T&I ASIA CHINA SPECIAL REPORT - Asia Alternatives · T&I China Special Report, Part 1, LP View. 9/19/08. © T&I, 2008. Contact: [email protected]

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T&I China Special Report, Part 1, LP View. 9/19/08. © T&I, 2008. Contact: [email protected]

T&I ASIA

CHINA

SPECIAL

REPORT PART ONE: THE LP VIEW

SPONSORED BY

BARING PRIVATE EQUITY ASIA

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PART ONE:PART ONE:PART ONE:PART ONE: T&I SPECIAL REPORTT&I SPECIAL REPORTT&I SPECIAL REPORTT&I SPECIAL REPORT LP VIEWS ON CHINALP VIEWS ON CHINALP VIEWS ON CHINALP VIEWS ON CHINA Hemal Mirani, Harbourvest (HM): Reflecting back on the past year and on 2007 since we last met in for T&I in Hong Kong, looking back at the funds that were raised, in terms of the number of investments that were made, the number of IPOs that we’ve had, we’re all asking ourselves, how the year could have been better and how we could have a better year in 2008? In 2007 there were a record number of deals, a record number of funds raised, record IPOs and record M&As. Looking back at that and thinking of the trends that we observe from the data set of the year we saw a number of trends that are interesting. In general there was less interest in investing in early stage IT and more interest, broadly speaking in traditional types of industry and in late stage investing. We should ask ourselves

what are the implications of that, especially given the large number of firms focused on technology investing in China. I hear a lot from GPs who talk about their great deal flow and the deal networks that they have exposure to in tier II and tier III cities, but if you look at the statistics, 50% of all VC investments in China are done out of Beijing and Shanghai. I wonder, in reality, whether we’ve seen this trend of VCs moving from the larger cities into the smaller cities? The other trend that we observe is that firms who used to be early stage investors are moving into the growth stage and firms that used to be growth stage investors are going into early stage investing. Then, there is a new phenomenon of everyone wanting to raise a PIPES fund

ALTERNATIVE INVESTING IN CHINA: LP VIEWALTERNATIVE INVESTING IN CHINA: LP VIEWALTERNATIVE INVESTING IN CHINA: LP VIEWALTERNATIVE INVESTING IN CHINA: LP VIEW

From Left: Meredith Jenkins, Hemal Mirani, Hugh Dyus, Markus Ableitinger, Rebecca Xu and Wendy Zhu.

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prompting the question of whether we’re going to see more of this in China? Is this merely something opportunistic that

people are taking advantage of, because the markets are being kind, or is this a land grab taking place for the China space with firms hoping to play across the investment spectrum? All of us have watched for the larger deals and to some extent, it’s been disappointingly quiet at the larger end of

the spectrum, causing concern that there has been insufficient regulatory change to allow that to take place. And speaking of regulatory changes, there is another issue here about RMB funds

and how that is going to impact the way that all of us invest in China or how we think about investing in China. RMB funds raise the question of whether there is going to be a tilt towards local players in China, who will have RMB funds. In that regard, we’ve all seen that the National Social Security Fund (NSSF) of China is making commitments to Hony and CDH. It’s nice to see money from local sources in China, going into and helping to evolve and mature the private equity asset class in China, but given that there are a lot of rules and regulations in China and that RMB funds have a more symbiotic relationship with regulators it raises a question about whether this is going to skew things against those of us who are foreign LPs looking at ways to access some of the deal flow in China and whether there will be differentiated IRRs for those of

us who are foreign LPs investing in China. It raises the question of whether we should be thinking, strategically, about our approach to that. On a macro level, having just observed the recent earthquake in central China and the approach and soon to be over Olympics in China, that everyone has been building towards, we wonder whether we’re going to see a slowdown? And if we do see a slowdown, will it combine with the slowdown that we’re already seeing in the public markets and have an impact on valuations? Or will it take something a lot more dramatic for us to see an adjustment in valuations for investments in China? Because not just in China, but in India as well, you’ve seen that lower valuations for public stocks, are not reflected in the valuations being given in terms sheets, are not reflected in what’s going on in the public markets. All of us have to wonder, whether there are macro reasons for a correction to take place in valuations, because valuations have gotten a bit out of hand, in terms of us being able to earn suitable returns on our investments. [In terms of the many investments in VC leading up to the Olympics that were not successful: TD-SCMA; 3G; mobile video and the impact on our GPs] it’s

going to be interesting to see what it means. My belief is that most of the GPs in China have moved away from pure technology. Maybe you see a few who work in semiconductors or in design houses, but at I’m seeing fewer and fewer GPs with such focused theses. Or maybe I’m missing these China managers and perhaps there are other LPs here who will convince me

HM: WE’RE ASKING OURSELVES HOW HM: WE’RE ASKING OURSELVES HOW HM: WE’RE ASKING OURSELVES HOW HM: WE’RE ASKING OURSELVES HOW 2007 COULD HAVE BEEN BETTER? 2007 COULD HAVE BEEN BETTER? 2007 COULD HAVE BEEN BETTER? 2007 COULD HAVE BEEN BETTER?

HM: HOW MANY GPS ARE TRULY HM: HOW MANY GPS ARE TRULY HM: HOW MANY GPS ARE TRULY HM: HOW MANY GPS ARE TRULY SUCCESSFULSUCCESSFULSUCCESSFULSUCCESSFUL,,,, JUST DOING TECHNOLOGY? JUST DOING TECHNOLOGY? JUST DOING TECHNOLOGY? JUST DOING TECHNOLOGY?

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otherwise. But having seen this much, having to justify a strategy that is pure technology, is….well, think about the US. You have to ask yourself, just how many GPs are there, who are truly successful just doing technology? It’s a hard strategy to make work. Hugh Dyus, Macquarie Capital (HD): One of the topics I’d like us to discuss

today is the ever-changing regulatory environment. Not only regulations as

they affect the private equity industry, but as these new regulations affect businesses. For example, the pressure on managers not to sell shares because the regulators think that the stock market is

too low is somewhat bizarre; that a regulator should seek to tamper with the level of stock market is bizarre. Another example, the oil price is capped. So that while other oil refiners are minting money, in China, for every barrel of oil refined in China, they’re losing money. That creates a different risk profile, the ever-changing nature of the regulatory environment here. HM: I wonder how much we all forget, that China is not a capitalist society yet? We expect all of these rules to work the way that the rules work anywhere else. I wonder whether we’re not setting ourselves up for trouble, more than anyone else is setting us up for trouble due to regulation?

Wendy Zhu. AlpInvest. (WZ): RMB funds are a very big issue for those of us who have existing commitments to funds in China and given that there is the potential for conflicts with these funds as they’re setting up separate vehicles to be invested in parallel with the US dollar funds. We’re keenly interested in what is going on with these funds. We also have concerns about the terms and conditions agreements with our managers because there is so much money going into China; our position as LPs negotiating with GPs who are investing in China is also changing, in relation to the demand for assets and as the amount of capital available is increasing. I have concerns about where our 2.5% fees – given that funds in China are from $300 to $500 million these days – are going. Rebecca Xu, Asia Alternatives, (RX): We often say that China has leap-frogged, in terms of technology and in terms of catching up with capital market system. Similarly terms and conditions have leapfrogged by at least ten years at a minimum. We’re facing what is very much at the moment, a sellers market, i.e. GPs are dictating terms, which is driven by, I think that it’s fair to say, the Silicon Valley firms who come into China with their top tier name and their loyal LPs. When they say I’m going to raise a China fund, people just sign the papers, without asking any questions and

HD: THAT A REGULATOR SHOULD TAMPER HD: THAT A REGULATOR SHOULD TAMPER HD: THAT A REGULATOR SHOULD TAMPER HD: THAT A REGULATOR SHOULD TAMPER WITH THE WITH THE WITH THE WITH THE STOCK MARKET IS BIZARRE.STOCK MARKET IS BIZARRE.STOCK MARKET IS BIZARRE.STOCK MARKET IS BIZARRE.

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without meeting the local teams. They’re happy to pay 2.5% and a 30% carry. For other reasons beyond their interests in China; certainly [these LPs] may be interested in China, but I think that there are other reasons why LPs are in these top performing funds. Whereas those of us who are only looking at, focusing on Asia and looking at the merit of the team and the market opportunities, see these fund terms are distorting the market.

Meredith Jenkins, Carnegie

Corporation of NY. (MJ): I thought about that a too, and in looking through our portfolio, it’s the American firms that have all of these premium carries. The worst terms seem to have come from the American firms who have set up here. More recently however

and anecdotally, one of our firms has stepped back on the carry and fee. They said that they did this because they see the market moving to more of a growth strategy, with a lower return profile and so they’re willing to make a deal on places where it hurts the LP.

HM: Another related T&A issue to discuss is whether key man agreements are even worth having in China; whether they mean anything, given the turnover we see in these funds. MJ: We’ve seen key man language set up to protect the LPs thrown out of the door when the situation has changed.

Markus Ableitinger,

Capital Dynamics. (MA): On a related topic, I’d like to look at the overnight success we’ve seen in fund raisings. I don’t see how to see how it’s possible for GPs in China to raise new

funds, double the size of any other fund, in such record times. HM: Well, given that you’re wearing a fund of funds hat, what is the advice that you’re giving your clients? MA: I’m looking to this group for advice on what you’re doing (laughter). The other issue I see is early stage investing and how difficult it is to do this in China and why most of these firms are shying away from it. The skill sets to be successful at this are enormous. On the other hand for those who are able to do this, it’s a great time right? Because there is no one else there in that investment space, so if you have the skills in place you are in a good place. But the reason why people are reluctant to do this in China, is that it’s very difficult and takes a long time to be successful. While at the same time, you see GPs making faster investments that suit the Chinese mentality a bit more; getting in and making returns more quickly.

WZ: There is another factor constraining early stage and technology: regulation. When in technology, for example, anything has to do with the food chain of the telecom industry, it’s heavily

MMMMA: I DON’T SEE HOW A: I DON’T SEE HOW A: I DON’T SEE HOW A: I DON’T SEE HOW GPS IN CHINA GPS IN CHINA GPS IN CHINA GPS IN CHINA RAISE NEW FUNDS IN RECORD TIMES.RAISE NEW FUNDS IN RECORD TIMES.RAISE NEW FUNDS IN RECORD TIMES.RAISE NEW FUNDS IN RECORD TIMES.

MJ: THE WORST TERMS MJ: THE WORST TERMS MJ: THE WORST TERMS MJ: THE WORST TERMS …………COME COME COME COME FROM UFROM UFROM UFROM U....SSSS.... FIRMS WHO SET UP HERE. FIRMS WHO SET UP HERE. FIRMS WHO SET UP HERE. FIRMS WHO SET UP HERE.

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regulated, even though you might be at the bottom of the food chain, you’re affected one way or another. So for those of our predecessor GPs who invested ten years before, our friends at H&Q and Walden International, their market timing may have been too early. There is

the dream and they’ve had a vision, but there is the reality of the market, the fact that the market is taking longer to develop than expected. And along the way, regulatory changes cause further delay, exacerbating the problems and causing risks. If I look at the technology

focused GPs that we’ve dealt with, one big area of advantage, vis-à-vis the newer foreign firms is that the older firms are intimately involved in the conversations with the policy makers and the ministries and the

research institutes, so they know where the market is going, not just because of the technology, but because of their knowledge of where the government is guiding certain technologies. T&I: How does the Silicon Valley mindset affect tech investing here? WZ: The first thing that I would say about firms who are paying upward of $50 million for an “A” round in China, is that these are GPs in whom we don’t invest (laughter from the table). RX: There is a large variation in the first round of valuations for portfolio investment in China. I was recently looking around in our portfolio to see where that kind of inflated investing

starts. If you look at the range of overall valuations being given to portfolio companies, the range can be from several million dollars up to forty or fifty million dollars. But typically, what people do is to invest half a million dollars first, to lock in a deal, to monitor a firm’s development, to see whether the company will meet their milestones. Then in another six months or nine months, they’ll invest another two million dollars. They invest in tranches, to control the risk of either a technology product or the management. And in some cases they may walk away from a company after an initial tranche because the founders can’t get their act together or can’t see eye to eye in terms of implementing a strategy. From that point of view, the managers that we support are managing their downside risks very carefully, watching valuation very closely. Anecdotally, I can say from talking to our managers that series A round valuations are still a comfortable margin below the Silicon Valley Series A level. Plus, you have to factor in the fact that burn rates are much lower among

Chinese companies, so that if you give them two million dollars, it goes a long way. The same phenomenon is true in India; has caused certain firms to think that if a GP gives them ten million dollars, even though their initial valuation might be higher, they think that money can carry them through the entire process of developing a product, it

WZ: …THE REALITY IS THAT IT IS TAKING WZ: …THE REALITY IS THAT IT IS TAKING WZ: …THE REALITY IS THAT IT IS TAKING WZ: …THE REALITY IS THAT IT IS TAKING LONGER TO DEVELOP THAN EXPECTED.LONGER TO DEVELOP THAN EXPECTED.LONGER TO DEVELOP THAN EXPECTED.LONGER TO DEVELOP THAN EXPECTED.

RX: …MANAGERS WE SUPPORT, ARE RX: …MANAGERS WE SUPPORT, ARE RX: …MANAGERS WE SUPPORT, ARE RX: …MANAGERS WE SUPPORT, ARE WATCHING VALUATION VERY CLOSELY.WATCHING VALUATION VERY CLOSELY.WATCHING VALUATION VERY CLOSELY.WATCHING VALUATION VERY CLOSELY.

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can take them all they way to an IPO. The entrepreneur thinks, “why should I take the risk of diluting the company further or why should I take the funding risk for the company if the market situation changes.” But coming back to the issue of valuations, I’m comfortable with the valuations that I see our early stage technology GPs paying for the companies they’re investing in. Going back to the original question, looking at say, a Stanford graduate leaving University and coming back to

China, at least in our portfolio, we prefer managers who are from China, who were born in China, who have exper-ience in China, but who also have, international investment experience and who have then come back to China. We want them to have on the ground investment experience, which we think is very important. We probably wouldn’t even consider a manager, who doesn’t have China experience. I don’t know how such managers can raise their money, but for us at least it’s very important that they have experience managing investments in China.

HD. Another interesting issue is the number of Chinese government institutions who are backing early stage managers, with quite large checkbooks and the impact that is going to have on the market as a whole.

All of the private sector VCs say “Ah, our managers, they’re not just after

money, they’re after someone who can help them.” And while they’re sophisticated enough to know that they don’t want a government partner for money, there is a lot of government fund raising and investing going on. I can’t help but feel that this is going to spoil the market somewhat, because the government is really an undisciplined investor. DOMESTIC LPS DOMESTIC LPS DOMESTIC LPS DOMESTIC LPS

RX:. That is a good point to segue to a discussion about domestic LPs. I think that while you see the headlines, that the National Social Security fund is going to give Hony and CDH two billion RMB for a 5 billion RMB fund – and while that is a substantial commitment for anyone for a fund by any standard – beyond the social security fund, I haven’t seen many other commitments of that size; including all the provincial governments, the local governments, who have what they call “guiding funds”, who are adopting the SBIC model, in order to stimulate their local economies or encourage technology businesses. Those are on a relatively smaller scale and they will back a larger number of managers. To look at this

through a positive lens, government LPs will nurture a new breed of local general managers, who may not need to raise foreign funds at all. Look at where Japan is today. Many of the more successful mid-market GPs have been supported by domestic GPs, while there have been US

RX: RX: RX: RX: …………IT WILL TAKE CHINA 10 YEARS IT WILL TAKE CHINA 10 YEARS IT WILL TAKE CHINA 10 YEARS IT WILL TAKE CHINA 10 YEARS TO DEVELOP TO DEVELOP TO DEVELOP TO DEVELOP AN AN AN AN INSTITUTIONAL INSTITUTIONAL INSTITUTIONAL INSTITUTIONAL FUNDING FUNDING FUNDING FUNDING BASE BASE BASE BASE FOR GPSFOR GPSFOR GPSFOR GPS....

HD: I CAN’T HELP BUT FEEL THAT HD: I CAN’T HELP BUT FEEL THAT HD: I CAN’T HELP BUT FEEL THAT HD: I CAN’T HELP BUT FEEL THAT THIS IS GOING TO SPOTHIS IS GOING TO SPOTHIS IS GOING TO SPOTHIS IS GOING TO SPOIL THE MARKET …IL THE MARKET …IL THE MARKET …IL THE MARKET …

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LPs who are fighting to get into those funds and who have been at the mercy of the local GPs as to whether they will set up an offshore vehicle or not. Maybe China will go in that direction, maybe not. I think that it will take China a minimum of ten years, to develop a true, substantial, consistent, institutional funding base for large general partnerships. For that reason alone GPs will continue to come to overseas LPs for capital and best practices. Going back to the point about the social security fund, they’ve invested in these two funds. The choices that they’ve made are the best they could. Those are two of the best managers in China. The NSSF have done their homework; I’ve run into them at conferences for the last 18 months. And the terms and conditions that the NSSF uses are industry standard practices; they’re not this old style, “I’m going to squeeze your people” kind of investors for the benefit of the government. They want to set the precedent that they are truly an international institutional LP. However, there is only one social security fund. It is going to take a long time for other institutions in China to get to that point. MJ: Our feedback from those managers who have been able to get in front of the NSSF is that they would not raise as much as we might expect from that pool. We assumed they would just raise as much as they could, but they say they wouldn’t because many of the government entities that would be interested are still of the model that “if we’re going to come in, you have to give us something,” in economic terms and the GPs have refused to do that, which is a welcome sign of discipline.

This relates to a point I touched on earlier, about the worst LPA terms in China coming from the US funds. Many of the truly local funds have had standard and fair terms. When they were raising smaller funds, having a 2% to 2½% fee for a fund made sense for what they were doing. But of course, when they keep that 2½% when they’re raising one billion or more (MJ in an interrogative pause)…

A more recent trend that is of the most concern for us is the carve-out for RMB funds, which you basically have to accept to go into these funds. This may be bad for non-RMB investors in the funds. Key-man clauses are a tough issue. We actually have a number of funds in the US who have no key man clauses and they’ve brought that over here. So there is no key man protection on any of the team members, which is unacceptable. That being said, these are firms that are able to get such LPA terms in the market. A good thing in most of the local fund documents that we see is that there is some sort of key

man protection. The bad thing is that there is still reliance in the key man clause on the person who historically or culturally was “the guy,” even though you know that the firm is no longer just that one guy. But there is no change in the key man because the firm culture is that it is the one guy. And we have seen

MJ: MJ: MJ: MJ: A TREND OF THE MOST CONCERN FOR A TREND OF THE MOST CONCERN FOR A TREND OF THE MOST CONCERN FOR A TREND OF THE MOST CONCERN FOR US, IS THE CARVE OUT FOR RMB FUNDS…US, IS THE CARVE OUT FOR RMB FUNDS…US, IS THE CARVE OUT FOR RMB FUNDS…US, IS THE CARVE OUT FOR RMB FUNDS…

MJ: MJ: MJ: MJ: WE’VE SEEN CASES WHERE WE’VE SEEN CASES WHERE WE’VE SEEN CASES WHERE WE’VE SEEN CASES WHERE THE THE THE THE ONE ONE ONE ONE GUY STAYS AND KEY MEMBERS LEAVE…GUY STAYS AND KEY MEMBERS LEAVE…GUY STAYS AND KEY MEMBERS LEAVE…GUY STAYS AND KEY MEMBERS LEAVE…

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cases where the one guy stays, and the rest of the key members of the team leave and you’re stuck with the fund for another eight years (laughter). FUND SIZE IN CHINA FUND SIZE IN CHINA FUND SIZE IN CHINA FUND SIZE IN CHINA

WZ: Another issue for us is the size of the funds. I’m wondering, what is the right size of venture funds in China? Rebecca mentioned earlier that the burn rate in China is very low. So what is the benefit of throwing $10 million or $20 million into a company and then they

last forever and we end up never seeing anything in the GP’s track record? HM: Right. That may be a worse problem, keeping their firm alive. WZ: Exactly. They’re not doing anything. They can keep their firms alive for ten years with the money they’ve

raised in the last two years. HM: You have to ask yourself, what you’re going see from 1999, when this fund matures and how much value disruption takes place, as opposed to value creation, especially when there is a lot of it that is driven by hype. We all see, I don’t know how many PPMs per week and you think, “who is this person?” MJ: And you ask yourself, how do they all have a special relationship with the government or with tone important guy? T&I: Can GPs in China manage funds the size of or larger than, in the US? MJ: When we ask this question we hear, “this isn’t like Silicon Valley.” These companies in China have real, established businesses and profits, they’re real business. They don’t need as

much handholding from the private equity partners because they’ve already gotten the company to this stage. But they need more money because they’re bigger businesses with huge growth opportunities; that response doesn’t necessarily make me feel comfort-table, but that is what we hear back. HM: The other argument that we all have to consider is how many countless other LPs are sitting out there, trying to get access to this market. Frankly speaking, the horror stories come out with the big numbers and a brake is put on that and people start cutting back on allocations in General Partnerships. Still, you have a certain amount of momentum that is at play in these markets. You’re not going to see behavior change in these markets. It’s going to take something monumental for LPs to get be frightened and to say, “Okay, from five relationships, we’re going down to two, and the numbers that we’re giving to these GPs is going to get smaller over time,” until the GPs prove themselves. MJ: As people don’t have returns, that will happen. HM: And the problem with those two funds that survive is that once those two funds have proved themselves, everyone wants to get into those funds. MJ: You are a very different LP based on what you’re saying. My LP experience base and bias is slightly

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different. My sense in the US and this is definitely the case for us and I suspect for the much of the endowment and foundation community, where you’re not getting a ton of money coming in from the outside; Endowments and foundations are really starting to be liquidity constrained so we’re going to

have to make those decisions. I know that fund of funds are still getting a lot of money in, but we’re seeing constraints, so that is going to force this issue to a certain extent, at least on the margin.

WZ: That would be a good thing. HM: But no one has been forced to make such difficult choices recently. You look at the liquidity that has been around the markets for the last four or five years in buyouts and venture. No one has had to make difficult choices.

T&I: What about new LPs in Asia? HM: There is a new set of LPs that coming in. But when I think back on the market of ten years ago and the funds that we backed; who got burned and who stayed back out of the market. If you think of names like Walden, that was a great name of those days and a lot of the investors who didn’t do that well from their participation in Walden funds of the mid-90’s have moved on and away from Asian markets. But there will always be new LPs that come to Asia and there are lessons to be learned. Whether the absolute amount of dollars

dries up or it just comes from another source and the rest of us who are slightly wounded and slightly scarred, get wiser about some of these investments or move away to something else, some of these markets are going to attract capital whether we like it or not.

MJ: One of the things that struck me as I was going through different managers in China was that the GP commitments tended to be really small, as a percent of the fund. I wonder is there enough of a principled mindset amongst the managers so that they say, we need to have a smaller fund to actually make returns and get our carry. You saw this at play in Silicon Valley when it all pulled back in 2001 and 2002 and GPs said we’re going to cut the size of the funds or we’re not taking any more money. The question is whether there is that kind of principled mindset in Asia, will it happen? WZ: Are you saying that you’re seeing less than a 1% GP commitment in their Asian funds? MJ: 1% is the best that I saw. On a number of occasions I saw at most 1%. There were a couple of outliers where that was not the case; in general it’s 1%. RX: Five years ago the argument was that these were people who came from a place where they didn’t make money and therefore they didn’t have money, but today, I feel at this point that they need to commit 1% at a minimum and in fact given the previous conversation about the size of funds and the fee and given we can’t push back on the size of the

HM: … THESE MARKETS WILLHM: … THESE MARKETS WILLHM: … THESE MARKETS WILLHM: … THESE MARKETS WILL ATTRACT ATTRACT ATTRACT ATTRACT CAPITAL WHETHER OR NOT WE LIKE ITCAPITAL WHETHER OR NOT WE LIKE ITCAPITAL WHETHER OR NOT WE LIKE ITCAPITAL WHETHER OR NOT WE LIKE IT

MJ:…IS THMJ:…IS THMJ:…IS THMJ:…IS THERE A MINDSET AMONGST ERE A MINDSET AMONGST ERE A MINDSET AMONGST ERE A MINDSET AMONGST MANAGERS WHO SAY…MANAGERS WHO SAY…MANAGERS WHO SAY…MANAGERS WHO SAY…WE WE WE WE NEED A NEED A NEED A NEED A SMALLER FUND TO MAKE RETURNS ?SMALLER FUND TO MAKE RETURNS ?SMALLER FUND TO MAKE RETURNS ?SMALLER FUND TO MAKE RETURNS ?

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fund and we can’t push back on the fee, at least then GPs need to put their money into the fund as a GP commitment; their own skin in the game. MA: I am reminded by what is happening here in Asia, of what happened earlier when East Germany was being integrated into West Germany. East Germans wanted from

day one, everything that West Germans had built over 40 to 50 years; their wealth, their salary. Within one night, they wanted everything to be worth tenfold what it had been. To an extent a similar thing is happening here. The east, the immature markets, sees what is there, these billions, these firms flush with money and they are more concerned with what is happening in the US and in Europe with the mega-buyout funds. I’ve remember a meeting with a prominent US buyout fund, at which its

CEO stood up for a toast at the end of the meeting, before which he asked the LPs attending whether they agreed to increase the hard cap fund size by a couple of billion. He looked around the room at the raised arms and announced,

“okay, that’s a majority and the total fund size increased by this billion dollar amount.” I think that mentality has come here, and that reality has been put blown out of proportion, and to put it into proportion, probably takes something big. The credit crisis here is probably a step in the right direction. But overall, I think it’s an inevitable situation in which

GPs here see what is happening with the biggest global GPs or whomever; the local GPs become greedy, when they see what these global GPs pay, what they do, and so on. At the end of the day, you (gesturing around the table) try to suggest discipline to these GPs but still we see first time Asian funds of one billion plus, with key people that have never done private equity deals from its very beginning to the very end and who also are trying to do the most difficult things possible; investing in minority stakes in State Owned Enterprises. I have to ask “what is that?” Only a really severe situation can flatten this out. HD: At this session last year, I upset a GP by saying that private equity compensation structures actually are very much in favor of the managers, the idea that of a 20% carry upside, means that they have a “heads I win, tails you lose” situation. (laughter). Speaker: They thought that what you were saying isn’t true? HM: They were upset because the 20% carry wasn’t favorable compared to what hedge funds earn. HD: And it’s true because we have an environment which is a strong bull

market, so that if you’re a successful investment banker, why wouldn’t you establish a private equity fund, raise as much capital as you can and bet it. And if it works, you’ve made a fortune and if it doesn’t work, it doesn’t matter, you go back to work for Goldman Sachs again. As a career choice it’s an environment, in which these people have to ask

MA: LOCAL GPS BECOME GREEDY… MA: LOCAL GPS BECOME GREEDY… MA: LOCAL GPS BECOME GREEDY… MA: LOCAL GPS BECOME GREEDY… WHEN THEY SEE WHAT GLOBAL GPS PAYWHEN THEY SEE WHAT GLOBAL GPS PAYWHEN THEY SEE WHAT GLOBAL GPS PAYWHEN THEY SEE WHAT GLOBAL GPS PAY

HHHHD: IF IT DOESN’T WORK, D: IF IT DOESN’T WORK, D: IF IT DOESN’T WORK, D: IF IT DOESN’T WORK, IT DOESN’TIT DOESN’TIT DOESN’TIT DOESN’T MATTER, YOU GO BACK TO GOLDMAN…MATTER, YOU GO BACK TO GOLDMAN…MATTER, YOU GO BACK TO GOLDMAN…MATTER, YOU GO BACK TO GOLDMAN…

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themselves why you wouldn’t “have a go” at this and that is why there are so many people having a go at investing in private equity. MA: I think of it like the times in the early 90’s in the UK when everything started, with the exception that there is

three times more money to feed China’s situation. Back in the UK it was not easy to raise money. All the firms started slowly even though the market fundamentals in the UK were great. The market here is just starting but there are people waiting, with coffers of money, so the

alignment of interests is not here. HM: The alignment is not here. The situation is backed by the macro-economic fundamentals, it is not backed by the private equity talent of the managers who are trying to see what they can do. The infrastructure doesn’t

exist to absorb the amount of capital being raised and actually give you quality returns. So the only way to cure the situation is for the LPs to step back and introduce discipline or if there is an event which similar to the Asian Financial Crisis, that then brings out quality in terms of who succeeds, who can work through these issues and who can get it right. WZ: I think that timing-wise, when you see managers raising money today, a lot

of them started in 2005 and they probably have one or two very good transactions and their returns look very good, but that was on the back of a very strong equity market. HM: And pricing didn’t have a lot of competition in that time-frame. That has changed dramatically over the last two to three years. WZ: I think that people who raised money in 2005, came back to raise money again in 2007 and 2008. And these vintages will prove who are winners and who will be the crying babies next time around. HM: The sub-prime crisis has not had as much impact in Asia as much as it had in Australia, where you don’t see any mega-deals being done. But you don’t see the sub-prime impact as much in China or India, where everyone is still ready to put money out to work. And despite some of the corrections in the public markets, you’re seeing some of the valuations going up again, in terms of what people are willing to pay for, say, real estate development or just about any kind of investment, where there are five other groups that are willing to share the deal at these inflated prices with you to get deals done. MJ: I’m reminded of someone that we were working with in ’01 and ’02, who said at the time, the problem with the various venture capital funds is that the barriers to exit are so high (laughter). I was thinking about that because of what you said Hugh, about why wouldn’t you give private equity a try. You could actually “try’ to do it for ten years,

MA: WITH COFFERS OF MONEY WAITING, MA: WITH COFFERS OF MONEY WAITING, MA: WITH COFFERS OF MONEY WAITING, MA: WITH COFFERS OF MONEY WAITING, INTEREST ALIGNMENT IS NOT HERE INTEREST ALIGNMENT IS NOT HERE INTEREST ALIGNMENT IS NOT HERE INTEREST ALIGNMENT IS NOT HERE …………

HM: INFRASTRUCTURE DOESN’T EXIST HM: INFRASTRUCTURE DOESN’T EXIST HM: INFRASTRUCTURE DOESN’T EXIST HM: INFRASTRUCTURE DOESN’T EXIST TO ABSORB THE CAPITAL BEING RAISED TO ABSORB THE CAPITAL BEING RAISED TO ABSORB THE CAPITAL BEING RAISED TO ABSORB THE CAPITAL BEING RAISED AND GIVE QUALITY RETURNS. AND GIVE QUALITY RETURNS. AND GIVE QUALITY RETURNS. AND GIVE QUALITY RETURNS.

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because you’ve signed an agreement with your LPs to do it for ten years and you’re entitled to a management fee for ten years, without necessarily being

successful. (room erupts in comments). HD: In this kind of environment, you can always find a greater fool, that makes you successful, provided that you can find someone else to come with more money, who comes in at a higher round (general expressions of agreement from around the room) you’re actually proved to be successful even if you’ve done nothing, if you do that. RX: Which is amazing. WZ: That is where some GPs make their reputation. I’ve seen that. The first round goes in this month. And then, boom, when the second round goes in, its over. It’s at three times money. And you have to ask what has this company done to prove, in just three months, that it is

worth three times more than just three months before? The answer is that it is just based upon people wanting to get into the company and that it is based on a game of negotiation; assets vs. capital. VALUE ADD BY GPS IN CHINAVALUE ADD BY GPS IN CHINAVALUE ADD BY GPS IN CHINAVALUE ADD BY GPS IN CHINA HM: Early stage technology investing takes a lot more patience than does the growth equity investing that is being done here. The quick money that people make in a short period of time here, tells you that people don’t have the patience to make long technology holds.

T&I: Jean Salata and Baring, invested into Jingde Gas and China Coal Bed Methane and turned those investments around at high rates of return in under 12 months. Hard core, mainstream industrial and mining deals. HM: Those kinds of deals are exceptions. When you’re talking about some kind of semiconductor investment, something that has to be designed for a phone and you’ve got regulatory change

going on in China, where you have one state-owned company buying another state-owned company, which changes the dynamics of the entire market changing, that has to be a different kind of risk, when someone has got to develop a product that someone else is going to use. How many of those have we seen that are successful. MA: Plus, in many companies here, you can add things which quickly add value to the enterprise. I recall in the Ukraine, in the mid ‘90s, investing in a company in which we put in a fax machine (laughter) … RX: the valuation went up because of the company had better governance. MA: Seriously, a lot went much easier after that. It was a brewery with more than 800 people. It increased the value significantly. Doing that one thing made a very big difference, incredible but true. Sure, there were a lots of other value-adds we have brought in R new technology, IT, marketing, sales, etc R but this one thing really sticks in my

HD: IN THIS KIND OF ENVIRONMENT, HD: IN THIS KIND OF ENVIRONMENT, HD: IN THIS KIND OF ENVIRONMENT, HD: IN THIS KIND OF ENVIRONMENT, YOU CAN ALWAYS FIND A GREATER YOU CAN ALWAYS FIND A GREATER YOU CAN ALWAYS FIND A GREATER YOU CAN ALWAYS FIND A GREATER FOOL, WHO MAKES YOU SUCCEFOOL, WHO MAKES YOU SUCCEFOOL, WHO MAKES YOU SUCCEFOOL, WHO MAKES YOU SUCCESSFUL.SSFUL.SSFUL.SSFUL.

WZ: …YOU HAVE TO ASK WHAT A WZ: …YOU HAVE TO ASK WHAT A WZ: …YOU HAVE TO ASK WHAT A WZ: …YOU HAVE TO ASK WHAT A COMPANY HAS DONE TO PROVE IT COMPANY HAS DONE TO PROVE IT COMPANY HAS DONE TO PROVE IT COMPANY HAS DONE TO PROVE IT IS WORTH 3X MORE IN 3 MONTHS? IS WORTH 3X MORE IN 3 MONTHS? IS WORTH 3X MORE IN 3 MONTHS? IS WORTH 3X MORE IN 3 MONTHS?

HM: HM: HM: HM: …………ONE SOE BUYING ANOTHER SOE, ONE SOE BUYING ANOTHER SOE, ONE SOE BUYING ANOTHER SOE, ONE SOE BUYING ANOTHER SOE, CHANGES THE DYNAMICS OF THE MARKETCHANGES THE DYNAMICS OF THE MARKETCHANGES THE DYNAMICS OF THE MARKETCHANGES THE DYNAMICS OF THE MARKET

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mind. Plus, our coming in as an institutional investor gave confidence to everyone involved in the operation immediately. So I can believe in valuations increasing by large amounts in a very short time such as those Rebecca was pointing out. Whether its justified is another question, but I can believe that this is a reasonable outcome from an investment round.

HD: The real question in such a leap in valuation, is whether the increase in value is sustainable. HM: And whether the fact of an outside investor coming in is more compelling than the

actual value of the investment you make. HD: And if you make large amounts of money over a short period of time. You have to ask how that affects your mentality and your discipline going forward. Because that kind of instant success tends to create an environment in which you want to deploy money in the quickest way possible because you can make money easily. MA: On the other hand that is the very definition of emerging markets investing; the inefficiencies, the things which are not in place. If you take by comparison, a US portfolio company, in which there have already been five PE players, there is little grass left to cut. As opposed to China, where if you do things the right way, you can start with nothing and incrementally change it. HM: Assuming that they know the right way to do it and that they know that the risk profile is that much higher in terms of the risk that they are taking, or at least

that the LPs have understood that this is what they’re signing up to do. MA: But in general, the inefficiencies of this market are its beauty. HD: Your point, Markus, I think, is that it’s the managers who are bringing

something more than money, or managers who are able to spot some type of growth trend or do something else, that actually helps their portfolio companies who are much more likely to create value in their companies on a much more sustainable basis. T&I: Chris what did you add to Little Sheep which is just about to IPO? Chris Rowlands, 3i (CR): Our IPO was primarily about people. Because it was a domestic organization, in terms of its market and its desire to grow as a domestic company, there was little we could add from market content to the domestic market, but we did bring people to the business; world class capability to the board room which they openly welcomed, a real credit to them, that this was not a fight by an investor. We brought the former CEO of Burger King to their Board. We brought the former Asian head of KFC to their board. And sadly for me, we brought a great CFO to their team; sadly for me because he left my team to join them, but in the end it’s been a win-win. And we found their COO. So we’ve helped at both the board level and at the operation level, we’ve made a big effort.

HDHDHDHD: THE REAL QUESTION IS WHETHER : THE REAL QUESTION IS WHETHER : THE REAL QUESTION IS WHETHER : THE REAL QUESTION IS WHETHER A LEAP IN VALUATION IS SUSTAINABLE.A LEAP IN VALUATION IS SUSTAINABLE.A LEAP IN VALUATION IS SUSTAINABLE.A LEAP IN VALUATION IS SUSTAINABLE.

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HM: How much of a challenge was that? One of the common themes that we hear about is the lack of talent and the lack of operating professionals in China. And what difference was there in listing locally on the HKEX and in listing for Nasdaq or the NYSE; finding a CFO who has done that before, to take a

company though all of that. CR: I’d say that the single largest barrier to success for such an IPO is filling that CFO seat; unless you can prise them out of an [a competitor] which you could do on a reward basis, but I guess, life is either very interesting or comfortable, and they don’t want to leap over the wall, in the way that they do in Europe, into the sexy and exciting world of private equity; that is still not here yet. It will come, but I think it’s a bigger cultural challenge, the role is not respected, by that I don’t mean by us the investors, but by the companies, the founders, the entrepreneurs, presenting us with our biggest hurdle. But, the lever for us is not, big bad private equity telling them to hire a CFO of that caliber but by our saying that if they think that they have any prospect of listing this business in a serious way, and they all do, then they had better get a CFO that looks and smells like this pretty quick. And they jump at that. Then the question becomes where do you find them? TEAM DYNAMICS TEAM DYNAMICS TEAM DYNAMICS TEAM DYNAMICS HM: Looking back at the early days, one of the constant themes used to be that most groups had not earned carried interest. So while you didn’t appreciate or like the fact that people were leaving,

to some extent you could see why they were leaving, especially if there was an emerging practice or a signing bonus somewhere else; they went in the hope of earning carried interest. Up until almost 2000, there weren’t a lot of groups earning carry. Having said that, a lot of these people who were leaving were partially responsible for that, because they contributed to investment decisions that were made in unsuccessful companies and hence no carry was generated on the lack of returns. So whether it was a bit too early for private equity, the way that it was practiced, whether it was minority deals that weren’t structured well, or whether GPs had invested in family owned businesses where the interests weren’t aligned, it took something like the crisis to change enough of the practices so that we are seeing better results today. I’m not saying that we’re there, in terms of having completed the evolution, but

thinking back on those days you have to ask yourselves, “God, would I have stuck it out if I had been a GP?” What we’re seeing today, is somewhat different. I don’t know that the ongoing job-hopping is necessarily driven by the fact that people won’t earn money. WZ: I think what we’re seeing in terms of personnel movement is based on the fact that we’re in an emerging state of the market and that there are not enough good, experienced private equity professionals and those that there are,

CR: THE LARGESTCR: THE LARGESTCR: THE LARGESTCR: THE LARGEST BARRIER TO BARRIER TO BARRIER TO BARRIER TO SUCCESS FOR AN IPO LIKE LITTLE SUCCESS FOR AN IPO LIKE LITTLE SUCCESS FOR AN IPO LIKE LITTLE SUCCESS FOR AN IPO LIKE LITTLE SHEEPSHEEPSHEEPSHEEP IS FILLING THAT CFO SEAT IS FILLING THAT CFO SEAT IS FILLING THAT CFO SEAT IS FILLING THAT CFO SEAT.

HM: SHM: SHM: SHM: SOME PEOPLE LEAVING, OME PEOPLE LEAVING, OME PEOPLE LEAVING, OME PEOPLE LEAVING, CONTRIBUTED CONTRIBUTED CONTRIBUTED CONTRIBUTED TO INVESTMENTS…IN UNSUCCESSFUL TO INVESTMENTS…IN UNSUCCESSFUL TO INVESTMENTS…IN UNSUCCESSFUL TO INVESTMENTS…IN UNSUCCESSFUL COMPANIES THAT GENERATED NO RETURNS. COMPANIES THAT GENERATED NO RETURNS. COMPANIES THAT GENERATED NO RETURNS. COMPANIES THAT GENERATED NO RETURNS.

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see the opportunities out there and they think, “I’ve done this for ten years. I’ve got a good track record. And I’m stuck

with these three other guys,” to share this fund or I can go out there and raise my own fund. HM: There is an upgrade mentality. You start locally, then you move to the US and work for another firm and then you start your own firm. At least that is the path I see the most on the VC side. RX: Given that there is this huge amount

of capital waiting to be invested, and a very limited supply of productive professionals, when a GP sees that there is an opportunity to set up their own shop and given that by their nature a lot of GPs are entrepreneurial in spirit, I understand why

turnover is quite high. HM: And that leaves us as LPs in a horrible position. You have to ask who is going to manage this portfolio and who do we task that to and how do you get to a comfort level with the next layer or the layer above, or whoever it is, that is going to manage an existing portfolio that someone else has created. WZ: Then the years of these teams

working together is lost and a lot of these teams only have five years of working together. It’s like the time spent in marriages, think about what the failure rate for a marriage is. And yet we expect GPs to see each other and to work

together for even longer. Sometimes it takes ten years before teams can work well together. Sometimes in the US you see teams who have been together 30 years before breaking up. RX: If you look at all of the breakups, there are many reasons for them. But one type of breakup that is a clear trend, is that in which the local team, the local partner in Asia, the China or India partners of a global firm, begin to feel that their view, the headquarters view and the investment community’s view are not on the same page. Or, otherwise, they have to stay up all night for all these phone calls (laughter) which

logistically, is just not very convenient. Over time, as these local professionals mature, if they feel that they can become an independent firm, they do so. And of course, the market helps, along with the amount of capital flowing in. Plus, all of us require these global firms to have local leadership, local teams, local GPs and senior professionals who are local. That is almost my first reaction when I see a proposal. If a firm pitching a fund doesn’t have senior level, local deal professionals, then forget it, how can I be convinced that you’re going to be able to compete with the CDH and Hony type firms of this world? Those factors plus the fact, that all Chinese are very entrepreneurial contribute to the majority of team departures. Of course there are also disputes among the partners, there are economics issues, but those are few and far between and mostly depend upon specific personalities, and are more or less severe, depending upon the people

WZ:…THEY THINK, I’VEWZ:…THEY THINK, I’VEWZ:…THEY THINK, I’VEWZ:…THEY THINK, I’VE GOT A TRACK GOT A TRACK GOT A TRACK GOT A TRACK RECORD, I CAN RAISE MY OWN FUND. RECORD, I CAN RAISE MY OWN FUND. RECORD, I CAN RAISE MY OWN FUND. RECORD, I CAN RAISE MY OWN FUND.

RX:..RX:..RX:..RX:...... THE CHINA OR INDIA PARTNERS THE CHINA OR INDIA PARTNERS THE CHINA OR INDIA PARTNERS THE CHINA OR INDIA PARTNERS OF A GLOBAL FIRM,OF A GLOBAL FIRM,OF A GLOBAL FIRM,OF A GLOBAL FIRM, BEGIN TO FEEL THAT BEGIN TO FEEL THAT BEGIN TO FEEL THAT BEGIN TO FEEL THAT THEIR VIEW AND THEIR VIEW AND THEIR VIEW AND THEIR VIEW AND THE HEADQUARTERS THE HEADQUARTERS THE HEADQUARTERS THE HEADQUARTERS VIEW ARE NOT ON THE SAME PAGE.VIEW ARE NOT ON THE SAME PAGE.VIEW ARE NOT ON THE SAME PAGE.VIEW ARE NOT ON THE SAME PAGE.

HM: THATHM: THATHM: THATHM: THAT LEAVES LPS IN A HORRIBLE LEAVES LPS IN A HORRIBLE LEAVES LPS IN A HORRIBLE LEAVES LPS IN A HORRIBLE POSITION… WHO IS GOING TO MANAGE A POSITION… WHO IS GOING TO MANAGE A POSITION… WHO IS GOING TO MANAGE A POSITION… WHO IS GOING TO MANAGE A PORTFOLIO SOMEONE ELSE PORTFOLIO SOMEONE ELSE PORTFOLIO SOMEONE ELSE PORTFOLIO SOMEONE ELSE CREATED?CREATED?CREATED?CREATED?

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involved. Beyond those examples, looking at the locally built teams, the successful ones have relatively short

histories so we’ll wait and see how they fare in another couple of years. But for now, we like these firms because there haven’t been departures, they’re all tied in, they’ve seen carry, they work together as a team. HM: And even among those most successful of the new generation of Chinese GPs you’ve got the question of their expansion and everything related to

the maturation of those teams. How much dilution there is of the founder’s time; whether the focus and the people that you want on the deals who are more senior, has shifted to looking across the firm or at other things, instead of making

investments, because at the time you invested, they were the ones looking at the deals, but now that they’ve got bigger…

RX: We don’t want them to expand to the point where there is that dilution of their attention and resources. At least in the case of some firms, every step that they’ve taken, has been a very thoughtful process and they’ve established separate teams, with separate leadership at a senior level; it’s not just the [senior] partners, overseeing a bunch of VPs on the ground who are running around, running the VC fund or running the real estate fund. They’ve proved that they can do this in the venture fund and

they’ve done so very successfully. And that is why we all focus on these top tier GPs. At least when they’re focusing on the different things, than you might want them to, they’re doing it in a more thoughtful way, not just moving ahead. ASSESSING GPS ASSESSING GPS ASSESSING GPS ASSESSING GPS AND TRACK RECORDSAND TRACK RECORDSAND TRACK RECORDSAND TRACK RECORDS

HD: Everyone here is familiar with Boston Consulting Group’s research on the returns from the US PE market, which shows that there is consistency in the returns from private equity, so that if you invest in the top quartile of managers, there is a probability that the fund itself will also be a top quartile performer. I think that a lot of people assume that the same approach is applicable to Asia and to China, and so they try to pick what they think are top quartile managers. There are great difficulties in applying that to Asia and China. The first question is how you measure the success with regard to whether someone is top quartile or not. The fund raising cycle is so short that when they come back to the market…

WZ: …there is no track record. HD:…you can’t tell where they are. You can’t evaluate where they are. To make this issue more complicated there is a

trend for managers to cash in their winners early and hang onto their losers. And they do that precisely so they can show some realizations and the early realizations… WZ:…are as good as it gets? HZ:…and that’s actually quite dangerous, because they’ve gotten out their good stuff and they’re holding the

HD: HD: HD: HD: …………MANAGERS CASH IN THEIR MANAGERS CASH IN THEIR MANAGERS CASH IN THEIR MANAGERS CASH IN THEIR WINNERS EARLY AND HANG ONTO WINNERS EARLY AND HANG ONTO WINNERS EARLY AND HANG ONTO WINNERS EARLY AND HANG ONTO LOSERSLOSERSLOSERSLOSERS………… TOTOTOTO SHOW REALIZATIONS. SHOW REALIZATIONS. SHOW REALIZATIONS. SHOW REALIZATIONS.

HM: EVEN AMONG SUCCESSFUL HM: EVEN AMONG SUCCESSFUL HM: EVEN AMONG SUCCESSFUL HM: EVEN AMONG SUCCESSFUL NEW GENERATION CHINESE GPS NEW GENERATION CHINESE GPS NEW GENERATION CHINESE GPS NEW GENERATION CHINESE GPS YOU HAVE QUESTIONSYOU HAVE QUESTIONSYOU HAVE QUESTIONSYOU HAVE QUESTIONS…………

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bad ones. Just because someone has some early wins, doesn’t mean that the fund is going to be good or not; you’re going to have to wait another five or more years to find out. RX: …or to see what they write off. HD: And the logic behind this, given that the history of private equity in China is quite young, is quite difficult. You can get good historic results from a strong market; which is to say luck and

also from excessive risk taking. To me India is the best example. If you had invested in the National Stock Exchange on 1 January, 2003 for five years, you would have earned 47% per annum. How many Indian private equity managers have

performed that well? So the question is of how PE managers in Asia add value,

versus luck. If you assume that the chance of a manager having reasonable returns from a fund is 50% and considering that there are, say, one thousand eight hundred managers in Asia, then the chance by luck alone that someone may have five successful funds, would be over 50 managers. Just because someone has consecutive good funds however, doesn’t necessarily mean that they’re skillful, it could mean that they’ve been lucky, and in fact there are more than 50 managers in the region who should have that kind of track record just through luck. Turning to the issue of managers who are excessive risk taking. I know from digging into the granularity of underlying deals, that sometimes the

risks taken by GPs when making any type of particular deal is huge. And while its unfair to cite a particular example there is one case, which is a

tremendous deal for a GP, in which they made double digit multiples in terms of cash on cash, but the founding entrepreneur had clearly been in breach of his promises to his international business partners. There was litigation. There was litigation risk. There was integrity risk on the guy, because he had clearly been screwing his foreign business partners already and in this particular case the deal was four times bigger than any other investment from the fund, so the risk they took on the deal was enormous and the deal made the investors and the manager a great deal of money. But the risk involved, showed that it’s very dangerous just looking at achieved returns and saying, “Ah, that is the evidence of a good manager.” You really have to look a lot deeper, to tell what makes up a successful manager and sometimes you just can’t say what it is. RX: One approach that we use in benchmarking teams, even though they may have short lives, is to look at their track record vis-à-vis the local capital

markets. So you take the return from a GP and compare their return with the equivalent local markets, in India or the Hong Kong Exchange or the Nasdaq and compare their return and try to figure out how much of their returns were driven by the overall sentiment of the market.

HD: HOW MANY PE MANAGERS IN HD: HOW MANY PE MANAGERS IN HD: HOW MANY PE MANAGERS IN HD: HOW MANY PE MANAGERS IN ASIA ADD VALUE, VERSUS LUCK?ASIA ADD VALUE, VERSUS LUCK?ASIA ADD VALUE, VERSUS LUCK?ASIA ADD VALUE, VERSUS LUCK?

HD: IT’S DANGEROUS LOOKING AT HD: IT’S DANGEROUS LOOKING AT HD: IT’S DANGEROUS LOOKING AT HD: IT’S DANGEROUS LOOKING AT ACHIEVED RETURNS AND SAYING THAT ACHIEVED RETURNS AND SAYING THAT ACHIEVED RETURNS AND SAYING THAT ACHIEVED RETURNS AND SAYING THAT IS EVIDENCE OF A GOOD MIS EVIDENCE OF A GOOD MIS EVIDENCE OF A GOOD MIS EVIDENCE OF A GOOD MANAGER.ANAGER.ANAGER.ANAGER.

RX: THEY MAY RX: THEY MAY RX: THEY MAY RX: THEY MAY DO DO DO DO BETTER THAN OTHER BETTER THAN OTHER BETTER THAN OTHER BETTER THAN OTHER GUYS BECAUSE THEY CUT CORNERS.GUYS BECAUSE THEY CUT CORNERS.GUYS BECAUSE THEY CUT CORNERS.GUYS BECAUSE THEY CUT CORNERS.

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On top of that you need to look at their value add. Sometimes they don’t beat the public markets in the three, four or five year time frame. And that’s okay if you understand as investors that this is the case and if you can see through other means of due diligence that they are adding value to their portfolio companies, the comfort comes when there is a market correction and these fund managers and their investments survive those market downturns better than others. We try to do that. In terms

of looking at excessive risk, that is very difficult to take away, because when you have a very strong market overall and everyone makes money, all boats are lifted, and even those in very risky situations continue to do well. They may even do

better than the other guys because they cut corners.

HD: Yes, they probably will, they do well right up to the point where they blow up (laughter from room)…and in fact, to my earlier point, by trying to select for the very best managers in Asia you could be selecting those managers who are going to blow themselves up if there is a very big correction. MA: I think comparing performance of Asian GPs with capital markets is a very tricky thing to do. In the US and Europe you can do this, because you have lots of data available, lots of historic track records, probably the deals done on an overall basis, if you look at all of the

private equity funds data for all of the deals for which there is data available, probably the returns from funds reflect to a certain extent the success of the market. But for markets like China it’s more difficult because the profile of companies listed there are sometimes very different. Their capital structure, their shareholder structure are so different from private equity firms or firms which are private. By analogy for the history and the underdevelopment of these markets, if I were to take the benchmark in Russia and compare this with Russian private equity, it would be fundamentally wrong, because the Russian stock market is largely driven by oil and gas only. RX: You’re right. So the way that we do that for China, is to compare it to Hong Kong, for the non-tech fund, non venture funds. And for the tech funds we compare them to the Nasdaq. You want to find out where these companies are eventually going to exit and if that is relevant. Then we look at the relevant index. But I take your point completely. You wouldn’t want to do that with A shares for example, because that is a completely different universe. MA: And because foreigners can’t invest in those companies. RX: Yes, exactly. WZ: I think that the message is, at the end of the day, that the measurement of a fund’s performance can’t be the track record alone. It needs to be a very well rounded discussion and understanding of the manager, the strategy, how they’re

HD: …THOSE TAKING RISKS MAY DO HD: …THOSE TAKING RISKS MAY DO HD: …THOSE TAKING RISKS MAY DO HD: …THOSE TAKING RISKS MAY DO WELLWELLWELLWELL UP TO THE POINT THEY BLOW UPUP TO THE POINT THEY BLOW UPUP TO THE POINT THEY BLOW UPUP TO THE POINT THEY BLOW UP

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positioned going forward, team dynamics… MA: At the end of the day it’s more of a

judgment of a startup firm. You, the LP as an entrepreneur, have to evaluate these firms and everything that they’re doing. We have to evaluate each GP with the exception that we have no future cash flow forecast model of the underlying business model, as one does when acquiring a firm. You have to look at each individual, you have to look at each member in a firm, you have to trust someone, somewhere. If you look at US or European success stories you see that a vast majority of these private equity

firms are built in a similar way. If you don’t have an alignment of interests in your GP you can say, more or less in the mid and long term, it’s going to go bad. It will not succeed. Similarly if you have a captive or a

semi-captive fund, sometime, somewhere along the way, it will fall apart. This has been proven in the mature markets and I think that the same will be true in Asia. Why should it be different? A semi-captive fund, might have a right to be part of a larger organization currently, but there is going to be a time when it’s going face a situation as in the US or Europe. Key people either leave or the fund operation seeks independence or make an MBO.

RX: You’re right. We’ve seen that beginning about ten years ago, in a slightly different form. That generation

of funds is going away because they weren’t structured properly. HM: We all here want this due diligence, we all want to do it, we all want the comfort level it provides. We just talked about the increase in fund sizes, and how quickly new funds are being raised, but how many of us here feel comfortable that we’ve crossed all the t’s and dotted all the i’s when we’ve made a decision about committing to a fund? You sometimes have six weeks, these days; it’s “here are the documents. Sign them and send them our way… WZ: …or its sign them first, before you do due diligence. RX: You can’t just start your due diligence six weeks or one day before a launch. I think that this is an argument for all of us to be here, living in Hong Kong. You have to be here on the ground. You have to watch GPs over time. You have to start your work from day one, to vet docs, to see what kind of deals they do, to see what kind of valuations that they pay and how they behave over time, so that when you get to that six weeks time range on the documents it’s mostly spent on pushing back on the fund size and the fees (laughter).

MA: I don’t think that the lack of track record is a real obstacle in finding a quality manager. A Kleiner Perkins also had to start at some point. Buts it’s a different job in Asia, than evaluating a long-standing GP in a mature market, in Asia you have to dig into the fundamentals of a firm and into the principals of a firm, to understand its strategy from the macro and micro point of view in doing your due diligence.

MA: A CAPTIVE OR SEMIMA: A CAPTIVE OR SEMIMA: A CAPTIVE OR SEMIMA: A CAPTIVE OR SEMI----CAPTIVE FUND CAPTIVE FUND CAPTIVE FUND CAPTIVE FUND WILL FALL APART. THAT IS PROVEN.WILL FALL APART. THAT IS PROVEN.WILL FALL APART. THAT IS PROVEN.WILL FALL APART. THAT IS PROVEN.

HM: THESE DAYS, SOMETIMES IT’S HM: THESE DAYS, SOMETIMES IT’S HM: THESE DAYS, SOMETIMES IT’S HM: THESE DAYS, SOMETIMES IT’S “HERE ARE THE DOCUMENTS.“HERE ARE THE DOCUMENTS.“HERE ARE THE DOCUMENTS.“HERE ARE THE DOCUMENTS. SIGN SIGN SIGN SIGN THEM AND SEND THEM OUR WAY.THEM AND SEND THEM OUR WAY.THEM AND SEND THEM OUR WAY.THEM AND SEND THEM OUR WAY.””””

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HM: Some of that, getting into the track record of a manager, is helpful just to understand their commercial instincts. Because getting in is easy, as we all

know. Spending money is easy, in terms of deals. Getting out of them and actually earning a good return on them is the more difficult part of the equation. So if nothing else, it gives you some ability to make a

judgment about whether they have the capability to find markets, do they know to go through the process, or do they fall in love with their companies and somehow they’re not able to let go. RECENT FUND RETURNSRECENT FUND RETURNSRECENT FUND RETURNSRECENT FUND RETURNS HM: We were positively cautious about returns last year at this time and not that much has changed. For me the big question is whether we’ll see cash on cash returns; that is the big challenge. Because we never know how much of that great exit, if it’s an IPO that has taken place, as it goes through this long process, will actually be converted at the

price that it IPO’ed or even above that, versus valuation going down while you’re still under lockup and you’re not able to get cash for your share allocation. CR: It seems to me in this part of the world, that unless you’re careful, you become investors in quoted funds not in private equity funds. And given that the

mark to market drop in the last six months has been pretty dramatic, even for those whom we all acknowledge are

the very best of China funds, this has been a challenge. No one has been immune from market fluctuations and I think that there has been a naiveté about hanging onto nice quoted positions and watching the price go up and then seeing it crash fifty percent. It’s not very intelligent really, if you’re a private equity firm, you’re supposed to be in the private equity business.

T&I: What about Pre-IPOs? RX: There are managers being formed to target that space in China. WZ: The PIPES phenomenon is more prevalent outside of China. Perhaps it’s more common in India than in China. HM: We are seeing managers talk about this because stocks are undervalued; asking us as their LPs whether some percentage of their portfolio can go into this? Or setting up separate funds, which are the larger growth funds, and these newer funds are set up with language that allows them to have the flexibility to take advantage of this. RX: I don’t think that any of our managers are coming out and saying that they want to do Pre-IPO transactions. HM: Not Pre-IPO, but undervalued, stocks that are already listed. RX: Or in buying publicly listed shares. Not in our portfolio, but, I have heard more and more about the phenomena, recently about the buoyant equity market, with people saying, “well, we’re

CR: THERE HAS BEEN NAIVETÉ ABOUT CR: THERE HAS BEEN NAIVETÉ ABOUT CR: THERE HAS BEEN NAIVETÉ ABOUT CR: THERE HAS BEEN NAIVETÉ ABOUT HANGHANGHANGHANGING ONTO QUOTED POSITIONS ING ONTO QUOTED POSITIONS ING ONTO QUOTED POSITIONS ING ONTO QUOTED POSITIONS … THEN SEEING THEM CRASH 50%… THEN SEEING THEM CRASH 50%… THEN SEEING THEM CRASH 50%… THEN SEEING THEM CRASH 50%

HM: THE BIG QUESTION IS WHETHERHM: THE BIG QUESTION IS WHETHERHM: THE BIG QUESTION IS WHETHERHM: THE BIG QUESTION IS WHETHER WE’LL SEE CASH ON CASH RETURNS.WE’LL SEE CASH ON CASH RETURNS.WE’LL SEE CASH ON CASH RETURNS.WE’LL SEE CASH ON CASH RETURNS.

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investing in this company today, which is targeting an IPO in a year and a half.” That comes up often, that kind of, this company is positioned to IPO, we’re going there. I also have to say that I’ve seen a lot of IPOs postponed, A Share, Hong Kong and Nasdaq.

Laurie Kan

On Capital (LK): The question that I have is whether any of your GPs explain to you how to go about a Pre-IPO A-share investment in China? Or how to go into certain sectors which are regulated, such as mining,

so that you can structure the deal so that you can get in legally, convert your currency and get out without problems. RX: We have seen private equity-backed listings on the A-share market. But to date, in terms of actually getting the money exchanged from RMB into US dollars, taking it out, paying the ten percent withholding tax… WZ: That hasn’t happened. RX: …that hasn’t happened yet. Well, at least I haven’t seen heard about that. LK: And we all know about the A share market and its future. A lot of people believe that the A share market is growing faster than the H share market, especially after the distressed debt crisis.

RMB FUND STRUCTURESRMB FUND STRUCTURESRMB FUND STRUCTURESRMB FUND STRUCTURES RX: Broadly, there are two fundamental structures. There is the pure RMB fund, with all the money coming from domestic sources. These funds have advantages in that they can invest in sectors that are protected or in which there are limitations on foreign investment. Second, these funds are not

required to go through the whole CSRC approval process, once they’re set up so it’s much easier and faster to make investments. The flip-side of those advantages is that Chinese company law

does not give you all of the bells and whistles, the protections that you as investors want or which you have in an off-shore structure, so you’re not as well protected legally. Then there is a second structure, that we call generally, joint venture RMB funds. These are essentially joint venture enterprises. Foreign investment enterprises, where you can raise RMB, you can import your US dollars into such funds, and you’ve already obtained approvals for that importation of foreign currency from the CSRC and SAFE to convert your US dollars into RMB. With these funds you have limitations on investment because fundamentally you’re still a foreign investor, however, the structure of these funds is such that you have an umbrella approval for the fund, so that on a deal by deal basis you don’t have to go through the approval process in each case. Therefore, arguably, it’s a little bit more efficient and faster to do deals, although I’m personally, not convinced that in fact, and on the record, that any of our US dollar fund managers absolutely needs an RMB fund for this reason alone; having said that, there is certainly a demand for RMB funds. If the Social Security Fund knocks on a

RXRXRXRX: …CHINESE LAW DOES NOT GIVE : …CHINESE LAW DOES NOT GIVE : …CHINESE LAW DOES NOT GIVE : …CHINESE LAW DOES NOT GIVE YOU AYOU AYOU AYOU ALL OF THE PROTECTIONS THAT LL OF THE PROTECTIONS THAT LL OF THE PROTECTIONS THAT LL OF THE PROTECTIONS THAT YOU…AS INVESTORSYOU…AS INVESTORSYOU…AS INVESTORSYOU…AS INVESTORS WANT… WANT… WANT… WANT…

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GPs door and says we only invest in RMB funds and we want to give you two billion in RMB, you don’t say no. And therefore, a lot of people view this as a competitive imperative. Right? Other

people are setting these things up. If I don’t have this then I am going to be disadvantaged one way or another. And there may be a marginal benefit, that in some cases, you can close a deal faster. HM: You’ve said it all. RX: But so far the flow of money into RMB funds has been small.

WZ: (photo left) Except for Hony and CDH. RX: Right, but those are sidecar funds and that is where the conflicts come in which I think is much more substantial than the joint venture funds. WZ: Why do you say sidecar funds?

RX: Side by side funds. WZ: They’re separate funds. RX: That is what I mean. Exactly. WZ: In both cases, these funds are managed by the same teams, who have to be prepared to make the investment decisions of how to use these funds. They have yet to address the conflict

RX: Whereas the joint venture funds that we have seen with our US dollar managers up until now have a portion of their US dollars which goes into the RMB fund, so that you have a little bit of exposure to domestic markets that way. WZ: Which doesn’t solve the problem.

RX: Right. The side-pool funds that CDH and Hony are managing, are independent funds on the other hand and they’re very sizable funds. WZ: And in those cases, those funds are becoming meaningful, separate pools of capital that they have to invest. And in reality, I think that the GP has a lot of discretion to decide which deal goes into which fund and theoretically they can invest from both funds in parallel if a deal is appropriate for both funds, so from a logistics viewpoint… HM: …how do you make that work? WZ: How do you make that work? HM: The RMB goes in right away, the US dollar waits for a year. Or whatever. RX: And it’s not entirely clear, in terms of the restricted sectors. Sometimes, it’s not absolutely clear, in terms of what the restrictions are in a sector and what’s not allowed for foreign capital. Sometimes it’s restricted. Sometimes it’s 25%. WZ: Yes. So for example if you’re looking at a bank and you want to get a controlling stake, you don’t use your US dollar fund, because you can’t get north of a certain percentage. RX: You can get a certain percentage. HM: So small it almost doesn’t matter. WZ: It 19% for a single investor and up to a total of 25% for all foreign investors combined. But in that situation you also don’t want to blend in your US dollar fund in that investment, because that is short-changing the regulators. HM: Do you ever foresee a time when all of us as foreign investors in China, can set up something in China and become local RMB investors?

RXRXRXRX:…IF CHINA’S SOCIAL SECURITY :…IF CHINA’S SOCIAL SECURITY :…IF CHINA’S SOCIAL SECURITY :…IF CHINA’S SOCIAL SECURITY FUND SAYS WE ONLY INVEST IN FUND SAYS WE ONLY INVEST IN FUND SAYS WE ONLY INVEST IN FUND SAYS WE ONLY INVEST IN RMB FUNDS …YOU DON’T SAY NORMB FUNDS …YOU DON’T SAY NORMB FUNDS …YOU DON’T SAY NORMB FUNDS …YOU DON’T SAY NO. . . .

WZ: THE TEAMS HAVE TO YET TOWZ: THE TEAMS HAVE TO YET TOWZ: THE TEAMS HAVE TO YET TOWZ: THE TEAMS HAVE TO YET TO ADDRESS THE CONFLICT ISSUE. ADDRESS THE CONFLICT ISSUE. ADDRESS THE CONFLICT ISSUE. ADDRESS THE CONFLICT ISSUE.

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RX: If you move to China and become local residents. FOREIGN INVESTMENT IN FOREIGN INVESTMENT IN FOREIGN INVESTMENT IN FOREIGN INVESTMENT IN STATE SPONSORED FUNDS STATE SPONSORED FUNDS STATE SPONSORED FUNDS STATE SPONSORED FUNDS

MJ: I think that investing in state owned domestic funds is wishful thinking on the part of GPs. T&I: We used to see a great deal of this in the United States; local government or

civic boosters all setting up their State or Municipal Tech Fund. MJ: There are so many cases of this where a GP thought that doing these deals would give them local

access, approvals, all that sort of stuff and… HM: …it hasn’t happened. MJ:…It hasn’t happened. Hemal Mirani: You go back in time into India, and you see the same thing. MJ: They do it and they still have to check all of the boxes in terms of approvals and in some ways, it’s almost worse because they’re under greater scrutiny because they have that relationship. So I think it’s a…

RX: a mixed bag. Right. HM: I look back on a similar era in India when GPs got into business with a family firm and then they found, God, now I’m stuck with all this family junk and those families weren’t going to send

them the family jewels. You have to ask, why a GP would go through all of this to get into something like that? You go through these joint venture government structures and you see a lot of ideas that have not worked. And I agree with Meredith that the scrutiny is a lot higher, in terms of what such a government relationship has brought you. You ask if you want to be in the glare of the government’s attention all of the time? WZ: I think the fact that the Social Security has chosen Hony and CDH is a testament to the fact that they, the government investors, themselves believe that these are difficult markets, versus some of the provincial set-up shops. NSSF wants to see a track record. HM: One of the things that Harbourvest might consider is the Universities and whether there is anything different for them from other government institutions. I wonder whether the Universities will get smarter about whether any license technology that they own. RX: Yes. There is a role for that. HM: Universities may be the one place where you see this succeed, where you have examples in the US of success, whether it’s Stanford University or someone else having done this. But that is a very different model from having a government linkage or someone that is trying to get benefits from this investing. WZ: No. It doesn’t work in China with the current government. RX: I’d say that having the relationship is not a bad thing… HM:…right. (dubiously). HD: …but you can’t base an investment strategy on that. RX: it’s just not the only thing that you should depend upon…but occasionally it might help you, right? If you use such a connection intelligently, but that is not sustainable.

MJ: …THERE ARE SO MANY MJ: …THERE ARE SO MANY MJ: …THERE ARE SO MANY MJ: …THERE ARE SO MANY CASES OF CASES OF CASES OF CASES OF A GP DOING THESE DEALS TO GAINA GP DOING THESE DEALS TO GAINA GP DOING THESE DEALS TO GAINA GP DOING THESE DEALS TO GAIN ACCESS ACCESS ACCESS ACCESS AND IT HASN’T HAPPENED. AND IT HASN’T HAPPENED. AND IT HASN’T HAPPENED. AND IT HASN’T HAPPENED.

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WZ: If you have a state-owned enterprise strategy like Hony it’s helpful to have some kind of government friendly hat that you’re wearing. RX: as part of their institutional backing. WZ: But typically this is not government backing, it comes more from the conglomerate.

RX: It can be like a key man situation “ I know someone who…” MA: When it’s raining, the hats come out. (laughter) RX: I think that having an institutional affiliation might be helpful. I think that no one denies that Hony is

successful, at least partially because of the Legend Connection and because Legend has been run as a best practices, international standards company, not just because it was founded and owned in part by the Academy of Sciences. WZ: The team is very independent. RX: Citic Capital, is another example; it’s a very solid team, it’s not just that they wave around the card of Citic and that opens doors for them and it’s not just one person in Citic that they align themselves with and therefore when there is some fallout in the ranks of the government they’re at greater risk. We shy away from any time when there is a key person linkage, because that is when it’s the most risky. (laughter). TECH & EARLY STAGE INVESTING TECH & EARLY STAGE INVESTING TECH & EARLY STAGE INVESTING TECH & EARLY STAGE INVESTING MJ: On the phenomenon of GPs drifting in stage, moving from early into growth and late stage. In some cases I feel like they’re just throwing money willy-nilly into new areas. They come out saying we’re IT focused and we

follow them – they work in IT, they have IT relationships, they know how to build IT businesses. But over time they

become growth capital guys and now that is really what they like better and (laughter) now maybe they’ll do some green technology as well. (more laughter). We’ve all seen this, but I guess that the specific question that I have about this, is whether this market is just different than it is in the US? Should we just ignore early stage over here? Is it just not an opportunity? Our bias in the US has been that early stage is much more attractive and as a result, that’s my bias over here and it’s further supported by the fact that more people have moved away from early stage investing. It would seem that there is more opportunity because there is less capital being invested there. It’s less competitive. The pricing seems to be more attractive. But the returns just aren’t there. Or are we just being impatient? Or are the GPs being impatient? And they’re doing what they should be doing economically speaking because the returns aren’t there for early stage.

MA: I think it’s impatience on both sides, because if you consider the underlying ingredients for success in venture capital, lots are here in China; the right people and smart people. The market depth and inefficiency is here. There are quite a few people who have experience investing in technology in the US. I think the right ingredients are here.

MJ: OVER TIME VCS ARE GROWTH MJ: OVER TIME VCS ARE GROWTH MJ: OVER TIME VCS ARE GROWTH MJ: OVER TIME VCS ARE GROWTH CAPITAL GUYS, AND MAYBE THEY’LL CAPITAL GUYS, AND MAYBE THEY’LL CAPITAL GUYS, AND MAYBE THEY’LL CAPITAL GUYS, AND MAYBE THEY’LL DO GREEN TECHNOLOGY AS WELL…DO GREEN TECHNOLOGY AS WELL…DO GREEN TECHNOLOGY AS WELL…DO GREEN TECHNOLOGY AS WELL…

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CR: Is Intellectual property created? MA: Yes. That is a good question. IP is something in which China is not

superior, yet. And the ecosystem is closed to an extent. But it’s not the case that we’re saying that it shouldn’t be here, or that it will never be here. HM: I think this is an old example, so this is going to date me. But one example that everyone was counting on in the semiconductor space was SMIC. Everyone was counting on that firm’s success. You had the A, the B, the C rounds. All the investors in the US came here for the D round. It was meant to be the big boom time in technology investing in China. The government was going to support SMIC; they were very keen to have the semiconductor industry here. Everything that you could want for that industry was provided for that deal. And then you look at who made money? Maybe the A round got a 2X. Maybe. MA: Have there been many successful. venture capital GPs in Europe who made 2X money in venture capital? HM: Not many. MA: And even then, we’re asking

outside of the twenty or so top money makers in US venture capital, who else has made significant money? HM: Well, we have twenty of years of history showing that money has been made in venture capital. Okay, venture has been in China for a shorter period of time and there is no data showing that money has been made consistently, that on the technology side or on the early

stage side, that you can make money. And we’ve been through different phases of venture capital in Asia so it isn’t as though it hasn’t existed. It has been here in different shapes, in different models. Whether it’s been a Pan-Asian model, that started in Taiwan, that had a lot of success there and then went on to a China-only investing model. But to me, it remains to be shown, that you can consistently make returns in early stage technology investing in Asia. There is a lot of talk about biotechnology and the like also

coming into Asia, but…

MA: I think that’s the definition of early stage investing. HM:. Look at the issue of standards. How long before we have to impose the same level of standards in investing here as we do in the US? MA: Which takes us again, back to the definition of VC, in which we say that if you have nothing in your portfolio that has earned high multiples such as 10X or 20X then you’re not a venture capitalist. If you’re just looking for a 1X or 2X, then you’re better off going into growth capital or buyout opportunities because the risk is less there for multiples still in the range of between 2x to 4x? Or is this not right? Voices around the room: No, this is right.

CR: IS CR: IS CR: IS CR: IS INTELLECTUAL PROPERTINTELLECTUAL PROPERTINTELLECTUAL PROPERTINTELLECTUAL PROPERTY Y Y Y BEING CREATED HERE? BEING CREATED HERE? BEING CREATED HERE? BEING CREATED HERE?

MA: IF YOU’RE LOOKING FOR A 1X OR MA: IF YOU’RE LOOKING FOR A 1X OR MA: IF YOU’RE LOOKING FOR A 1X OR MA: IF YOU’RE LOOKING FOR A 1X OR 2X, YOU’RE BETTER OFF GOING INTO 2X, YOU’RE BETTER OFF GOING INTO 2X, YOU’RE BETTER OFF GOING INTO 2X, YOU’RE BETTER OFF GOING INTO GROWTH CAPITAL OR BUYOUTS GROWTH CAPITAL OR BUYOUTS GROWTH CAPITAL OR BUYOUTS GROWTH CAPITAL OR BUYOUTS

HM: …IT REMAINS TO BE SHOWN HM: …IT REMAINS TO BE SHOWN HM: …IT REMAINS TO BE SHOWN HM: …IT REMAINS TO BE SHOWN YOU CAN CONSISTENTLY MAKE YOU CAN CONSISTENTLY MAKE YOU CAN CONSISTENTLY MAKE YOU CAN CONSISTENTLY MAKE RETURNS IN TECH ASIA.RETURNS IN TECH ASIA.RETURNS IN TECH ASIA.RETURNS IN TECH ASIA.

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MA: So, take the best US VC’s history. They actually have some vintages which were disasters, if you look back across all their funds, if you were in those then you’ve lost almost all your money. But if you’ve been in every fund, from the first one to the last one, then compounded, then you’ve created wealth. HD: on an aggregate basis, you’ve done very well.

MA: … maybe that is what we have here too when investing in emerging Asian GPs. Maybe you have one or two successful funds. Then we’re in dry period again. And maybe over twenty years, you’ll have one or two in which you’ll say, we invested in the first through the last, and… (laughter) HM: So in 20 years, we’re coming back here, to see who of us…(laughter) WZ: …made money RX: I think that your original point is valid. We’re still in a very early stage of where the overall technology investing and the technology market is going to be in China’s future. And China, I will venture to say, is probably one of the very few markets in the world that has this potential in a single country market. So you have to believe in the twenty year prospects for China, to be an early stage investor here, as we are doing, investing in early stage technology focused firms. Because that is the return that we’re waiting to see. The soonest that we’re going to see firms like that in our portfolios are in another five years; which is fine. If you get plenty of ten or twenty times your money back on investments, or forty times, then you’re paid back. But you really have to be patient. You really want to have a small

portion of your portfolio in that early stage technology investing bucket. WZ: Recently I saw a list, during a GP presentation of all the billion dollar companies coming out of China. I found it really interesting. It’s a long list. cTrip, Baidu, Alibaba,… RX: …very few of those are technology companies. WZ: Right. That is what I’m saying. I’m talking about early stage venture backed companies, not necessarily technology. (Cacophony of voices erupts) RX: …right there are a lot of internet, media advertising, technology-enabled or product companies.

WZ:…service models CR: …companies that investors can bring to some scale HM: and that is one of the similarities between China and the US. You’ve got a homogenous market, so that if you can get product that will succeed in that domestic market, the potential for growth in that market is huge. RX: …right and you can do it very quickly, in five years. WZ: …at a very low burn rate. RX: …so it seems like the potential is there and that is why a lot of money is going into those sectors. WZ:…I’d say tying back to our discussion about GPs and Chris’s comments about the need to find good management for these companies, that

RX: YOUR ORIGINAL POINT IS VALID. RX: YOUR ORIGINAL POINT IS VALID. RX: YOUR ORIGINAL POINT IS VALID. RX: YOUR ORIGINAL POINT IS VALID. WE’RE IN AWE’RE IN AWE’RE IN AWE’RE IN A VERY EARLY STAGE VERY EARLY STAGE VERY EARLY STAGE VERY EARLY STAGE,,,, TECHNOLOGY IS CHINA’S FUTURE.TECHNOLOGY IS CHINA’S FUTURE.TECHNOLOGY IS CHINA’S FUTURE.TECHNOLOGY IS CHINA’S FUTURE.

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the market is here, the potential is here. The biggest problem is talent. The people for every level. HM: What doesn’t get talked about in the media, which focuses on the successes, is the failures. We’ve all heard about the success stories, but we haven’t heard about the failures that GPs

have had to go through to get to that success. And maybe GPs don’t want to have those things up in your face, but if you haven’t gone through the experience in the US of having seen what the VC firms have gone through, what evolution has to take place for the industry to get to the stage where it is viable, then you won’t understand what VCs in China are going to have to live through.

STAGE AND SECSTAGE AND SECSTAGE AND SECSTAGE AND SECTOR DRIFT TOR DRIFT TOR DRIFT TOR DRIFT MA: I think about this as a former competitive skier; this is like a slalom skier who also wants to do downhill racing. It’s quite difficult, or vice versa. It’s possible, but it’s difficult. There are a few, maybe 1%, who successfully do

both, like Bode Miller (US) or Benjamin Raich (Austria). As an LP, I don’t want to exclude GPs from doing these kinds of things, to say you can’t do this, but you want to have a discussion about their doing it. You can do it. You can succeed.

I know one European based, very prominent private equity firm which is a good example. Over a long period of time, they have done pretty much

venture capital investing and they’ve been very successful. Then they started shifting into buyout investing over the years and slowly got rid of their venture business. They did this successfully. And there are other examples. Then there are evolutions in the team, but not everyone is able to do that. CR: I’m very interested in the cultural impact of investment strategy changes on a firm. Going back to your earlier point of whether I as an investment firm should just stand back and be fat and happy and lazy, because the fee income is great, and it’s a toss up about the value of the assets anymore. I have seen that cultural shift in firms here and as a consequence of having taken people away from those firms here. Because GPs felt that shift in strategy and that shift away from the tightness of “these are my assets, I’m part of this too” into the mind set of twelve investment bankers have now arrived, this thing is massive, we’re asset managers, not investors any longer. HM: The question I have about this discussion, is whether perhaps Asia is different, because Asia is a larger geography, or has different geographies; China, for example, is as different from say Australia as you can get. Given that,

you’ve got to give managers a bit of flexibility. And while strategy drift is something that we don’t like, perhaps Asia is different and you allow managers a bit of flexibility within the investment thesis. If you look at someone who is a regional fund, for example, they’re not

MA: I DON’T WANT TO EXCLUDE MA: I DON’T WANT TO EXCLUDE MA: I DON’T WANT TO EXCLUDE MA: I DON’T WANT TO EXCLUDE GPS FROM [EVOLVING], BUT WE GPS FROM [EVOLVING], BUT WE GPS FROM [EVOLVING], BUT WE GPS FROM [EVOLVING], BUT WE WANT TO DISCUSS THEIR DOING IT.WANT TO DISCUSS THEIR DOING IT.WANT TO DISCUSS THEIR DOING IT.WANT TO DISCUSS THEIR DOING IT.

HM: PERHAPS ASIA IS DIFFERENTHM: PERHAPS ASIA IS DIFFERENTHM: PERHAPS ASIA IS DIFFERENTHM: PERHAPS ASIA IS DIFFERENT.... YOU YOU YOU YOU ALLOW MANAGERS A BIT OF FLEXIBILITY?ALLOW MANAGERS A BIT OF FLEXIBILITY?ALLOW MANAGERS A BIT OF FLEXIBILITY?ALLOW MANAGERS A BIT OF FLEXIBILITY?

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going to do the same kind of deals in China that they’re going to do in Australia. There are going to be inherent differences in the structures of the deals, in the size of the deals, which part of the capital structure that they play in. I think that you’ve got to make allowances for that. But, I for one, would be very unhappy to invest in an early stage investor, who suddenly decides that the opportunities are a lot better on the growth side so forget early stage, I’m doing growth. MA: Momentum shifts are dangerous. They almost never work out. HM: What you are seeing is that everyone wants to be everything. MA: Take some prominent Asian funds. They broaden their scope into real estate, hedge funds, infrastructure investing and so on. They want to do this. To do that. Okay, they might succeed. But they might screw up if they don’t do this properly; lose their focus and determination. HM: I think vision is a good thing. But I think that one thing that we have to realize is that the firms in the US who provide models for all of us took a long period of time to develop those models. They didn’t do everything overnight. MA: The best US and EU private equity firms took years to mature.

HM: It took twenty years for all of that to happen and maybe, while I hear from a lot of GPs that “time” in China, has a different meaning, (loud laughter) and maybe that is true. I hope some of them will take their time instead of doing everything overnight. CR: It’s taken 3i, sixty three years and we’re still learning things.

HM: It’s as though things in China have gone into a time warp, everything has to happen yesterday, not even today to feel like it’s moving forward.

RX: The other thing that occurs to me is that this entire market, and this is probably true for India as well, the market itself is evolving. Every day the market dynamic is changing. You had venture capital, now you have growth and green tech, so that there are a lot of opportunities out there. I think that the biggest danger for the GPs is that they see so many low hanging fruit, outside of their own investment focus and they feel like they can reach out and take them. GPs need discipline. WZ: And increasingly the GPs here have to realize that they must differentiate themselves, because if they do everything and everyone else does everything, how do those of us who are LPs pick one over another? GPs need to say, I’m good at this and I’m going to stick to this. RX: Eventually they’re going to have to go down that path. I think probably not just yet. Today we still have people very much overlapping, doing the same things, over and over again. But eventually they’re going to start hearing from us, the LPs, I’ve got enough exposure to this. I don’t need to do another fund like this, you need to differentiate yourselves in terms of the skill set that you have on your team. And

RX: THE BIGGEST DANGER IS GPs RX: THE BIGGEST DANGER IS GPs RX: THE BIGGEST DANGER IS GPs RX: THE BIGGEST DANGER IS GPs WHO SEE LOW HANGING FRWHO SEE LOW HANGING FRWHO SEE LOW HANGING FRWHO SEE LOW HANGING FRUIT, UIT, UIT, UIT, OUTSIDE THEIR INVESTMENT FOCUS OUTSIDE THEIR INVESTMENT FOCUS OUTSIDE THEIR INVESTMENT FOCUS OUTSIDE THEIR INVESTMENT FOCUS

HM: WHAT YOU SEE IS THAT EVERYHM: WHAT YOU SEE IS THAT EVERYHM: WHAT YOU SEE IS THAT EVERYHM: WHAT YOU SEE IS THAT EVERY----ONE WANTS TO BE EVERYTHING. ONE WANTS TO BE EVERYTHING. ONE WANTS TO BE EVERYTHING. ONE WANTS TO BE EVERYTHING.

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you were right, Markus, it can be done in some cases, but GPs need to have the right people to do it. And whether new members of a team can fit into an existing team in terms of the dynamics and the economics is another issue. MEASURING SUCCESS IN ASIAMEASURING SUCCESS IN ASIAMEASURING SUCCESS IN ASIAMEASURING SUCCESS IN ASIA

T&I: Aren’t all of the conditions for investing set out in your T&A? HD: For what you’re investing in you can protect yourself. But you can’t protect against what a manager is going to do in the future. And that is where they end up going in multiple, or different directions. T&I: You all sit on the GP’s advisory committees. You go in every two months, quarterly? (shuffling of feet or chairs, then laughter.)

HM: It’s a done deal by the time we get there. I think the only time when you have any real influence is when you’re doing your investment negotiations, in terms of either sector protections or country protections.

MJ: But even then you’re not

necessarily protected. I remember back in 1999, in our venture capital agreements, they could not spend the fund in less than a year. So when they had spent all the money in eight months, they just came back to the LPs and got an amendment that all the LPs signed that it was okay to raise a new fund. And

all of the terms that everyone says that they hold the line on, and says no, no, no we’re going to protect ourselves in the documents [are abandoned] when the manager comes back and says, we’ve decided that we want to build a new sector effort, because there is a lack of capital there and we actually want to spend a higher percentage of the fund

there than we originally said. And everyone signs the agreement. T&I: What is different in Asia, this time, that will make you sign amendments that Meredith is describing? HM: What is different this time? Nothing is different this time. T&I: This will end badly? HM: Some of it will. Hugh talked about the statistics. Just look at the statistics. HD: Statistics aside it’s just hard to say how this round of vintages are going to end. We’ll just have to watch. One thing that you can say, is that some people are taking greater risks than others people. I personally prefer to put my money in people who are taking lower risk. But, it could be that the people who are taking greater risks may be the big winners. It, the future, is Asian and Asia is going to do well. And maybe the people who take the biggest risks are going to be the big winners. But I’d rather not bet my money on firm’s taking the big risks.

HM: THE ONLY TIME YOU HAVE HM: THE ONLY TIME YOU HAVE HM: THE ONLY TIME YOU HAVE HM: THE ONLY TIME YOU HAVE REAL INFLUENCE IS REAL INFLUENCE IS REAL INFLUENCE IS REAL INFLUENCE IS DURING DURING DURING DURING INVESTMENT NEGOTIATIONSINVESTMENT NEGOTIATIONSINVESTMENT NEGOTIATIONSINVESTMENT NEGOTIATIONS…………

HD: IT COULD BE THAT THE HD: IT COULD BE THAT THE HD: IT COULD BE THAT THE HD: IT COULD BE THAT THE PEOPLE TAKING GREATER RISKS PEOPLE TAKING GREATER RISKS PEOPLE TAKING GREATER RISKS PEOPLE TAKING GREATER RISKS MAY BE THE BIG WINNERS. MAY BE THE BIG WINNERS. MAY BE THE BIG WINNERS. MAY BE THE BIG WINNERS.

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HM: Statistically, there is no way that all of the funds that we’ve seen in the market can make money. So if you were topredict the outcome based on sheer

math and the numbers, in terms of the numbers of funds raised, what was the number? (looking at notes) India has 369 fund managers and they’ve raised on average from $100 to $150 million apiece. There is no way that 369 fund managers can make money in any given vintage. And do it consistently. Some of this is going to end in tears. I don’t know who these LPs are who are investing in all of these funds, but a lot of money has been raised in some of these markets. Considering all of that you say to yourself, either the periods of holding onto assets is going to get a lot longer, or more unpredictable with regard to the exit. Then the other issue, is that everyone is sitting around scratching their heads, over whether they re-up with their existing managers, because you haven’t see the return of value from them that you want. And you come back to the flight to quality at some point. HD: The fear is, that the less disciplined people, spoil the market for everyone. And yet some people are able to maintain their discipline and create proprietary deal sources and are able to

do well while other people are on the path to blowing themselves up. HM: We just have to… HD:…wait and see. MJ: We’re all I think, in the business, of trying to create sustainable risk-adjusted

returns, not just returns, so yes there will be people who make money on a swamp in Macau that someone told them about. (gasps from around the room). You hear crazy stuff, and money goes into that (laughter from around the room.) And yes, there will be one or two people who do make money that way. Big, ridiculously large amounts of money. But that is not a long term strategy. HD: Everyone looks at value creation as a way of getting better returns, but actually if you look at it as a graph where you have the relationship of risk and return, if you can get the same return for lower risk, that’s a very better return for the value creation, its not necessarily chasing the highest return, and ultimately, the people who chase the highest returns, are the people who tend to blow themselves up, because they’re taking imprudent risks. NEAR TERM OUTLOOK FOR ASIANEAR TERM OUTLOOK FOR ASIANEAR TERM OUTLOOK FOR ASIANEAR TERM OUTLOOK FOR ASIA RX: When we were doing a quarterly review on our entire portfolio, trying to figure out what this whole global slowdown’s impact was going to be on Asian private equity and in our markets, our observation was that whether you looked at our statistics or at the depth of piles of PPMs on our desks; our business hasn’t slowed down. The PPM’s keep coming in, including the re-ups. There are new managers, including hedge funds raising private equity. Global funds raising local Asia funds. It gives

HM: HM: HM: HM: …………STATISTICALLY THERE IS NO STATISTICALLY THERE IS NO STATISTICALLY THERE IS NO STATISTICALLY THERE IS NO WAY THAT WAY THAT WAY THAT WAY THAT ALL OF THE FUNDS IN ALL OF THE FUNDS IN ALL OF THE FUNDS IN ALL OF THE FUNDS IN THE MARKET CAN MAKE MONEY.THE MARKET CAN MAKE MONEY.THE MARKET CAN MAKE MONEY.THE MARKET CAN MAKE MONEY.

MJ: …MJ: …MJ: …MJ: …THERE WILL BE PEOPLE WHO THERE WILL BE PEOPLE WHO THERE WILL BE PEOPLE WHO THERE WILL BE PEOPLE WHO MAKE MONEY ON A SWAMP IN MAKE MONEY ON A SWAMP IN MAKE MONEY ON A SWAMP IN MAKE MONEY ON A SWAMP IN MACAU…MACAU…MACAU…MACAU…THAT’S NOT A STRATEGYTHAT’S NOT A STRATEGYTHAT’S NOT A STRATEGYTHAT’S NOT A STRATEGY

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us reason to think that we’re sitting in a very tricky period of time in this year, because despite the global slow down and the local public market correction, the private equity market response seems

to be lagging behind. We’ve done our survey among our GPs, asking them if they see a fundamental earnings slowdown at a local company level, and by and large, people are still saying that they are not adjusting their earnings projections for ’08 and ’09. They’re projections are still strong and even if they’re growing at 50% instead of 80%. I’m kind of happy to hear that, but I’m suspicious at the same time. WZ: Is this China or more for Asia? RX: Mostly China, but India as well. And of course, there are those people out there who are much more pessimistic about both of these markets. I think that liquidity is one of the biggest drivers of these markets and that if anything is going to cause a major crisis down the road it is going to be this significant over-liquidity. MJ: Key issues for terms and agreements at the moment? Unfortunately it’s the same issues as

always, but they’re not sticking points, because no one will listen. So its premium terms, premium carry, key man…

T&I: Premium carry means? MJ: 2% management fee and 25% carry, sometimes 30% carry or some kind of escalator clause, based upon

performance, which we would prefer, but we’d really prefer is 2% and 20%. WZ: The related issue is investments in an RMB fund and our GPs ability to invest in them, which is creating really complicated agreements. They need the flexibility in the LPA to raise these funds and then we need to know the terms and its complicated. MA: Most of these LPAs are imported from the West aren’t they? They’re all pretty similar? RX: Not PPM’s but the LPA’s are. HM: The question that I want to pose in closing, is whether, given the slow down in the US, and given the slowdown in Europe, wouldn’t we see the global funds spending more time, resources and doing deals in this region and what impact is that going to have on valuations and competition. MJ: I think you will see more competition in this region. Just anecdotally, living in Hong Kong, HM: Tells you something doesn’t it? The number of fly-in investors. MJ: Not even about the fly-ins, I’m surprised at the number of families in the private equity community and among the investment banks, being sent over here, at a fairly senior level in these organiza-tions, because nothing is going on in the US or in Europe. At least here, some-thing is going on. HM: And because of the desire to get things going here. Or they’re wanting to do something, because you can’t just sit here and not do something. MJ: There’s the risk, that they think, “We have a team there, we’ve got to do something.”

RX: …WE STILL HEARRX: …WE STILL HEARRX: …WE STILL HEARRX: …WE STILL HEAR GPS SAY GPS SAY GPS SAY GPS SAY THEY THEY THEY THEY AREAREAREARE NOT NOT NOT NOT ADJUSTING PORTFOLIO ADJUSTING PORTFOLIO ADJUSTING PORTFOLIO ADJUSTING PORTFOLIO EARNINGS …BUT I’M SUSPICIOUS EARNINGS …BUT I’M SUSPICIOUS EARNINGS …BUT I’M SUSPICIOUS EARNINGS …BUT I’M SUSPICIOUS

MJ: THERE’S THE RISK THAT [GPS] MJ: THERE’S THE RISK THAT [GPS] MJ: THERE’S THE RISK THAT [GPS] MJ: THERE’S THE RISK THAT [GPS] THINK, “WE HAVE A TEAM THERE, THINK, “WE HAVE A TEAM THERE, THINK, “WE HAVE A TEAM THERE, THINK, “WE HAVE A TEAM THERE, WE’VE GOT TO DO SOMETHING.” WE’VE GOT TO DO SOMETHING.” WE’VE GOT TO DO SOMETHING.” WE’VE GOT TO DO SOMETHING.”

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HM: And what our team that just started, who came to do buyouts here, who then say, you know, China is different. Maybe we’re going to do

minority deals here. You’ll see a bit of that, changes in strategy, from firms who

have been traditional buyout houses global. RX: My final comment is about fund raisings. I have the feeling that the pace is increasing, that fund raising sped up during the first half of 2008, maybe in the view that the window is closing later

in the year. WZ: That is absolutely right. I think there is that view. I think that a number of managers, who were planning to come out with a new fund towards the end of the year, are now trying to close funds this summer, in anticipation of a

slowdown. But, I think that we may be seeing the last wave of this whole expansion cycle. RX: Country funds. Sector-focused funds. I think that these may be the last response to what has happened. Green-tech, Telecom, Financial Funds, Healthcare, Infrastructure, Energy funds. We’re seeing more of these on the table. The general purpose funds are done and now people are … WZ: …trying to differentiate themselves by stepping into sector focus funds. MJ : I think that the Asian private equity markets are still too shallow to support these. It’s too early. T&I: Global versus Regional funds? HD: There are definite advantages and disadvantages for each model. I think that particularly in terms of deal sourcing, local funds have a real advan-tage, but there is room for everybody. T&I. END OF PART ONE.T&I. END OF PART ONE.T&I. END OF PART ONE.T&I. END OF PART ONE.

WZ: I THINK THAT WE MAY BE WZ: I THINK THAT WE MAY BE WZ: I THINK THAT WE MAY BE WZ: I THINK THAT WE MAY BE SEEING THE LAST WAVE OF THIS SEEING THE LAST WAVE OF THIS SEEING THE LAST WAVE OF THIS SEEING THE LAST WAVE OF THIS WHOLE EXPANSION CYCLE.WHOLE EXPANSION CYCLE.WHOLE EXPANSION CYCLE.WHOLE EXPANSION CYCLE.

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T&I ASIA CHINA SPECIAL REPORT - Asia Alternatives · T&I China Special Report, Part 1, LP View. 9/19/08. © T&I, 2008. Contact: [email protected]