"The Balance Of Power Has Shifted To LPs"

By Shrija Agrawal

  • 27 Apr 2012
"The Balance Of Power Has Shifted To LPs"

 A lot more questions are being asked as to how the private equity funds are deployed, why they are deployed in certain categories and not in others and why the valuations are not being marked down. Limited Partners are asking tough questions to the General Partners these days. Also LPs are also getting a lot closer amongst themselves discussing their GPs which has resulted in the balance of power shifting in favour of LPs. The days of easy money have gone. VCCircle speaks to Rahim Penangwala, Head of India, private equity, LGT Capital, a prominent fund of funds, on the dynamics of private equity fund raising. Excerpts:

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Any specific reasons for your interest in India?

Asia in general is of big interest to us. China and India are the emerging tigers of Asia. When we make investments in Europe or the US, where most buyouts happen, there is generally a leverage component attached to the investments. In contrast, the growth capital companies in India were doing extremely well, with no leverage on their balance sheets. This has helped us in the current downturn since the valuation of our portfolio companies has remained stable. It’s good hedge against portfolios that we have in other economies. Plus, compared to the rest of the world, Asia is still seeing a fair amount of growth. The recent elections in India also has given a signal to the western LPs that stability will prevail and the structural changes that were lukewarm in the previous term will continue in full strength. Here is India's chance to shine.


Any concerns for India now that we have reduced GDP numbers?

Not just across India but across the world, we see the dramatic effect of what’s happening in the US and Europe. In India, one of the key factors that people banked on was the growth of the middle class (and their purchasing power). But since the economic slump, the middle class has had a hard time acquiring jobs. That will have a negative effect on portfolio companies because internal consumption will decrease.

Secondly, India was buoyed by the fact that there was a lot of FDI coming in, and that has obviously stopped in the last two quarters. As a result the rupee has taken a 20% hit in the last one year. Given that our investments are in US dollars, this has brought down the portfolio company valuations on a dollar basis by 15-20% (though this has been somewhat offset by the gains seen by these funds over the last 2-3 years, depending on when the investments were made). That combined with the middle class holding less money, and a stagnant job market, we will see less overall growth than we saw in the last couple of years. 


The government has a chance to offset this deceleration by investments or policy changes in infrastructure, education, and health care.

What do you think about the fund raising environment?

I think it’s very challenging. Though on a daily basis we meet at least one or two primary funds globally, the bar to make investments is high. Limited Partners (LPs) have realised that though the next 18 months is the best time to deploy capital, it may not be the best time to raise a fund, especially for a first time fund. If the funds which were in the market in the last two to three years have invested prudently, or rather, not invested due to risk/valuation mis-match, they should have enough dry powder to take advantage of the current economic downturn.


One surprising phenomena that we have seen in Asia is that General Partners (GPs) are still raising bigger funds. This does not completely add up since there are fewer good deals in the market and the valuations have come down since a year. So, in totality, the fund size should remain stable. However, according to some, private equity is an asset management business and thus amassing larger funds is the course that they take. Others have evolved, graduating from investing in smaller, mid-market companies, to taking larger, controlled stakes in large cap companies. However, LPs have to be convinced that the same team that was successful in one space will be able to scale to another. Thus, PE funds are definitely facing a challenge.

There are examples of 2006-2007 vintage funds where the amounts raised are now being called in to question. Some of these managers are returning part of the capital while others are venturing different geographies to justify their fund size. In a recent example of LPs re-thinking their investment philosophy, a prominent GP which till end-2008 had no room in its buyout fund is now closing it at a lower target. Thus, GPs are listening to LPs and realize that investing is a long term process. Even established funds in India and China realise that it is a tough environment to raise money.

In general, unless fund managers that are raising funds the second or third time can prove that they can give returns to the LPs, it is going to be very difficult for them to raise money. Unfortunately, in India, the private equity industry has only been around for about seven-eight years. Except for four or five (funds), not many have shown return for capital.


On the brigher side, I think the situation will improve in Q4'09/Q1'10, since in the next two quarters, different factors are likely to play out. For example, for secondaries, the valuations are more attractive than they are at the primary Private Equity (PE) fund level. 

There have been a lot of firms which managed to raise funds like Jacob Ballas, Avigo and Rabo. What do you think worked for one and didn’t work for another?

Jacob Ballas had a final closing last year at USD 450 million. In India, when you are raising a $400 million - $500 million fund, it is understandable, since the middle market growth equation is robust. At Jacob Ballas, the team has been together through one fund, they have shown decent returns, and they have a strategy that has worked. And don't forget, they hit the fund raising trail at the right time. 

Contrast this to some prominent fund managers that are currently raising funds or have just completed fund raising. They have all come down in size from USD 1 billion+ to less than USD 750 million. These are managers with a good track record, very well liked by LPs as well as entrepreneurs/promoters. And the same themes have applied for all - investors want to see consistency, want to see returns, and would like team stability.

If you ask LPs, they all agree that India is predominantly a growth capital market and it is very difficult to put money to work if the fund size goes beyond USD 750 million. The avenues to deploy capital are reduced. There have been instances where managers have made large PIPE investments. Though these investments may make money in the long run, LPs already have public market exposure through their investment vehicles. They would like to see pure play private equity, where managers have control, to some extent, of their investments. Though in India PIPEs are pre-dominent, it is very different making such investments in smaller, growth based businesses versus larger, global organizations. A smaller fund size mitigates this risk.

Coming to Avigo, they have kept their fund size small, have a stable team, and is consistent in its investment philosophy - they will probably raise money. 

Which funds in the market can raise money now?

Funds that can raise money are the ones  that have shown consistency in performance over the years, a stable team, and a investment philosophy that mirrors the opportunities available in India.

There are also teams from existing funds that are branching off to start new funds. This is an interesting phenomena that we are seeing more of in India and China and the trend will continue.

We see one India fund almost every week. Managers are raising money not only in traditional PE but also in Real Estate, Infrastructure, and distressed buyouts. Some of these managers have no previous track record but believe that the themes mentioned are "in" in India. These themes are "in", however, LPs are becoming a lot more selective about who they back going forward. The time of easy money has ended for the forseeable future.

Distressed funds- do you think there is enough appetite for it? 

There is appetite, but I think that from an India/China perspective, PE firms have not done distressed investing in the past. In India, managers have not seen a distress situation in the last four to five years. Thus, it is very hard to quantify the actual expertise of these new funds. LGT has done distressed investing in the US and Europe and managers have been successful. In India, many things can go wrong in distressed situations - entrepreneurs/promoters are not open to outside PE firms dictate terms in general.

So even during good times when GPs have downside protections on their investments, they generally cannot take over the company since they need the on-the-ground expertise of the promoter or don't have the necessary set up to take control of a firm. When things go wrong, you don’t want to own an asset  that you don’t have the expertise to execute. This situation worsens in a distressed scenario. Also, the necessary mechanisms to make turnarounds viable are absent in India - the legal system is not favorable - unless you have the support of the entrepreneur/promoter.

So yes, there is a definite appetite for distressed funds, but converging on the right candidate is difficult.

How would you evaluate an investment proposal?

The evaluation is always the same, but there things we would definitely like to see a lot more now than before. 

Local experience - six years ago, having a first time PE fund was acceptable in India and China. Experienced managers from the West set up shop in Asia. First time funds are still acceptable in India and China. However, LPs want to see local PE expertise.

Track Record - We would like to see funds that have performed consistently in the past.

Team Stability - In a mature fund, we would like to see the team work together through at least one cycle. That shows that the fund is doing something right - it is offering its team members the right set of incentives to grow professionally and personally, which translates to better work ethic and performance.

Expertise - Consistency in investment execution in the promised segment. For example, funds that don't have the bench strength or organizational width to handle buyout transactions should try to refrain from it. Also, funds that have done well in minority investments in private entities should not get lured in to making PIPE investments because the public markets are undervalued. Markets change and the manager may not have the expertise to exit a successful PIPE investment in time to capture value.

Bench Strength - Let's face it, there will always be movement in private equity funds as managers gain experience. That is quite healthy. What a fund needs is deep bench strength to weather such losses.

Fund Size - We have spoken about this at length, but to re-iterate, raising a fund with a long term view in mind makes it easier on the LPs as well as keeps the GPs honest. For example, we have very deep relations with some Pan-Asian buyout funds. Recently, they realized that valuations have come down and they would not be able to deploy the huge amount of capital raised to give a good IRR for its investors. They have come forth to reduce their fund size. That is commendable. So keep the fund size within reason.

Fee Structure - It is very hard to broach this subject unless the fund size is big or if the GP voluntarily decides on a fee structure that is LP friendly. As long as the GP is true to its investment philosophy and offers consistent returns, this subject is hard to negotiate.

Talking about PIPE funds, do you think the fee structure is being questioned?

Absolutely. Investing in PIPEs in the last seven to eight years worked well. But now as the funds have grown, managers in India cannot deploy funds in mid-market companies without moving their investment return needle. Thus, they have resorted to making investments in large, publicly listed companies. When that happens, I think LPs are taking a step back and asking themselves why they are giving 2% (management fee) for investments in large-cap, publicly listed companies.

We understand that PIPEs in India are different from PIPEs elsewhere in the world and we are supportive of that. However, as a firm, we would rather see the manager do a PIPE transaction in a company where it can work with the management team, rather than deploy it in a Wipro or Tata or Infosys, where, in general, fund managers have little or no say. That’s like putting passive money to work, which we are not looking for when we make our private equity allocations.

Do we see any kind of shakeout happening in the PE space?

Yes, I think that applies to both GPs and LPs. There is a very prominent LP in Europe which had plans to start an Asia fund three or four weeks ago. They had a very bad investment in Europe because of which they had to shut down their Asia plans. That’s one of the ramifications of this kind of environment. The big funds will become bigger, the smaller funds will strive hard and will not survive unless they show returns to the LPs. So if you look at some of the marquee names in the Indian PE space, such as ICICI Venture, Chrys Capital and IVF - the ones who have returned money to LPs and shown that they have the execution power - they will strive to raise bigger funds and probably be a lot more successful at it than those who have yet to prove themselves. 

Going forward there will be a lot more stress in the system. Fortunately for the LP community, the returns were coming without the need to ask questions. However, with the current downturn, LPs are asking a lot more questions. If you went for annual meetings last year, LPs were not as active as nowadays, when they are banding together to ask for fee reductions, or fund size reduction, or valuation corrections, or governance issues.

There is a lot more active conversation among LPs now than before.

Are LPs getting more involved with the PE funds in terms of where they are investing?

I think LPs are taking an active interest in the actions of the GPs when it comes to governance, fees, etc. A lot more questions are being asked on fund size, fees, funds deployment, valuations. For example, with the downturn of the Indian rupee, a logical correction should in the valuations of the portfolio companies. That has not consistently happened across the spectrum of PE funds. Such issues, along with other governance issues are being handled with greater interest by LPs.

So, what are your demands in terms of returns and expectations from GPs?

As LPs, we want consistent returns and ethical standards. The hurdle rate (minimum acceptable rate of return) which GPs have is 8%. The 20% carry structure on this hurdle rate is fine as long as the focus is to generate returns and not to increase assets under management. Thus, the management fee (2% of the funds under management, every year) should come under scrutiny, especially as second, third, and subsequent funds are raised. It should be about returns and not fees.

LPs just want GPs to be honest in terms of deploying capital the right way.

Going forward, what can we expect from the industry?

There will be a lot of churn in the industry; the non-performers will shrink in size and the ones which shine will continue on to garner a larger mind share from LPs. There will be spin-offs as the standout teams will want to re-create the model under their own umbrella. 2009-10 will definitely not be the same as 2005-06; money will be tight for atleast another 18 months as the industry absorbs the funds that were raised in 2006/2007.

Within Asia, India got $18 billion of PE investments in 2007. We may possibly reach these levels again in 2011 - not on the strength of traditional PE but more due to infrastructure and other sectors such as power, education, which India sorely needs.

The PE industry is shrinking at the moment, but if the much-needed reforms are undertaken by the Indian Government and business ethics are maintained, India could definitely be a standout performer in the private equity arena.

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