Emerald Hill Capital Partners, a Hong Kong-based private equity fund-of-funds, recently closed its second fund bringing its assets under management to over $500 million. The firm, which is active in the Indian PE landscape, is also one of the first independent private equity fund-of-funds in Asia in 2005. Eugene Choung (formerly Director of Private Equity for the University of Chicago endowment), Managing Director and Founder, Emerald Hill, talks to VCCircle on the current fund raising environment, the attractiveness of first time fund managers, performance of India from a returns perspective, and the importance to be given to economics in the fund. Excerpts:-
What is your assessment of the Indian market?
India is a very important market for us. I spent over six months working in Mumbai back in 1996, and have been actively engaged in both the public and private equity sides of the market since then. Emerald Hill’s investment strategy places a fairly strong bias on emerging markets in Asia, and India certainly represents a very large emerging market and a critical part of our mandate.
However, we don’t pursue India as a beta play, despite the broadly positive macro and demographic trends. Our investment strategy dictates that we pursue the highest possible absolute returns across all opportunities in Asia – so we attempt to cherry-pick the most promising Indian investment teams that are pursuing very specific opportunities through highly targeted market niches and strategies.
We can’t disclose our investments in India but I can tell you that India made up a fairly large portion of our Fund I and has already begun to play a prominent role in our current Fund II portfolio.
What are the kinds of funds you are looking to invest into?
We are fairly picky investors and, because we don’t invest out of a huge fund, we need to be extremely disciplined and selective. In fact, fund size discipline is something we stress with all of our underlying managers, so we certainly try to practice what we preach. We believe that too much capital can lead to bad behavior and we try our best not to fall into this trap.
From an investment perspective, our goal is simply to back funds that we think have the greatest cash-on-cash multiple potential for our clients. Many factors contribute to this potential, but we basically look to invest with highly experienced teams that have worked together for a long time and who have exhibited strong evidence that they can execute against a sound and thoughtful strategy.
There are a number of interesting first-time funds, composed of teams that have spun out of more established franchises. Many of these groups have good team chemistry, strong domain expertise and fairly deep track records. In contrast, we see a lot of established brand name organizations that have faced a great deal of turnover and fairly meaningful strategy shifts over time. So, at the end of the day, we pay less attention to a fund’s “Roman numeral” and more attention to the history, experience and capabilities that a specific team brings to the table.
How much of a comfort is “personality” in a fund?
As we go through our due diligence process, there are a number of aspects that we look at. We have never backed a fund solely because of one strong personality per se. This can certainly be a strong contributing factor, but we need to see much more than just a strong and charismatic person at the top. The reality is that a strong personality can be a double-edged sword – it may provide a fund with immediate credibility and gravitas among entrepreneurs, but funds that rely solely on this also tend to have a hard time in growing and incentivising other important players on the team, often times resulting in key turnover and a one-dimensional perspective.
How has India fared from a return perspective?
India, for the most part, is still a young and relatively unproven private equity market. Although deregulation in India started back in 1990, the fact is that much of the benefit from this has only been seen in the last 5-10 years. Indeed, we have probably witnessed more progress in India in the last five years than in the 20 years prior to this. This makes India both an exciting and an unpredictable market for private equity investments.
Anybody who requires a long track record of consistent realized returns will probably find India to be a fairly unattractive investment option. Unfortunately, looking at India through the rear-view mirror will, in our opinion, result in significant missed opportunities. We believe that taking a strong bottoms-up approach to selecting experienced managers with sound strategies could yield possibly some of the more attractive returns in private equity over the next five years. However, again, we believe that India is not a “beta play” and that proper manager selection will be critical.
Within emerging markets, what is it about India which is the biggest pull factor?
One of the most significant and attractive phenomena driving the “India story” is probably the highly attractive demographics and the growing middle class, which will have a profound impact on consumer growth and the broader economy over the next decade and beyond. This will impact not only the immediate consumer space but will also drive opportunities in infrastructure, real estate, healthcare, education, energy, manufacturing and technology.
Indians represent possibly one of the most entrepreneurial people in the world today. Since my first visit to India in 1996, I have witnessed a tremendous rise in optimism among many of these young entrepreneurs. This combination of opportunity, optimism and entrepreneurship is not only unique but is a powerful force that makes India a highly attractive and distinctive market for us as private equity investors.
How are you reading the current fund-raising environment?
Things have certainly improved since this time last year, but there is no doubt that the fundraising environment is still quite challenging. In particular, endowments and foundations (E&Fs) – who have traditionally had very high allocations to private equity and other types of illiquid alternative investments – were hit quite hard when the liquidity crunch impacted the global economy. About 70% of our LPs are endowments and foundations, so fundraising was particularly challenging for funds like us that cater mainly to E&Fs.
During the one-year period spanning from fourth quarter of 2008 to third quarter of 2009, not a lot happened on the fundraising front for anybody. Since then, however, the public markets have rebounded and there has certainly been a good deal of renewed interest in Asia. Many investors will acknowledge that they are underweight Asia and that there is a good deal of catch-up that probably needs to take place within their portfolios. However, I think that the broader interest in Asia has probably outpaced the interest in private equity per se.
We are still seeing a good deal of aversion towards illiquid investments and many institutions are still hesitant to replace liquid dollars with 10-year locked-up dollars. This appears to be manifesting itself into a greater demand for the more liquid hedge funds and public equities in Asia (over private equity), and this liquidity bias appears to be one of the big contributors for continuous fundraising challenges on the private side.
Can you please provide more specifics on the funds you would look at?
First and foremost, we need to see strong potential for outperformance. It is, indeed, fairly easy for us to quickly screen out funds that do not show this initial potential. We specifically look to find distinct “differentiating” factors that provide tangible and unique advantages to a team. This could come in the form of real advantages on the deal sourcing side, strong operating skills that can allow a fund to create tangible and bankable value to a company, and/or unique resources that can allow a fund to provide its portfolio investments with a true unfair competitive advantage in the market.
The reality is that India is home to an awful lot of private equity funds, and many of these funds have similar strategies and fairly generic team profiles. Given that our mandate is to select what we believe will be the top one to three most promising Indian investments in any given vintage year, we spend a great deal of time and resources in trying to identify funds with specific and tangible advantages. Because of our investment pace and level of selectivity, we will probably end up ultimately passing on a good number of very promising funds that may end up being quite successful. However, we accept this as a necessary occupational hazard, in exchange for allowing us to “cherry pick” the market.
Does a niche focus work well?
Our fund is essentially a portfolio of niche funds. We generally avoid looking at India as a broad country play (which is also the case for other markets we look at in Asia). We seek niche strategies within India that look to capitalize upon specific opportunities in which our team has strong long-term convictions. These niche strategies could be around a sector, an investment stage or a geographic focus within India. Indeed, most of the Indian funds that we have invested in have followed a specific theme, with a fairly strong focus on a specific sector, stage or other factor. We have generally avoided overly generalist funds with broad and unfocused strategies and mandates.
The fund raising environment continues to be challenging, and the LPs are batting for tougher LP-GP principles. What are your thoughts there?
I have heard a lot of talk amongst LPs and other market commentators that the center of power is shifting towards the LP. However, I remain fairly sceptical about any near-term wholesale changes to terms. I recall hearing similar talk in Silicon Valley when the tech bubble burst in the earlier part of this decade but ultimately nothing really materialized. I hope I am wrong, but I can’t help but be a bit sceptical when I hear people talk about changes in the balance of power.
I personally think that 2:20 is a fairly firmly-embedded structure in the private equity world and I think it would take a lot to see this suddenly change overnight. However, that being said, we have had much success in negotiating non-economic terms, which often times can be more meaningful than a simple fee reduction.
From our perspective, we have found many GPs willing to accommodate firmer keyman language, stricter limitations on investment pace and scope, and basic governance and alignment-of-interest points that are very near and dear to our hearts. Each fund is different and, ultimately, the ability to secure LP-friendly terms is driven by the amount of negotiating leverage that one holds. In general, we have been quite successful in securing terms that improve protection of and alignments of interests, but we continue to see resistance on outright fee and carry reductions.
What really worked for you in the fundraising?
Asia undoubtedly remains a challenging place to invest without a knowledgeable on-the-ground team. In more developed private equity markets, the spread between first and fourth quartile funds is not only material, but can be significantly greater than the incremental fees and expenses charged by fund-of-funds – and we believe that this spread is likely even greater in Asia. As a result, the cost of making a poor investment is high, while the reward of making a good investment is potentially meaningful.
Given the strong interest in Asia (relative to more developed Western markets), we believe that those fund-of-funds who can make a convincing argument of their ability to invest in top quartile funds “should” have greater success in fundraising. In our case, we pursue a fairly unique strategy that appeals to many endowments and foundations, and have had great success in attracting other like-minded investors. Additionally, three members of our investment team previously worked at leading endowments and this has provided many of our LPs with comfort that we represent a team that looks and feels similar to the type of team that they might hire, were they to open their own Asia office.
Although our team and strategy may not appeal to all investors, we make no attempt to be a one-size-fits-all fund. We believe that we are extremely good at what we do, that we do not (and cannot) appeal to all investors and that we can provide a unique value proposition to like-minded investors – many of whom, by the way, are not endowments or foundations. Focusing on this niche of LPs has been a highly successful fundraising strategy for us and has helped to differentiate us in a heavily crowded market.
How important are the economics of a fund in the current environment?
Naturally, we would always prefer to pay lower fees and give away less of our carry, all things equal. However, we are ultimately charged with maximizing “net” returns – so the economics of a fund are but one component of a much broader decision making process. If we believe that a more expensive fund will provide higher net returns than a less expensive fund (post fees and expenses), then we will always pursue the higher “net” returning fund. Likewise, we will not be likely to commit to a fund simply because of better economics unless we believe their net returns will be superior.
It is important to note that, unlike more efficiently-priced asset classes (such as fixed income or equity index funds), private equity is not a “commodity business” and the performance spread between good and bad managers can be meaningful. As such, fund economics must be incorporated into the broader due diligence framework and ultimately analyzed on the basis of expectations for the highest possible risk-adjusted net absolute returns.