Tensions rising between private equity GPs, LPs
Sophisticated investors such as Canada Pension Plan Investment Board (CPPIB) and Ontario Teachers’ Pension Plan are staffing up in Asia, inserting themselves into the deal-making mix, learning and building contacts in the hope of boosting their returns on investments.
The result is an increasingly complex web of relationships between private equity firms and their largest investors that US regulators worry is causing conflicts of interest.
Take last month's bid by PE giant KKR and Canada's largest pension fund, CPPIB, bidding for Bharti Infratel, a deal that could be India's largest private equity deal ever, at around $5 billion. CPPIB has long been a big investor in KKR's Asian funds and recently hired a former member of its deal team Gloria Song.
CPPIB had already hired Mark Machin in 2012 from Goldman Sachs in Asia and in May named him global CEO. In turn Machin put Suyi Kim, a private equity expert, in charge of Asia in June.
Asia is also a growth market for Ontario Teachers, said Olivia Ouyang, a director at the fund. It has about $28 billion invested in private equity globally and is at the forefront of co-investing with PE funds and leading their own deals around the world.
Institutional investors and sovereign wealth funds co-invested with private equity firms on 74 transactions worth $36 billion in 2016, according to consultancy Bain. These mega-investors have mainly led deals in the US and Europe, but sources say the trend is on the rise in Asia. SWFs were involved in 10 of the market’s 22 megadeals in Asia Pacific last year, said Bain’s 2016 private equity report.
A survey by data provider Preqin in September 2015 found that 30% of investors are targeting Asia co-investments, and that percentage is growing. Singapore state funds Temasek and GIC have long made direct investments globally and are being joined by their peers around the world.
This evolution of what were once passive investors to partners to rivals has increased the complexity and tension between PE firms, also called general partners (GPs), and their largest and savviest clients, or limited partners (LPs).
“There is an increasing conflict between LPs wanting to be GPs and GPs trying to fend them off,” said Eric Marchand, who is responsible for Asian primary and co-investments at asset manager Unigestion. “I’ve had a few situations where the GP has asked me to sign a non-solicit [agreement].”
Those tensions are likely to keep rising as more pension funds and insurers seek their own slice of the private equity pie.
In one high-profile example, private equity firms MBK Partners and TPG won a fierce bidding war in October to buy Hong Kong-based telecoms firm Wharf T&T for HK$9.5 billion ($1.22 billion). Their closest competitor was another telecoms firm, Hong Kong Broadband Network, whose biggest shareholder is CPPIB. A person familiar with the matter said the Canadian fund was actively involved in the deal negotiations and offered to help with financing of the acquisition.
CPPIB has also worked alongside Korea's MBK on deals. Only last year the Toronto-headquartered firm invested $534 million alongside MBK in its $6 billion acquisition of Tesco’s South Korean business Homeplus, in Asia’s largest-ever buyout. Homeplus' operating business continues to struggle say industry sources, which may curb the Canadian fund's appetite for further co-investments but is unlikely to derail CPPIB's strategy.
The Wharf T&T deal took place while both TPG and MBK are trying to raise billions of dollars for new Asian funds.
Risk and reward
The world’s biggest institutional investors are seeking out high-risk, high-reward alternative asset classes to help bolster returns in the face of record low, even negative, interest rates on fixed income investments around the world.
AsianInvestor’s July survey of the region’s largest 300 asset owners, the AI300, showed their clear intention to boost allocations to private equity over the next 12 to 24 months.
Beyond just committing capital to pooled funds for GPs to manage on their behalf, some of the biggest and most sophisticated investors are using their clout to push for co-investment opportunities to eke out an even better result. Almost two-thirds of LPs reported that their co-investments had outperformed overall PE portfolios in recent years in a survey by Coller Capital of 110 institutional PE investors between March and April.
CPPIB made $182 million this year when it sold its 23% stake in Key Safety Systems to a Chinese buyer, after co-investing in the company in 2014 with mainland PE firm Fountainvest. The latter is also led by a Goldman Sachs alumnus, Frank Tang, and the Canadian institution has been an early and consistent investor in its funds.
Ontario Teachers started investing in Asia via a fund of funds in the 1980s. It opened a Hong Kong office in 2013 and still mostly puts its $2.5 billion in Asia to work via six managers' funds. But its co-investment and direct investment activities are ramping up.
“We expect to co-underwrite the deals together with [GPs],” said Ouyang. “Every day, every month we want to be in conversation with our GPs and look at co-investments together,” she said at the SuperReturn Asia conference in Hong Kong in September.
Click on page two for analysis of regulatory scrutiny of coinvestments
Risk of conflict
While the desire of large and powerful asset owners to gain co-investment tranches is understandable, it raises potential conflicts for the private equity firms, also known as general partners, working with them.
GPs typically charge a 2% management fee and 20% performance cost for pooled funds, but will often reduce these costs for side co-investments and structured accounts and will sometimes keep such arrangements secret.
“We automatically go for the so-called co-investment,” said Kimihiro Fukuyama, deputy director general of global equity investment at state-owned Development Bank of Japan. “This is a big conflict in some senses, but GPs have to figure out a way to handle this trend.”
“If most LPs are paying two and twenty, and say five are paying less, then that is somewhat of a conflict,” said Eric Marchand, who is responsible for Asian primary and co-investments at asset manager Unigestion.
The US Securities and Exchange Commission (SEC) has said it is increasing its scrutiny of this so-called world of “shadow capital' to make sure the process of allocating co-investment opportunities is transparent and fair for all investors, whose end clients include pensioners, foundations and universities.
In a sign the SEC is watching co-investment carefully it said on December 14 that it has fined India-foccused and well-connected private equity firm, New Silk Route Advisors, $275,000 for a conflict of interest in its co-investments.
GPs accept that being able to call on their LPs gives them more firepower to do deals and means they don’t have to share tactics and industry knowledge with direct rivals.
“This is part of the evolution of the industry, to have closer relationships between GPs and LPs,” said Jean Eric Salata, CEO and founding partner at Baring Private Equity Asia. “It helps us do much larger transactions than we could normally do on our own, so we are actively looking for opportunities to work with our LPs on co-investments.”
Too much of a good thing
But one potential danger of pursuing co-investing is over-commitment. To gain access to co-investment opportunities, LPs risk having to place too much money into pooled funds.
This is a danger because PE funds are an illiquid investment tool, and asset owners have no easy way to regain assets in the event of difficulty.
“Sometimes LPs should ask themselves whether a decision to invest in a fund is more driven by the annex business rather than the primary programme,” said Unigestion’s Marchand.
Ontario Teachers is a good example. It has to make about $2 billion in pension payments every year, yet its illiquid assets have grown to over 60% of its AUM. Hence its asset-liability management (ALM) is of paramount importance.
Ouyang said: “For a pension, this is a dangerous thing. We can’t really hit the 70% [level], given the monthly cash outflow that we have to dispense.” In Asia, ALM is even more crucial as capital markets are much more shallow, she added.
Another risk of co-investing is that too many parties end up dictating how a deal gets done. Some LPs told AsianInvestor that they only invested in a fund after conducting extensive due diligence on the GP. That work is moot if other LPs negotiate rights to interfere in deal-making or gain board seats at portfolio companies.
Two-thirds of LPs believe the growth in shadow capital – LPs’ non-fund-based PE investments, such as direct deals, co-investments and separate accounts – will hurt the returns of commingled funds, according to Coller Capital’s 2016 survey of LPs.
To address some of these concerns, Barings Private Equity is seeking to keep overall control of the investments it makes. “We set [investments] up so that we are still the only GP, [and] the co-investors come into a new vehicle as LPs that we control – that keeps things straightforward,” said Salata.
Yet there are many benefits for the lucky few that secure a sought-after co-investment deal – some not immediately obvious.
DBJ's Fukuyama said: “One big reason pension funds are asking me for co-investments is that there is greater transparency.” More people want to monitor the investee company, he added, as environmental, social and governance (ESG) and related factors are gaining more attention these days.
It also helps improve the day job.
“We find it has been an extremely helpful way for us to get to know the GP, because we are working with the team and understanding their investment process,” said Melissa Kang, an executive director at Morgan Stanley Alternative Investment Partners. “When we do that, we tend to choose better in the primary programme.”
This article has been corrected to show Gloria Song did not join CPPIB directly from KKR