Private equity's China moment

David Pierce of HQ Capital reflects on his 20-year career in private equity in Asia and looks at the road ahead for China.

David Pierce has a 20-year career in private equity in Asia. He joined HQ Capital in 2014 to run its Asia business. HQ Capital is the investment vehicle for the heirs of German industrialist Harald Quandt and was formed from the amalgamation of several alternative investment units in 2015. Its roots go back to 1989 when it began to invest in US alternative assets, first for the family and then for other German family offices and institutional investors; it has invested in Asian private equity since 1997. Pierce, who previously ran Squadron Capital (now a unit of Flag Capital Management), met with Jame DiBiasio to discuss the outlook for private equity in China. For the first part of this interview, click here.

You’ve been seeding GPs in Asia for a long time. What’s changed?

What I do here at HQ Capital is a continuation of what I’ve done for 20 years. I think about the usual things you’d want in a private equity fund and the alignment of economic interests. Today there is more to look at. There are plenty of GPs now marketing fund number three, or four, or five. And there’s also been a change in the GP environment: some people have learned this business really isn’t for them, while others have gotten better at it and are more thoughtful about how to structure their business in order to retain liquidity.

Why is liquidity so important now? Aren’t GPs investing over a long cycle?

If you take a minority stake in a company, the entrepreneur who owns it may not want to sell. The GP’s fund has a 10-year lifespan. You need a clear understanding at the outset in order to match that timetable to the shareholder’s aspirations. The GP needs a plan for liquidity before it even starts to invest. If the GP relies on a public offering, it needs a plan for other mechanisms if IPOs don’t work. What we’re seeing today in China is not new: China has officially closed its public markets eight or nine times in the past 20 years.

What are methods GPs use to ensure liquidity if they can’t exit via IPOs?

They could agree to give shares back to the owner or compel a sale of their interest, or provide for a compulsory dividend, or structure their stake to convert into debt.

A lot of funds in Asia have not employed these mechanisms and now they’re stuck. A marooned fund in a company controlled by somebody else is not an attractive place to be.

Has the nature of risk changed?

Currencies were not volatile for much of my career; now they are very volatile. That’s a problem for investors. There’s nothing we can do about it; hedging is too expensive. But GPs need to build currency risk into their business case.

How important is it that LPs with Asia programmes have public markets expertise?

We don’t study IPOs but it’s important for GPs to have internal or external expertise on capital markets. When the window does open you need to already have your ducks in a row.

For GPs in general, co-investments are becoming a bigger part of their business in Asia. Many feel they are getting forced into co-investing because LPs just want to lower fees. How important is it to you?

Co-investment is seeing an increasing amount of dealflow. Because of the nature of most private-equity investments, these are not into control situations. So they’re more risky. Our objective is to enhance the overall return of our fund, which does mean selectively putting capital to work to reduce fees. Having lower fees is not a goal in itself; we pay good fees for good investments. But some of our segregated accounts like co-investing if they have a view on a sector they know and want to grow their own business.

So some of your family office clients use co-investing to help those families extend their primary business activities into Asia. Given HQ’s German background, do you do such deals primarily for German companies?

All of our segregated accounts are German but what you’ve described is not the major driver of the co-investment trend. Flow here is growing but it’s lumpy. Some GPs offer co-investment because it’s the flavour of the month. Others do it because they feel compelled to do so. We might co-invest with a GP in order to take a larger stake in a company than the GP would otherwise want; this avoids overconcentration of positions in a commingled programme. There are not many control deals out there, however, so most LPs’ portfolios are lighter on co-investments in Asia than they are in the US.

What hasn’t changed about private equity in Asia?

It’s something you need to do steadily. It is a long-term contributor to investment returns. In the short term it can be volatile. So invest steadily and look past what public markets are doing. That should result in steady distributions but there can be times when you are short of capital. Sentiment is a factor, such as concerns about growth in China or the possible devaluation of a currency.

Macro views don’t produce micro returns but population, the growth of cities, and other macro considerations should produce attractive, risk-adjusted returns in private markets that are higher than those in developed markets. Right now entry-point valuations have fallen, so it’s a good time to get into companies.

But valuations haven’t fallen evenly: hot consumer stories are still expensive.

The private-equity market for capital is not efficient in Asia. The public multiple is relevant but smaller companies can’t get listed or access bank debt. The P2P market is expensive; who knows what’s going on there? Some of them look like Ponzi schemes. So this is a good opportunity for private equity – when companies can’t get capital anywhere else.

There is a psychological effect from the public markets too. A year ago, when it seemed the government was underwriting the bull market in China, entrepreneurs required very high valuations from GPs. Few deals got done by the GPs we support. Today, entrepreneurs have to make a more sober assessment. Deals are getting done, even in hot sectors. Sellers are being more realistic. Perhaps they are affected by capital flight or by pessimism about structural reform in China.

How important is SOE reform to private equity?

The policies for state-owned enterprises as enunciated by the Communist Party and the government are consistent with the reform path and make sense to me. But we’re hearing on the ground that relatively little of that is being implemented. The anti-corruption campaign or other factors have taken the wind out of the sails of reform. We get the sense that there is not a lot of action right now.

Do you have GPs involved in SOE restructurings?

We do and they’re a little frustrated. But the government realises its SOEs require reforming. There may be a role for private capital but it’s likely to be only in a few cases.

Do you therefore switch to opportunities in Hong Kong or Singapore?

We don’t do venture capital, so there are not a lot of deals. There is a vibrant venture community in Hong Kong and plenty of transactions with holding companies but PE deals are rare.

For private equity in general, distributions in 2015 outpaced capital calls. Is that healthy?

It’s to be expected in Asia because there was so much capital invested over the past 15 years and now we’re seeing money being returned. Capital markets were buoyant during the first half of 2015, particularly in the US, so it was a natural time to harvest capital. Meanwhile, money doesn’t come back to GPs because valuations were too high. But 2016 will be a year when money is put to work, particularly in Asia.

Despite concerns about China?

Many investors held the conviction that over the long term China would move to a market-based economy and a pluralistic political system. That’s not happening. But private equity can be the right way to address that concern. The private/public market mix is different in Asia because transparency in public markets is different to what you get in the West. At least in private equity you own a company and you know what’s going on underneath the hood.

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