The institutional investor perspective on private equity REPRINT AltAssets 2012 www.limitedpartnermag.com Q2 2012 Gearing up for growth As investors come to terms with the eurozone crisis, many are seeking to transfer their equity to Asia but the tumult has also led to opportunities in distressed debt, according to private equity manager Hamilton Lane Published by Connecting LPs & GPs worldwide
HAMILTON LANE Gearing up for growth As investors come to terms with the eurozone crisis, many are seeking to transfer their equity to Asia but the tumult has also led to opportunities in distressed debt, according to private equity manager Hamilton Lane In the aftermath of the market chaos over the Greek crisis, investors with a global private equity focus are increasingly ramping up their allocation to Asia and distressed strategies as they seek to reassess their approach. While institutional investors are understandably easing back on capital allocations to Europe, they are not easing up on the asset class entirely, seeking new methods of accessing the region through less traditional types of funds. The majority of LPs are waiting to see if Europe gets its act together, with fewer new allocations suggesting they want a different slice of the pie than they did just a few years ago, according to Andrea Kramer, managing director of Hamilton Lane s fund investment team based out of its Philadelphia headquarters. It remains unclear how the current crisis in the eurozone will play out, and the level of uncertainty merits a degree of caution when it comes to making new commitments, she says. There are serious concerns that the European credit markets are not going to return to normal for some time and that this will have a knock-on impact across the broader economy. On the flip side, this level of dislocation presents a number of specific opportunities. There is a consensus among LPs and GPs alike that the European work-out will take a lot longer than the US work-out, mainly because of the sheer scale of the problem and the number of individual national agendas involved in any solution, she says. An upshot of this reassessment is that allocations to distressed strategies are on the increase, at least for Europe. According to Hamilton Lane research, interest in distressed debt is a significant factor in determining LP allocations, accounting for 20 per cent of distributions in 2011. Capital structures The majority of LPs considering investments in the European private equity sector are still preferring to wait and see. And although they are showing increasing interest in funds targeting strategies that are designed to benefit from the current difficulties, this does not mean that allocation strategies are moving away from the region. Kramer says, If you look at where our portfolios were five years ago compared to where they are today, you would see that there is a lot more conservatism around European investment. That translates to portfolios such as ours preferring senior positions in the capital structures, as opposed to riskier equity positions. That is something that is consistent with the discussions we have had with GPs about what other investors are looking for. In seeking to access these investments at the top of the capital structure, Hamilton Lane has focused on a small group of managers with the requisite skills to address this opportunity. If you look at where we are putting more capital, it is in senior loans or midmezzanine. Holistically, for institutional investors, private equity has been one of the key areas that has generated returns across the portfolio. LPs are still actively investing in private equity, but doing so with a recognition that things could change very dramatically, which makes them very careful about where they are putting their dollars, she explains. In addition, large institutions now prefer to commit their capital to specific managed accounts, providing a tailored approach to the asset class. At the recent Superinvestor event Hamilton Lane chief executive Mario Gianinni confirmed, You will see a lot of investors using predominantly special accounts. Dislocation trends An increased polarisation in the market is anticipated as LPs develop a more informed view of the winners and losers in the aftermath of the recent financial crisis, says Jim Strang, principal at Hamilton Lane s London office. The reality is that many of the funds currently operating in the market won t survive in their current form. Conversely, Strang says he expects LPs to have to work harder than ever in securing access to those franchises that have emerged stronger from the crisis. Accessing those leading franchises across the whole spectrum of the European market is a constant challenge. We work hard at positioning ourselves as a long-term partner for the funds we invest in, to give ourselves the best chance of making our chosen investments. The dislocation of LPs is also occurring across North America, with the more mature fund investors in the region, namely large US state pension funds, taking very robust private equity portfolios, according to Kramer. This often equates to these institutions having a considerable amount of capital to commit, which needs to be www.limitedpartnermag.com 35
LP PERSPECTIVES The level of uncertainty merits a degree of caution when it comes to making new commitments Andrea Kramer Hamilton Lane allocated in large volumes or to a large quantity of managers. This is a very unusual challenge to have, since most pension funds could not sustain this level of management of up to 150 to 200 GP relationships. This phenomenon is creating a shift change in certain GP funds, she says. We are definitely seeing a reduction in the number of GP relationships in today s environment. While LPs are investing, they are just no longer investing either with so many GPs or in such large amounts as they had historically. That is probably a good thing since you just cannot manage that many relationships. The period of frothy fundraising and record allocations to private equity has now been replaced with a climate that lends itself to hard LP negotiations and more tailored sets of terms. One manifestation of this is an increased appetite for co-investment. There certainly seems to have been an increase in LP interest in co-investment in recent years and to some extent GPs have been happy to acquiesce to this. LPs like the strategy as it gives an added degree of control to the timing of investments, while also typically lowering the cost for the client, notes Strang. From a GP perspective, having a small cadre of qualified coinvestment partners can have its advantages, particularly in markets where there are real question marks over the availability of credit and where equitisation levels in deals have risen materially. GPs are now offering co-investment opportunities to their investors as an enticement, even though LPs have always been asking for it, Kramer notes. The challenge is evaluating the co-investments and making decisions in a timely manner. Deal processes are generally very time-critical and that is why GPs have historically not wanted to co-invest. Understandably, LPs are keen to invest additional dollars to those managers they think are the best of the best. In search of a lower cost of deal, however, LPs are often choosing to invest directly and find themselves competing directly with funds, often bidding at much higher prices than GPs for the same deal. Kramer reiterates that many LPs are adding a credit investment focus as well as emerging markets to their portfolios, although these regions are mainly offering pure venture and growth-orientated investment opportunities. Expectations, therefore, need to change, despite the wider growth story. She says, The timeline for growth tends to be longer since you are waiting for the markets to mature. Corporates are already looking for strategic purchases in emerging markets, but they have to also consider if the local market has the long-term capital and infrastructure to support the business. Strategic investors will be looking to buy when things are priced appropriately and they see growth to their underlying earnings, Kramer suggests. We believe we will start to see that sooner rather than later because strategics are more optimistic. But then we ll see them start to sell these assets in five to ten years just like they always have. It is rare to find a globally-focused private equity investor who is not at least considering an allocation to Asia. Indeed, according to Juan Delgado, managing director and head of Hamilton Lane International based at the firm s Hong Kong office, a large proportion of the rest of the world dollars are now being allocated to the region. No longer pioneers All the institutions are looking at Asia and doing so seriously. It is no longer a pioneer market for LPs, Delgado says. For certain institutional investors international commitments which could be between ten and 20 per cent of their rest of the world allocation some 70 per cent is typically earmarked for Asia. This is not just in China or India, this is a vast region, he adds. The region is proving equally popular for both US and European fund managers, as well as the new breed of locally-based spinout funds. Strategies to address Asia still tend to vary somewhat, with institutional clients often preferring to gain access through a customised product, Delgado says. We are looking for top managers who we can use as building blocks for customised portfolios, so we are prepared to take the same level of risk as we do in any of our other markets. Our teams come in and assess the managers and their portfolio companies we keep to the same playbook across the globe. Notwithstanding individual country growth, the region as a whole has developed and changed rapidly, presenting a further challenge to prospective investors. The market started back in the 1990s, then you had the tech bubble in the 2000s when the number of investors was very small, 36 Q2 2012
HAMILTON LANE though some were already here and still bear the scars. Some good money was made in the financial distress markets, such as in Korea and Japan, during that time, he recalls. Before 2005, there was a ballooning of old-style strategies and you had your champions in each given market, like CDH in China or CHAMP in Australia. Then from 2005 onwards you started to see a lot of first-time funds and the arrival of the global players that had yet to come over here. He adds, In just seven years there has been this fantastic growth. You have every choice now, though strategically it is about 60 per cent growth across most markets with limited credit and a very high number of first time or second time funds. Localised risk Investors are now faced with an ever-growing choice of managers in up and coming markets, such as Indonesia. According to the latest figures from Investment U Research, foreign investors poured a record $16.1bn into the country in 2011 double the level just five years ago and nearly four times the amount ten years ago. Echoing the natural progression of the industry seen a decade ago in Europe, spin-out funds are developing out of the investment banks in Asia, such as Morgan Stanley and Goldman Sachs. In addition, the upbeat momentum of these economies is creating IPO opportunities, which has seen the second generation of funds coming to market more quickly than in other private equity markets. Specialist regional funds are also cropping up at great speed. Raising a first-time fund here is easier than in any other region of the world just due to the sheer demand, says Delgado. To capitalise, spin-outs are also coming out of the established private equity players, corporate finance firms and family offices. He adds, The common denominator is still that track records are shorter than those in the US or Europe of that there is no question and that most of the gains in those track records is unrealised, that is driven by mark to market, but not in cash. Even though there are few quality track records to choose from, the risk is they are seen as representative of these markets as a whole. We are not worried about losing our principal; the main risk is that you don t make an adequate return, and that you experience far more volatility and fraud and execution challenges. Delgado notes that the main market currently in the Asia region lagging behind in liquidity is India, but that other markets in the region are producing very attractive exits. There is the risk of returns falling short of your expectations. Picking wrong here is not the Oh no I might lose my money kind of risk, but rather I was expecting to make four times my return on this great opportunity in India, and in the end I only made 1.7 times my money. It s in those cases that you feel that you could have invested for that amount in Texas or France, for example. Talent shortage When it comes to best-of-breed management within the investee companies, there is a very short supply. According to Delgado, investors often find themselves dealing with the original founders/ entrepreneurs, who are non-professional managers in many cases. Frequently you also have managers from state-owned companies. To a significant extent this is very much how Europe was in the late 1990s and similar to the US during the early days of its venture industry. Technically, the people we are Andrea Kramer, managing director of dealing with are either Hamilton Lane s fund investment team entrepreneurs or functionaries for the state, so private equity has to explain itself and then the private equity fund needs to determine how that type of manager will work, since no-one has had the experience on the other side. Overall, the system is working and the managers are reacting to the incentives the same way that anyone else would react in another private equity market. There is just not enough talent, explains Delgado. Foreign funds investing in the region learn quickly that the handson approach to investing is uncommon. That hands-on, intrusive, operational scrutiny is lower here than in the US. Here it is much more financially driven. But here you have this background of growth, the strong IPO markets, and in many cases you are not a controlling shareholder add those three aspects together and you are in a very different situation than in the West. The incentive for these companies is not that the manager is taking money off the table, but that they are going to make the company money. When you exit, the company is public and the manager stays with the business. You are creating a lot of first-generation wealth, but that wealth is staying attached to the company. Few deals in Asia represent 100 per cent money out for the founding family, he adds. For the most part, the region has clear advantages combined with a unique risk outlook. The optimum goal is to go public, which is reminiscent of the glory days of the more mature private equity markets of the US and the UK. While the draw to public listings remains a key driver to private equity growth, exit routes for Asian private equity-backed businesses will, after moving through the evolution of private equity cycles, undoubtedly wear a different guise looking more like their Western counterparts. And while a homogenisation of the private equity industry is unlikely, markets are opening and expanding to the extent that those investors seeking optimal returns will need to stay abreast of regional developments and leverage their increasingly global presence. www.limitedpartnermag.com 37