15.04.14 / Author: Asian Venture Capital Journal
Private equity firms, and the LPs, are placing greater emphasis on adding value to portfolio companies. But what is the best way of developing operational capabilities in Asia, and who should pick up the tab?
The typical Asian GP is changing. In the early years, the average private equity shop might have compromised a small group of deal professionals with investment banking backgrounds. Fast forward to the present and the bankers are still there, but they are increasingly complemented by partners from broad range of disciplines; consultants, former Big Four auditors and CEOs from various industries.
This transition is largely a function of the evolving environment in which GPs operate.
They were passive investors taking minority stakes in emerging markets businesses and replying on a combination of multiples arbitrage and macroeconomic growth for returns, but there is now a sense that the low-hanging fruit has been picked. There is more competition for deals and portfolio companies face more challenging commercial conditions. Investors and investees expect PE firms to offer guidance and expertise in addition to capital.
Rumblings started among the larger players but they are now percolating through the lower tiers of the market. The onus is on operational capabilities as a means of driving growth. In this context, the need for a diverse range of talents is clear.
For GPs reassessing their approach, the question becomes how to best accommodate the new blood. Building a large in-house operating division is not easy. It requires resources that are beyond some firms, while others might rely on the capabilities and experience of the existing deal team. As part of this discussion, GPs must decide what can be dealt with in-house and what should be outsources to third parties. The challenge is identifying the most cost-effective solution and figuring out who pays for it.
“In the last five years there have been a number of cases – especially in the US and Europe – where we have had to get the EBITDA up by working the operational fundamentals of a company,” says C.V. Ramachandran, managing director and head of Asia at AlixPartners, a consultancy specializing in turnarounds.
“That trend is starting to come to Asia. A case in point is India where a lot of funds in the 2007 and 2008 vintages ended up paying top dollar for assets only to see the devaluation of the rupee later. When prices start dropping, private equity needs to do something different.”
Operational involvement as a means of driving returns when macroeconomic shifts – whether the global financial crisis in Europe or a capital flight and currency crisis in India – have thrown growth projections off track is one factor. Another is opportunity.
While private equity in Asia, dominated by emerging markets like China and India, remains a predominantly growth capital game, control transactions are on the rise. According to AVCJ Research, there were 199 buyouts in the region last year, the most since 2008. Minority growth deals, have declined every year since 2011, in part reflecting the lower exit multiples available through public market exits in China.
In or out?
What has become apparent throughout the emergence of operational value-add models in Western markets and now in Asia is that there is no one-size-fits-all solution. A GP’s approach depends on its resources, its remit and the markets in which it operates.
The global buyout firms, with their substantial resources and presence in multiple geographines, have tended to focus on in-house teams.
KKR established Capstone, its internal operations division which operates as a seperate entity, in 2000 and brought it to Asia in 2008.
The regional team is now 18-strong, with five professionals in Hong Kong and the rest deployed around the region.
“We decided that we want to go beyond the board and into the companies,” Scott Bookmyer, head of KKR Capstone in Asia, told the AVCJ Forum in Hong Kong last November. “There is not one right way to do this, there is a lot of great governance and lot of great value creation that can happen outside of that, but we decided build a team with proven experienced executive.”
TPG Capital took a similar approach. However, rather than build a stand-aline entity within its organization, the firm developed a network of operating partners, known as Human Capital Team. A total of 19 team members are based in Asia, including three operating partners and 16 senior advisors.
“Our human capital organization helps us assess all the leadership teams before we go into an investment and if there are gaps in the management we will go out and source the appropriate individuals,” explains Steve Schneider, a partner at TPG and head of Asia operations. “If you get the management right, and the incentives right, you end up with a pretty good outcome.”
While the global buyout firms may have taken the lead in building out operational capabilities, a number of smaller GPs with narrower geographic remits have embraced the concept, albeit on a less grand scale.
Navis Capital Partners is one such example. Set up in 1998 by a group of former Boston Consulting Group executives, the firm has spent the last 16 years developing its capabilities to the point that most operating functions can now be carried out in-house. While there is no separate operations units, Navis draws on the experience of its deal team to drive value-add.
“We are on the extreme end of in-sourcing,” says Rodney Muse, the firm’s co-managing partner. “Our deal teams are slightly different in composition to your average PE firm in that they have more operational experience than financial engineering experience. Part of their mandate is to go in and assist in operational improvements in general.”
Lunar Capital – a consumer-focused mid-market buyout firm in China – has also found a way to bring about operational improvement without a dedicated in-house team. The PE firm recruits individuals with relevant expertise before making an investment and uses them during the due diligence process. They are then offered salary-plus-equity packages as CEOs of portfolio companies.
For the vast majority of regional and country GPs in Asia, operational capabilities comes from a combination of internal and external sources. It is just not economical to provide certain specialist service, often required on an ad-hoc basis, in-house.
Unitas Capital has three deal partners and four operating partners working on every investment; one deal partner and one operating partner then assume responsibility for the business in the post-investment period. But it still uses third-party service providers. “We have a clear idea of where the opportunities are but realizing these opportunities can depend on detailed work such as data collection and significant in-depth analyses of the business,”says Ajeet Singh, a partner at Unitas.
He cites the example of Hywa, a manufacturer of hydraulic cylinders and hydraulic-tipping solutions used for heavy-duty transportation equipment. Unitas acquired the business in 2011 and then hired a consultant to spend six weeks examining the company’s procurement processes – what components it was buying, where there were being bought, and how many suppliers were being used globally.
“Collecting all that information requires a fair amount of time and that is where we would use a consultant because companies typically don’t have that scale to collect that information in a manner through which we can devise a strategy,” Singh says.
Furthermore, the extent to which a GP can rely on its in-house resource is arguably limited. Even those with substantial operational resources call in a third-party consultant when a company requires support beyond what the GP can offer. Schneider notes that TPG has been known to bring in external advisors for operational turnarounds where the skill-set needed is not one the firm would want to keep-in-house full time.
In these situations, AlixPartners is often the service provider that receives the call. Ramachandran explains that is his firm is often brought in a few months or even up to two years after the initial investment when a company is not hitting its targets. And it is not necessarily smaller GPS that are in need for assistance.
“We find there is a big segmentation by size; the smaller GP spends a lot more time getting the deal right because it doesn’t have the bandwidth to fix the companies,” Ramachandran says. “Whereas the bigger guys take more risks and so they need more operating help.”
Nevertheless, there are still private equity firms that resolutely oppose the use of external consultants. Creador, a minority investor focused on Indonesia, Malaysia and India, recently launched its own operating unit because it doesn’t believe third-parties can meet its needs. Known as Creador+, the team comprises former Boston Consulting Group employess.
“We don’t believe in using external consultants for two reasons,” explains Brahmal Vasudevan, founder and CEO of Creador. “First, a strategic consultant tends to be very expensive, and second, the strategy is often not implementable. We believe that whatever strategy we come in with, we have to have to make it work from an implementation standpoint, hence we believe in handling theses functions internally.”
This explanation offers insight into how GPs are grappling the financial burden of investing in improved operating capabilities. An in-house team might be expensive to assemble but if it can address portfolio companies’ needs quickly and effectively, does it make more sense than hiring a third-party service provider whose fresh pair of eyes might not deliver workable solutions?
In the past, GPs have been able to charge for their service by charging fees to portfolio companies in addition to the standard management fees and carried interest. However, these so-called monitoring fees for management and advisory services have come under increasing scrutiny from both regulators and LPs.
Most industry participants note there has been a shift away from the practice of charging portfolio companies fees since the global financial crisis. There are two reasons for this. First the more challenging fundraising environment of recent years has presented LPs with great leverage in dictating terms and demanding concessions from GPs.
“It is very hard now for any GP to get away with charging substantial fees to portfolio companies that are not reimbursed back to the LPs,” says one fund-of-funds LP who asked not to be named. “Few LPs are willing to tolerate that and, for ourselves, we have not committed any capital to a fund where there has not been 100% fee offset for many years.”
It leaves GPs with dilemma of being required to invest in deeper operational capabilities and receiving lower fees in return.
Seconds, additional pressure has come via the International Limited Partners Association (ILPA) Private Equity Principles – a set of principles intended to deliver alignment of interest, governance and transparency between GP and LPs.
The guidelines state that all fees charged to the fund or any portfolio company by an affiliate of the GP should also be disclosed. Furthermore, any transaction, monitoring, directory, advisory, exit fees and other considerations charged to a portfolio companies by the GP should accrue to the benefit of the fund.
More recently, the US Securities and Exchange Commission (SEC) has also got in on the act. The regulator has formed a dedicated group to investigate private equity firms. Its reported areas of focus are said to include the fees charged to portfolio companies.
Accordingly, GPs are increasingly steering clear of potential controversy and scrutiny. Navis, for example, claims that integral part of its business model is that is does include any charges for value-added services extended to portfolio companies.
“That is important because you do not want the management or shareholders of a portfolio company to think, ‘Are these guys in it for equity appreciation or are they in it for the management fees?'” says Muse. “Any kind of fee is leakage – at a minimum it is leakage from other shareholders and at worst it is leakage from LPs. We don’t do it and we are very explicit about it.”
This approach has been mirrored by a number of GPs, and it is not limited to those in the buyout space – as evidenced by the launch of Creador+. Vasudevan rejected the idea that the GP would ever charge for its services.
“We decided it is an important investment for us, and that most of the value we get should be created through the carried interest,” he says. “We believe that if we do the right thing that profit share is where the team will create their value and LPs will see this as a clear differentiator.”
There are, however, probably almost as many ways of charging portfolio companies for operational improvement as there are models for operational improvement itself. And no approach is definitely right or wrong.
KKR’s Capstone, for example, is a stand-alone entity and so fees are not charged directly by the GP. The unit will invoice portfolio companies for services, but only so far as to cover its costs. The rationale is that this is cheaper than outsourcing the function to a third-party provider. Additionally, fees charged to a portfolio companies by third-party providers are still accepted as part of the value-add process – as was the case with Unitas and Hyva.
“These services are paid for by the portfolio company as an investment leading to improvement,” says Unitas’ Singh. “It is an investment that is taking cost out, so any expense the portfolio company incurs is for future profitability.”
Clearly, how private equity firms deploy their resources towards achieving operational value-add depends on their specific needs. But as the example of Creador+ illustrates, more GPs are having the internal conversation, including those whose remit would not normally warrant it.
No one, it appears, is immune from broader industry sentiment. Whether investments in operational capabilities pay off for private equity firms across the strategic spectrum remains to be seen, but LPs are generally less willing to back GPs in Asia that don’t have these capabilities.
As one LP observes, these concerns are a natural function of a more competitive environment and concerns about the sustainability of returns. “If you are looking for a sustainable source of return, you are looking for a sustainable source of value creation, and operational value-add is it,” he adds.