Huang, a Hong Kong-based partner at Pantheon Ventures.

“At that time, we will see the focus on building companies becoming popular again,” he says, although he adds the trend towards a greater value-add model has been seen before, when “the window for USD funds to invest into offshore companies and then list them overseas started to narrow” three to four years ago.

“When the A-share market opened up, people forgot about adding value and started playing the new game,” he notes.

Survival of the fittest

Looking ahead, Pantheon’s Huang predicts that in key Asian markets we are heading towards a survival of the fittest scenario.

“The more established GPs are likely to be more operationally focused. Some GPs will disappear, the survivors will be the ones that have the foresight to build operational capability when they don’t have to,” he says.

However, with both China and India still growing apace and attracting the attentions – and capital – of increasing numbers of LPs, that day of reckoning may still be some time off.

In the meantime, a final incentive for growth-focused GPs to up their game and move to a more traditional, longer-term and operationally hands-on approach to private equity has been LP pressure.

As Menka Sajnani, a Hong Kong-based vice president for Asian Private Equity at Auda Alternative Investments, puts it: “Three years ago many first-time funds raised money without some box-checking elements. But LPs have more expectations today – they are asking whether GPs have delivered.”

When LPs talk about “delivering”, they want to see that managers capable of producing “alpha” – or more specifically, outperformance due to real value creation at the portfolio company level as opposed to returns that were derived from financial engineering or a bull market.

“In the last four to five years there has been a significant bull run – it’s actually hard to find any one investor in the last five years who didn’t do well. You tend then to look at track records – have they just been lucky enough to ride the wave? Or did they do something specific to add value?” asks Sebastiaan van den Berg, a Hong Kong-based principal at fund of funds investor HarbourVest Partners.

Sometimes, the returns and value-add might be there, but there may still be question marks over the sustainability of the GP’s strategy going forward, says Pantheon’s Huang.

“In the China context, getting an IPO for a company is a major value-add which solves the bottleneck issue,” he says, adding that the average return on private equity- and VC-backed IPOs in the A-share market has been an astronomical 10x.

However, he cautions, “LPs shouldn’t just be looking at the returns numbers. The question is, is this repeatable? How do LPs evaluate whether it’s sustainable?”

As van den Berg and Huang make clear, LPs have their work cut out evaluating the strategies and track records of GPs. And with so much of the impetus for forward momentum and greater maturity coming from LPs themselves, there is a certain amount of scepticism at this point as to the real extent of the GP buy-in to any changes in strategy.

“The GP community has cottoned on to discussing their operational value-add and earnings improvements – very few people now present themselves as opportunistic multiple expansion seekers even if some of them earned their early successes that way,” states IFC's Raju.

“A quintessential quality in a good GP is the ability to step in and turn things around in a portfolio company and control outcomes when needed. I don’t see as much of this as I would like,” Raju adds.

He is seconded by Sajnani, who notes that in the case of Indian firms, she asks to understand their need for operating partners and how they plan to implement such a strategy “in the most tangible way”.

“GPs are becoming more sophisticated at investing, but also at marketing,” she notes.

As such, while the trend towards greater value-add is undoubtedly welcome and positive for the long-term future of growth capital investment, you are unlikely to find LPs accepting it at face value. In fact, GPs will need to prove that the focus on operational value-add continues long after the fundraising road-show has ended and the investment cycle has begun.