The following article first appeared in the July 2008 edition of AsianInvestor magazine. Each month we offer online a feature from the magazine. To subscribe for more in-depth industry analysis that you canÆt find on our website, please send an e-mail to: [email protected]

A 30% per annum net return, over an eight-to-10 year period, sounds like music to the ears of any investor, particularly one seeking to match long-term liabilities. Illiquid and unquoted a private equity investment may be, but investment committees listen to this siren song and then take the plunge into that asset class.

Oops. ThatÆs where it goes wrong, because far from hitting the jackpot, institutions often get their timing and manager selection wrong. Their investments end up in the outliers and underperformers of the bottom quartile. That is often enough to put off an investment committee from future private-equity investment for a very long time.

The difficulty in manager selection plus the need to have sufficient money to assemble a diverse portfolio of private equity has resulted in the growth of a new industry in Asia. The private equity fund of funds does exactly what it says on the tin, composing a varied portfolio of private equity investments in return for a management and performance fee.

In many ways it mimics the fund-of-hedge-funds structure.

This particular industry has mushroomed in recent years, from just a couple of players three years ago to over 30 now in Asia. By theme they are both general pan-Asian funds and country-specific funds.

These include big global specialists, like HarborVest, Partners Group and Pantheon, investment banks like Goldman Sachs, and insurance companies like Allianz and Axa. Also because this business can also be run with small teams of just a few people, niche boutiques are starting to spring up, such as Asia Alternatives and Axiom.

Before the Asian crisis it was hard to make money in Asian private equity, given the regionÆs weak legal systems, lack of enabling regulation and poor attitudes toward corporate governance.

That has all changed. So far this decade, China and Indian deals have made very attractive returns and investor money has returned. The economic crisis of 1997/98 created a new breed of private-equity managers, many of whom came to fruition in 2003, accessing the higher returns available in Asia, approximating three-to- six times returns for buyouts, and four-to-10 times returns for growth deals.

As a result, the funds of PE funds have likewise flourished. For example, HarborVest, among the first global FoPE funds to invest in Asian strategies, now has $2 billion deployed to the region thanks to the proliferation of private-equity players. This is thanks not only to a greater number of Asia-oriented PE firms, but in the greater dispersion of PE strategies away from simple buyouts, which traditionally dominated business in Asia, says Philip Bilden, managing director at HarborVest.

A typical FoPE portfolio consists of a blend of three components: firstly a number of investments in different private equity funds; secondary investments, which means buying an investment interest from someone who wants to sell out; and thirdly, direct investments in firms.

As an example, Partners GroupÆs FoPE fund at present comprises of 50% investments in private equity funds, 30% secondary investments and 20% direct investments. Of its $25 billion in assets under management, $18 billion is in private-equity products.

The right vintage

ôLike wine, good managers get better as they become seasoned, and it is as if they are stickyé in the sense of consistently generating good returns,ö says Christoph Rubili, head of markets for Asia at Partners Group.

The best vintages will often include PE firms that are independent of large financial groups, allowing them to shape strategy without conflict; investors who can add operational value to investee companies, particularly in choppy stock markets; and PE firms that have a strong enough bench and succession plans to avoid key-man risks.
This requires FoPE managers combine portfolio construction skills with the most basic tenets of due diligence.

When it comes to evaluating Asia-based PE investors, however, managers need to remember the basics, says Kelvin Liu, principal at Invesco Private Capital, which manages $4 billion within a series of global FoPE funds. His firm favours working with managers that have experience or education in the West and have therefore been exposed to corporate-governance issues.

Such experience can also help with access to capital, which is now critical because the subprime mortgage crisis has dried up credit. ôPrivate-equity funds of funds can get access to PE funds with capacity issues. Individual funds and partners often respect an experienced investor and accept their money because they know that they wonét panic when the market corrects by 30%. Sometimes individual investors do panic.ö

Remuneration

Fee-wise, funds of private equity funds are a negotiable industry, and less lucrative than their hedge-fund peers. Competition to build assets is strong, and to get critical mass some of the newer entrants are compromising on fees, by offering no fee arrangements in order to build their assets and give themselves credibility. ThatÆs a two-edged sword, as offering your products for free in order to give the illusion of a successful business may backfire.

Unlike the hedge-fund world, moreover, FoPE funds have never been able to charge that industryÆs two-and-20 fee structure, perhaps because the fees among underlying PE managers are already so high.

In fact, FoPE fund fees are often more generous in Asia than in the United States or Europe, where the industry is more competitive. In this region, typical annual management fees range from 0.5-1.5%, with performance fees from 5% to 10%.

A good proxy for understanding this industry is Squadron Capital in Hong Kong. This stemmed from Search Group, the family office of Robert Miller that he established to oversee his alternative investments at first hedge funds but later private equity.

ôMy family has been in private equity since the early 1980s,ö Miller says. ôWe were sourcing managers ourselves and when we found a good deal, we did a direct investment. Those direct investments take quite a bit of time, so we preferred to go to a private equity manager, who can do the drilling down.ö

Out of Search Group germinated a private-equity investment subsidiary, named Squadron. That firm recently opened up to the public with a fund of private equity funds. It now manages the $300 million Squadron Asia Pacific Fund. This particular fund currently has investments in 14 funds and two co-investments, with no secondary interests. It charges a 1% management fee and a 10% performance fee.

ôInvestors are looking for diversification across geography and strategy,ö says David Pierce, the CEO of Squadron; European investors typically want diversity in the size of underlying portfolios, although the size of Asian PE firms hasnÆt become so large to warrant this parsing.

ôWe donÆt invest top down and weÆre not looking for a country because we think that country can produce returns,ö Pierce explains. ôThere is a big dispersion of returns across private equity, and funds of funds tend to smooth out those returns.ö

Liquidity in private equity

Liquidity is a term seldom mentioned within private equity. If you are invested in a private fund, unless you find a secondary purchaser, you are in for the duration, and your private-equity manager is not going to make a two-way market.

One marketing angle for FoPE funds is their attempt to bring private equity as close as possible to a mutual fund structure, making it easy to buy and sell via a component of liquidity.

There are a few ways of accomplishing this. It can be done by establishing the fund as a unit trust structure, say, by an open-ended mutual fund registered in a jurisdiction such as Luxembourg. In this type of structure, the investor goes in and out at the reported net asset value.

Alternatively, the fund of funds can be set up as a closed-end listed investment company quoted on a stock exchange. That gives daily turnover, but is more volatile, and its price can swing between premiums and discounts to net asset value. Thirdly, there are listed partnerships and listed funds of funds, like the structures adopted by Pantheon or AIG.

The funds of private equity funds are selling themselves on these liquidity structures. Plus they are selling themselves on the ability to diversify a portfolio, so that one investment bad egg does not stink up all of an investorés private-equity exposure. In order to bolster the claim that FoPE funds can monitor all this, they have built proprietary databases, which drill down into the management accounts of the underlying investments and conduct ratio analyses on them. These firms are almost always unquoted and so without such a monitoring mechanism, there would be opacity at investment level.

Private equity is a lot harder than the 30% plus returns banner suggests. FoPE funds are banking on the assumption that even with $100 million, it is hard to diversify as a direct investor into the asset class, even with the help of a consultant. On the other hand if you are a giant alternatives investor, a CalPers or the Yale University endowment, you might find it hard to find managers who can accept a $500 million cheque, a problem that many Asian institutions now also face.

Such rationalisation lies behind the explosion in Asian FoPE companies. Over-population may become the concern if the trend continues. Is there enough meat to sustain them all? Private equity is a cyclical industry, and credit squeezes hurt. If this credit crunch continues to unfold at the same pace as the growth in funds of funds, then consolidation must lurk just around the corner.