Kleiner Perkins

Where is the PE industry headed in China? How can it rebuild from the current state of crisis with thousands of unexited investments and tens of billions in stranded LP money?  I have a suggestion. The future is separate managed accounts.

This is a form of institutional investing that is especially needed, and especially appropriate, in China. Separate managed accounts would give LPs what they want, access to good investment opportunities in China, but with little or none of the high risk, waste, misaligned incentives of “blind pool” investing in a typical PE firm in China. Separate managed accounts have the potential to fix what is manifestly broken in China private equity.

Briefly, separate managed accounts are an arrangement through which an LP hires an investment team, usually but not necessarily a PE firm, to manage money directly on its behalf, rather than put money into a larger bucket (a typical PE or VC fund) alongside other LPs. That’s the way the system generally works now — PE firms pool money from LPs large and small, build and manage a single “all-purpose” portfolio. LPs, even the largest ones,  all pay pretty much the same annual management fee (around 2%) and surrender the same share of accumulated profits (usually 20% and up) to the team investing the money.

From an LP perspective, the advantages of a managed account are numerous. The three key ones are lower fees, greater ability to hold the investment team accountable,  and a portfolio more specially tailored to its needs, including the timing of liquidity events. In private equity terms, separate managed accounts are more like no-load index funds than fat-fee mutual funds. Leverage and gains are transferred to the people whose money is at risk, not the ones who manage it.

The private equity industry is as ripe for this kind of disruption as the mutual fund industry was in the 1970s when John Bogle (a genuine hero of mine) began offering index funds at Vanguard. Bogle stripped out most of the fees and overheads charged by traditional mutual fund companies, and so let investors keep more of what they earned. He showed that paying “superstar fund managers” to build a portfolio was usually nothing more than a colossal waste of money.

Bogle’s ideas and business model took awhile to catch on. The traditional mutual fund industry fought it every step of the way. But, today, Vanguard is the largest, as well as the most admired mutual fund company in the world. John Bogle hasn’t gotten particularly rich doing this. But, he has made millions of dollars for millions of others.

My guess is if John Bogle and Vanguard wanted to get into private equity, they would set up a business to provide separate managed accounts. The “two-and-twenty” approach of most PE and VC firms has come under increasing pressure everywhere. LPs, often with large unfunded liabilities, are under ever greater pressure to improve returns.

Overall, PE and VC has a pretty good record of producing returns above the basic hurdle rate of around 5-8% a year. This is especially true when returns are based on a PE firm’s own “marked-to-market” valuations. Actual cash-on-cash returns are usually lower, because exits are not common enough.

Once you subtract the GP’s fees and cut of the profits, an LP’s returns, especially when you factor in a liquidity premium,  is often not a lot to get excited about.  For LPs, cash returns are what matter most. Pension funds and insurance companies need to disperse real cash every month， not marked-to-market audit statements of a PE fund’s notional investment returns.

If done well, an LP investing through a separately managed account can get all the performance and diversification benefits of PE investing, but at lower cost, with greater control, both over the outlays of cash and the kind of deals being done. In China, the appeal of separately managed accounts should be particularly strong. We’re now seeing — and LPs feeling most of the pain — of the problems, distortions and heavy risks inherent in the current model of private equity in China.

PE firms raised tons of money by rightly pointing to China’s attractions as an emerging market — huge population and market, with economic growth far higher than in Europe and the US, and a large number of strong, private sector companies hungry for capital.   There was also a legacy of very lucrative PE deals done during the industry’s early years in China, including investments in China’s main search company Baidu, as well as Shenzhen Commercial Bank, Pingan Insurance.

To gain access to Chinese investment opportunities, LPs were persuaded to accept a level of risk that they might ordinarily shun. PE investing in China, they were told, is different, with opaque regulations, shifting government policies, a business environment rife with corruption and cronyism, primitive capital and debt markets. The PE and VC firms were often either newly-formed, or familiar names (like Kleiner Perkins, Sequoia, KKR) staffed with local Chinese-speaking teams who operated more like franchisees.

Hundreds of PE firms crowded into China. Almost all chose to adopt the identical investment strategy and target the same kinds of companies — those that looked the likeliest to have an IPO. Two hundred billion dollars was poured into over 10,000 Chinese companies. It turned out in many cases to be among the blindest forms of blind pool investing ever — a lottery ticket strategy in search of lottery returns.  The result is $100bn or more of LP capital now stranded inside illiquid investments. A large proportion of these deals will likely not exit before the expiry date of the fund. That represents a serious problem for LPs.

For most LPs, liquidity is a paramount concern. PE investing in China seems to have lost sight of that, with its reliance on IPOs as a single unhedged exit strategy. Even at its high point six years ago, IPOs were a low probability outcome. Fewer than half the PE deals done in 2007 exited through IPO. Following that, the number of deals done each year grew by over 50% from the 2007 amount, while the number of IPOs peaked in 2010.

Incentives don’t often get more perversely misaligned than those between PE firms in China and the LPs they invested for. The PE firms got fees, profit shares and very little scrutiny. Once a year or so, they marked-to-market their illiquid investments. This helped persuade LPs all was well. In my experience, China GPs often focused more on keeping the fees coming in, including by continuously raising money,  and less on achieving reliable and timely exits for current LPs.

Had LPs been investing through separate managed accounts, there is far less likelihood any of this would have occurred. The LPs would have assessed more closely each deal that was being done, and put money only into deals that closely matched the LPs specific appetite for risk and timetable for achieving liquidity.

Better safeguards would have likely been put in place to make sure investments had a “put clause” that was more enforceable than the one used in the majority of PE deals in China. Done properly, the “put” allows an investor to sell shares back to the company after several years if all other exit channels are blocked. In other words, it places front and center, in any PE deal, that eventual liquidity is a minimum requirement.

LPs accept that investing in private equity and venture capital carries higher risks than buying publicly-traded securities. They also know that every PE portfolio will have its share of losers. But, where China PE is unique is in having such a high percentage of investments in flourishing businesses where the PE stake is illiquid, and unliquidatable within the remaining life of the fund.

In many cases, the investee companies used the PE money wisely, and have grown in the years since. They might like to have an IPO at some point, of course, but it isn’t necessary for their survival. The PE money is stuck inside. It’s not yet a crisis for the company. It is a crisis for the PE firms, and even more for the LPs, since it’s their money that’s now unrecoverable.

As a rule, the fees paid to managers for separate managed accounts are lower than those paid to a GP.  The profit carry is also usually lower. The spread between gross and net returns will be far narrower.  This will help LPs close what, for many, is a widening gap between current performance and future unfunded liabilities.

Although separate managed accounts seem an ideal business model for alternative investing in China, it may prove extremely difficult for LPs to find competent firms to provide the service. The economics of a typical PE fund are, of course, far more favorable for GPs than LPs. Separate managed accounts would reverse this.

John Bogle built the world’s largest and most successful mutual fund company by putting investors first, by chopping out wasteful fees, hidden charges, huge salaries, bonuses and overheads. He saw what was wrong with the mutual fund industry, that it was achieving mediocre results for investors while making huge piles of money for itself. He met a need, and for forty years now, he and Vanguard have done well by those who trusted them with their money.

China private equity needs a John Bogle. Will it get one?

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