Standard PE fund model `unworkable' in Asia

Hong Kong-based EXS Capital is a firm without a fund. It raises capital from institutional LPs, family offices and wealthy individuals, but on a deal-by-deal basis.

That means it doesn’t have to hit the fundraising trail and is not under time pressure to exit investments – i.e. “to sell winners too early”, as chief executive officer Eric Solberg puts it.

By raising capital per deal, EXS is able to match the right type of capital – in terms of duration, risk and return expectation – to the right investor, he says. So the transaction is more like a long-term business investment than a three- to five-year private equity deal.

“We get in earlier and get involved deeper with a smaller number of transactions than a standard closed end fund.” As a result, the value-added work “is far beyond what most private equity firms do”, he insists.

The firm has led $300 million worth of transactions since inception – and Solberg says every deal has made money for both the investors and management team. “That’s relatively unusual, and our different business model with clean incentives and alignment of interest is driving it.”

In Asia’s volatile environment, Solberg believes the standard private equity closed-end fund is unworkable.

He points to data over a 20-year period showing the wild swings of Hong Kong’s Heng Seng index versus the comparatively flat Dow Jones. The volatility means a typical firm raises money in rising markets; then there’s a strong incentive to put that money to work quickly, which likely means investing at the top of the market; and the environment influences exit decisions.

“Asia is so volatile that by the time you’ve identified what opportunity set you’ve focused on, put together a team and proposal, hit the road, found an anchor and raised initial money, the environment has changed significantly. What’s mattered in Asia is not just skills, but overwhelmingly, timing.”

For all these reasons, the survival rate of GPs in Asia has been much lower than people think. Solberg argues that although private equity funds have been in Asia since the early 1990s (albeit the first one, he suggests, was in 1974), only a small percentage are past their third fund – a typical marker of an institutional-grade firm.

Solberg further claims that LPs and sovereign wealth funds in Asia are finding this out as they increasingly make deal-by-deal direct investments in the region.

So does the market agree? Fund formation lawyers say they hear talk – but they’re not seeing client demand.

Longer-life vehicles have historically been used for infrastructure funds, which have a far longer holding period than common growth capital funds. Likewise, hybrid funds have emerged – but in vehicles that have a debt element to the strategy.

Classic buyout funds, however, aren’t coming under pressure to change their fund structure, according to one fund formation lawyer in Hong Kong.

One reason is the ability to tweak standard funds, says another. “Volatility has already been factored into closed-end fund structures through extension mechanisms on capital investment and overall fund life.”

Another challenge is institutional resistance to change. In 2011, EXS went on the road to raise an evergreen private equity fund. Even though investors liked the vehicle and particularly the logic underpinning it, Solberg was unable to convince conservative LPs to invest.

“There are few evergreen funds in Asia,” said David Pierce, partner at FLAG Squadron, speaking at a recent industry event. “Institutional investors are just not geared for it.”

In other words: winning the logical argument is only part of the battle.