Insightful investors in Asia Pacific Private Equity April 2011 KEY TOPICS: Management fees Distribution waterfalls No-fault divorce provisions Key person clauses Limits on concentration and PIPEs Renminbi / US Dollar parallel fund issues INSIDE Survey Highlights and Information 2 Management Fees 3 Management Fee Offsets 4 Distribution Waterfalls 5 Preferential Fee Terms 6 No-fault Divorce 7 Key Person Provisions 8 Fund Suspensions On Trigger of Key Person Clause 9 Annual Limitations On Capital Calls 10 Ability For / Limitations On Public Market Investing 11 RMB Funds Managers Potential Allocation Policy Issues 12 ASIA PACIFIC PRIVATE EQUITY 2010 FUND TERMS SURVEY The rapid and continuing growth of private equity in the Asia Pacific region has heightened interest in private equity fund terms among investors ( limited partners or LPs ) comparing potential funds for investment, and fund managers ( general partners or GPs ) seeking to benchmark their terms against the market norm. Increasingly, private equity participants are examining how fund terms in Asia compare with best practice principles issued by the Institutional Limited Partners Association ( ILPA ), and seeking to understand why there may be differences in fund terms relative to other markets globally as well as where discrepancies may be acceptable industry differentiation. In response, Squadron Capital and the Emerging Markets Private Equity Association ( EMPEA ) joined forces to produce this Asia Pacific Private Equity Fund Terms Survey, providing market data and analysis on the key terms and conditions that prevail in the Asia Pacific region, with year-on-year comparisons to track changing dynamics and benchmarks against global norms, where available. The first survey in this annual series, covering data on funds raised in 2009, is available on request from Squadron Capital. Based on input from 94 Asia Pacific GPs that achieved a final closing during 2010 or who were actively fundraising as of 31 December 2010, this unique Survey provides a snapshot of some of the current hot topics in private equity within the Asia Pacific region, including the level of management fees and management fee offsets, key person clauses and no-fault divorce provisions. We also examine a topic of specific relevance to many markets within the Asia Pacific region - the flexibility or lack thereof for funds to invest in PIPEs - as well as a topic of specific relevance to Chinafocused managers, i.e. the allocation of investment opportunities between parallel US Dollar and RMB funds. 2011 Squadron Capital Management Limited. All rights reserved.
Survey highlights: Annual management fees in the Asia Pacific are higher than the global average, likely reflecting smaller average fund sizes in Asia and certain fixed costs of fund management irrespective of fund size; Almost three-quarters of the respondent Asia Pacific funds currently grant a 100% management fee offset, compared with less than half in the 2009 Survey, reflecting the greatest year-on-year shift in fund terms; Demonstrating best practices as per the ILPA guidelines, 84% of Asia Pacific private equity funds follow a European-style fund-by-fund distribution waterfall and 91% have a key person clause in place; Fund sample by investment strategy Distressed / special situations / other 12% Venture 14% Buyout 11% Growth 63% Fund sample by geographic focus Over half the funds surveyed lack a no-fault divorce clause, although voting thresholds for those which do make such provisions compare favorably to the global average; and Of the 44% of China-focused GP respondents that manage parallel Renminbi and US Dollar funds, 60% allocate investments between the two purely at the discretion of the GP. Pan-regional 14% Southeast Asia 13% Korea 9% Australia/New Zealand 14% Greater China 21% Survey information: The information in the Survey has been derived from responses to a questionnaire sent by Squadron Capital to over 450 Asia Pacific GPs, with the Asia Pacific region defined as including Australasia, Greater China, the Indian subcontinent, Japan, Korea and Southeast Asia ( ASEAN ). Following the removal of GPs that were not actively fundraising during 2010 and largely incomplete responses, the Survey results cover 94 Asia Pacific GPs that either achieved a final closing during 2010 or were actively fundraising as at 31 December 2010. For funds which were still being raised as at 31 December 2010, the terms stated by the relevant GPs may not reflect what are or will be the final versions of the limited partnership agreements or constitutional equivalents thereof. Accordingly, the actual final terms and conditions agreed upon for such funds within the Survey - and therefore for the sample size as a whole will likely be more LP-friendly than the study suggests. The summary details of the sample funds have been displayed in the charts on this page. Japan 2% Indian Subcontinent 27% Fund sample by target fund size $1 billion and above $500-999 Less than 4% million $100 million 13% 20% $100-499 million 58% 63% 2
Management fees Management fees continue to be a key area of focus for LPs globally, particularly with respect to the alignment of interests and incentivization of GPs to earn their fees through carry rather than annual management income. Annual management fees in the region are in general higher than those elsewhere in the world, though this may reflect the overall smaller fund sizes in the Asia Pacific. Despite higher fees, funds in the region might not necessarily be generating annual fee income levels in excess of their GPs likely cost bases, or what the ILPA Principles refer to as reasonable operating expenses and reasonable salaries, as the majority of funds that are charging annual fees in excess of 2% are sub- $250 million in size. Comparative management fees Management fees (%) >2% 2% <2% 0% 20% 40% 60% 80% % of funds Asia Pacific average Global average* * Source: 2011 Preqin Global Private Equity Report Management fees (%) 2.5% Management fees by fund size 2.0% 1.5% 1.0% 0.5% 0.0% 0-99 100-499 500-999 > 1,000 Fund size ($ million) Note: Private equity fund fees have two components an annual management fee and a share of the profit. 3
Management fee offsets Transaction, monitoring, directory, advisory, exit fees and other consideration charged by the general partner should accrue to the benefit of the fund (ILPA Private Equity Principles) Management fee offsets has been the category that has seen the greatest shift since the 2009 Survey, with almost three-quarters of Asia Pacific funds now granting a 100% fee offset, compared with less than half in the previous Survey. This proportion is also significantly in excess of the global average, where less than 40% of funds are currently in line with what ILPA regards as best practice. Fee income offset (%) against management fee % of funds 80% 70% 60% 50% 40% 30% 20% 10% 0% 59% or less 60-99% 100% Fee income offset (%) Asia Pacific average Global average* * Source: 2011 Preqin Global Private Equity Report Note: In addition to management fees, GPs in some cases also derive income from underlying portfolio companies (through advisory fees, directors fees and so forth) as well as from other sources. 4
Distribution waterfalls A standard all-contributions plus preferredreturn-back-first model must be recognized as a best practice (ILPA Private Equity Principles) One issue where Asia Pacific private equity fund terms are already by and large in line with best practice is the distribution waterfall, where market practice in the region follows a Europeanstyle fund-by-fund rather than US-style dealby-deal approach. This varies according to fund strategy, however, with a disproportionate number of venture capital funds in the Survey applying deal-by-deal waterfalls. Carry structure (Asia Pacific sample) Deal-bydeal 16% Fund level 84% Carry structure (Global sample*) Deal-bydeal 28% Fund level 72% * Source: 2010 Preqin Global Private Equity Report Note: Distribution waterfalls govern the order in which the proceeds from the sale of investments is distributed. Under a fund level distribution waterfall, investors would be repaid all of the amount they invest into a fund plus a minimum profit hurdle before GPs start becoming eligible for their carry (the term used for incentive payments). Under a deal-by-deal distribution waterfall however, LPs could theoretically have to start paying out carry to GPs even though the LPs themselves have not been repaid all of their original capital investment. 5
Preferential fee terms There has been an incipient trend in the private equity industry globally for certain GPs to offer differential fee or carry terms to a subset of investors for reasons of relationship (such as fund sponsors or parent organizations), commitment size (in the case of large anchor investors) and/or timing of entry (in particular for first close LPs). Equality of fee/carry terms versus preferential deals % of funds 100% 80% 60% 40% The adoption of such an approach may well enable a GP to kickstart a fundraising process and/or attract large commitments, but at the expense of potential difficulties further along in the fundraising process as some LPs may view the existence of such deals adversely. For a GP, there are also obviously the financial implications of offering such fee or carry discounts. 20% 0% Yes, all LPs pay the same fees and carry No, certain LPs pay a lower management fee No, certain LPs pay a lower carry While the vast majority of funds in the Survey offer all LPs consistent fee and carry terms, there are a small number which have granted preferential terms to a subset of investors. Interestingly, of the funds which offer differential carry terms for certain LPs, the majority of these are Indiafocused funds. 6
No-fault divorce No-fault divorce clause in place No fault rights upon a two-thirds in interest vote of limited partners for the removal of the general partner (ILPA Private Equity Principles) The presence and nature of no-fault divorce clauses in the Asia Pacific region as a whole is a matter which is still significantly short of what the ILPA regards as best practice. Over half of the funds in the Survey lack a no-fault divorce clause, though closer analysis of the data set indicates that this is disproportionately the case amongst funds which have not yet achieved a final close as at the end of 2010. No 51% Yes 49% Even for those funds that do have such clauses, the voting thresholds are generally higher than the ILPA s recommended two-thirds figure (though lower than the global average), with 75% being the most common threshold. % vote required for no-fault divorce Vote required (%) 90% + 80-89% 70-79% 50-69% 0% 20% 40% 60% 80% % of funds Asia Pacific average Global average Note: A no-fault divorce clause refers to the ability for investors to terminate the management agreement between the fund and the GP, which in the ordinary course can often run for 10 or more years. 7
Key person provisions Key person clauses remain a key area of focus in many of the Asia Pacific private equity markets, perhaps more than elsewhere. The high volatility of Asia Pacific markets combined with the fact that many Asia Pacific GPs have not as yet gone through a full investment cycle means there is a lower opportunity cost for teams or team members leaving or spinning out of their existing firms. Indeed, a significant number of spinouts have occurred during the course of 2010 and 2011 to date. In addition, a greater proportion of GPs in the region continue to be overly dependent on a single founder or individual compared with the more institutional partnership structures of GPs in established markets, which increases the risk of problems should such an individual leave or be unable to continue with the GP. Key person clause in place No 9% Yes 91% While the majority of funds within the sample size are in line with the revised ILPA Principles on this matter and have a key person clause in place, a minority of funds are not. 8
Fund suspensions on trigger of key person clause Automatic suspension of investment period if key person clause is triggered Automatic suspension of investment period, which will become permanent unless a defined super-majority of LPs in interest vote to reinstate within 180 days, when a key-person event is triggered or for cause (ILPA Private Equity Principles) No 51% Yes 49% What happens in cases where the key person clause is triggered? Approximately half the funds within the data set apply best practice automatic suspension of the investment period, while the other half requires an LP or advisory board vote in order to suspend or terminate the fund. For suspensions which are not automatic, the median threshold of 75% is a surprisingly high figure. Where the suspension is automatic, lifting of the suspension can generally be achieved by the approval of either a simple majority or two-thirds of LP interests or the advisory board. Practice in the Asia Pacific region is thus broadly in line with standard practice elsewhere in the world. If suspension is automatic: % of LP interests or advisory board required to lift the suspension % of funds 35% 30% 25% 20% 15% 10% 5% 0% 51% 67% 75% 80% % LP interest or advisory board vote required If suspension is not automatic: % of LP interests or advisory board required to suspend/terminate % of funds 60% 50% 40% 30% 20% 10% 0% 51% 67% 75% 80% % LP interest or advisory board vote required 9
Annual limitations on capital calls Vintage diversification is a key tenet of private equity investing. This is arguably even more true in the case of many of the markets within the Asia Pacific region, where historically higher levels of market volatility imply that timing has an even greater than usual impact on returns. Despite this, barely 10% of Asia Pacific private equity funds have per annum limits on capital calls - approximately the same percentage as last year s Survey (8%) with most GPs and LPs taking the view that full temporal flexibility in investing becomes more rather than less important in the volatile markets within the region if they are to invest opportunistically to maximize returns. Annual restrictions on investment activity Yes 11% No 89% 10
Ability for / limitations on public market investing Investment restrictions in publicly listed companies Private investments in public entities ( PIPEs ) remain a topic of significant debate within the region, being viewed by members of the private equity community both GPs and LPs either with disdain, reluctant acceptance or as unique opportunities to generate value. A majority of funds (59%) in the 2010 data set have formal restrictions on PIPEs, which is a statistically similar proportion when compared with the 2009 data reported in last year s Survey (57%). Where restrictions are in place, there appears to be a polarization of the market between funds with ceilings of 10% or less and those with ceilings of 20% or more (at the expense of those with a 15% ceiling). No 41% Yes 59% Limitation of investments in listed companies % of funds 35% 30% 25% 20% 15% 10% 5% 0% 0% Up to 10% 15% 20% 25% or higher Public investments ceiling as % of fund Note: Where applicable, the ceilings above represent the proportion of each fund that can be invested in publicly listed companies, beyond which any such investments can be made only with the approval of the fund s LP advisory board. 11
RMB fund managers potential issues relating to allocation policy As it becomes increasingly common for Chinafocused GPs to manage parallel Renminbi and US Dollar funds, the topic of managing potential conflicts of interests between parallel funds has become a key matter of concern for LPs globally. In excess of 40% of China-focused GPs who responded to the Survey now manage parallel Renminbi and US Dollar funds. Of these, 60% allocate investments between the two funds at the discretion of the GP. The fact that a large proportion of China-focused GPs managing parallel funds have discretion over the allocation procedure could indicate on the positive side that LPs have taken a pragmatic view of the issue, and on the negative side that LPs may in certain cases be too willing to accede to these points in order to ensure access to certain GPs in the market. Do you manage RMB-denominated private equity fund(s) as well as USD-denominated fund(s)? Yes 44% No 56% What is the basis of allocation of opportunities between the RMB and USD funds? Strictly pro rata for all encouraged/permitted sectors 40% Purely at the discretion of the GP 60% Note: The pro rata category also includes GPs which to a large extent avoid the potential conflicts of interests issue by having entirely separate teams managing each of the Renminbi and US Dollar arms. 12
ABOUT SQUADRON CAPITAL Squadron Capital is a private equity investment firm based in Hong Kong and focused on the Asia Pacific region. On behalf of its clients, the firm constructs and manages portfolios of private equity funds, with aggregate assets under management currently well in excess of $1 billion. Squadron Capital has one of the largest professional investment teams dedicated to private equity in the region, with investment professionals hailing from eight Asia Pacific countries. The firm is widely recognized as a leader in the industry and has won several industry awards. Responsible Investor of the Year in Asia: Squadron Capital ABOUT THE SQUADRON CAPITAL WHITE PAPER SERIES In order to provide existing and potential limited partners with an overview of key private equity trends and activity in the Asia Pacific region, Squadron Capital compiles a series of white papers that are updated regularly. This Survey, which is conducted annually by Squadron Capital, is part of the firm s white paper series. In preparing these white papers, the intention is neither to set out a definitive analysis of the state of the private equity markets in the Asia Pacific region, nor to execute a data dump of raw information, but rather to provide a considered and insightful overview of the key factors and trends likely to influence the level of private equity activity over the investment periods of the underlying funds into which vehicles managed by Squadron Capital are likely to invest. The data contained in the Squadron Capital white papers has been compiled from various publications and databases and in certain cases has been directly quoted from the relevant sources. The identification and selection of key factors and trends is our own, and the qualitative evaluations represent our opinion based on our own analysis. While Squadron Capital seeks to ensure that the information contained herein is accurate, no representation or warranty of any kind, express or implied, is made with respect to the accuracy or completeness of any such information. Squadron Capital reserves the right to change any such information, at any time, without notice. No reliance may be placed for any purpose whatsoever on the information contained in this document or on its completeness. No information contained in this document constitutes an offer to sell or an invitation to subscribe for any securities. The data and charts contained herein may be reproduced, distributed or published on the express condition that you attribute any data and charts you use to Squadron Capital. Squadron Capital Advisors Limited is licensed by the Securities and Futures Commission in Hong Kong to conduct Type 4 (Advising on Securities) and Type 9 (Asset Management) regulated activities and may only deal with professional investors. The Company is also registered with the United States Securities and Exchange Commission as an Investment Adviser. 2011 Squadron Capital Management Limited Squadron Capital Advisors Limited 46th Floor, Cheung Kong Center 2 Queen s Road Central Hong Kong Tel: +852 2826 2000 Fax: +852 2297 0880 email: info@squadroncapital.com www.squadroncapital.com 13
ABOUT THE EMERGING MARKETS PRIVATE EQUITY ASSOCIATION (EMPEA) The Emerging Markets Private Equity Association (EMPEA) is an independent, nonprofit, global industry association that catalyzes private equity and venture capital investment in the emerging markets of Africa, Asia, Europe, Latin America and the Middle East. EMPEA s more than 250 members comprise a broad array of fund managers, institutional investors and other industry stakeholders, representing more than 50 countries and over US$1 trillion in assets under management. The Emerging Markets Private Equity Association (EMPEA) was founded in 2004 by a handful of visionaries at the heart of the industry who shared the belief that private capital has the potential to unleash economic growth in emerging markets while simultaneously generating strong returns for investors. EMPEA is unusual among membership associations in producing proprietary research that provides an authoritative global view of the market in support of our mission. We leverage the scope and connectivity of our membership to help deliver research and insight built on solid empirical data. We also organize conferences and unique member events around the world, often in partnership with global media brands where the EMPEA network facilitates powerful business networking opportunities. EMPEA provides the asset class with a voice on key public policy issues to global regulators and policymakers, and works to advance the dialogue on emerging markets opportunities and challenges among institutional investors. For more information, please visit www.empea.net. Emerging Markets Private Equity Association EMPEA Headquarters 1055 Thomas Jefferson St NW Suite 650 Washington, DC 20007, U.S.A. Tel. +1.202.333.8171 EMPEA Asia Headquarters Suite 3205 No. 9 Queen s Road Central, Hong Kong Tel. +852.3713.4879 14