22 March 2019 - Article
Over the past two decades a substantial amount of private wealth has been created in Asia. There are now a large number of newly wealthy individuals and families in Asia grappling with the problem of maintaining and growing excess capital.
There are many choices that can be made for managing this surplus – property, stocks, bonds, etc. – and increasingly Asian families are looking at placing a percentage of their wealth in investment funds (private equity, hedge funds, REITs, etc). Also, the current market volatility makes stable, long term private investments more attractive.
Family offices in Europe and North America have traditionally allocated a larger portion of their total assets to private equity than other investors, such as pension funds, foundations, asset managers, etc. Early indications are that Asian family offices are following and surpassing this trend. This is occurring in an environment where family offices globally are increasing their allocations to private equity at rates higher than other investors.
Fund investing by Asian family offices
While the majority of investments by Asian family offices will be made in established investment funds run by professional, international managers, we are seeing a significant portion invested into funds managed by friends, family or people in their networks outside of the big global banking institutions and private equity houses. This is partly due to the unique way business is conducted in Asia, a reticence to trust international advisors and attempts to place funds where outsized returns may arise.
Often these new, independent funds are small and opportunistic and are managed not by seasoned professionals but by savvy businesspeople with strong local connections and networks. These funds are almost always private and funded by a handful of high net worth individuals and families. Lawyers specializing in family offices and high net worth individuals have an active role to play in establishing these bespoke new funds, acting for families or sponsors.
Asian investors – especially those from first or second generation wealth – typically seek an active role in how their funds are being managed and deployed. These investors have limited experience (and trust) in having third parties manage their wealth and they currently either own their families operating business or have recently owned this business. The decision makers in these families are used to making all decision in relation to their business and this attitude is reflected in their desire for control over how their wealth is managed.
European and American investors, in contrast, are more inclined to take a “hands-off” view of capital oversight and often have generations of experience in how to manage their excess capital. Time will tell whether this contrast is cultural or the product of a large amount of Asian wealth being managed by the generation that created the wealth.
Family offices in Asia also show a significant appetite for co-investing with funds, more so than family offices in Europe and North America. This investment activity is concentrated in industries where the family's wealth was generated and where families can use their experience and existing networks to identify high-quality opportunities (which also benefits their co-investing fund).
Improving the terms of the partnership agreement
For families investing in established, international investment funds there is often little leverage or scope for families to amend or adjust the terms of their investment to ensure they receive a larger portion of returns relative to management and sponsors or have some say in investment or divestment decisions.
For families investing in newer, smaller, private investment funds, however, there is significant scope to shape the terms of their investment and the operation of the fund.
Generally these funds are set up using a traditional model, with sponsors or fund managers as general partners, and investors as limited partners.
Significant limited partners can use their leverage to remodel key aspects of their agreements with general partners to create a more favorable balance between management and investor interests. Family offices will look to encourage management to earn their profit through carried interest and not through management fees and expenses. Asian families are often aggressive in seeking to limit management fees and expenses to estimates provided prior to the execution of subscription agreements and limit fees charged as a percentage of assets under management.
At the core of the limited partner/general partner relationship is the distribution of revenue generated by the fund. After the return of capital contributed by the partners, a certain percentage of the profit is distributed to the general partner, called “carried interest” or “carry”, traditionally around 20% of the profit. The percentage of carry, when it is distributed, whether it is distributed after the limited partners have received a previously agreed upon rate of return and whether it is distributed upon exit of each investment or upon the broader performance of all investments is negotiable. While management will seek the right to receive their performance fees at an early stage in the fund life cycle, cornerstones will try to ensure profits from each investment remain available within the fund in case of future losses.
Cornerstone investors can also negotiate “side letters” with general partners to provide special terms and conditions such as discounted fees, preferential liquidity provisions and additional investment capacity. These letters may include “most favored nation” provisions that automatically provides cornerstones with benefits granted to other significant limited partners.
Asian cornerstone investors not only want improved returns, they also seek improved transparency and control. Activist Asian family offices seek positions on investment committees that oversee fund activities and seek specific decision making powers over matters including conflict of interest, valuation methodology and significant investments or divestments.
Some Asian family offices seek shares and board seats in the general partner both for reasons of transparency and to receive a percentage of carry. While this will improve returns and access to information, it also increases litigation and regulatory risks for the family. If not structured properly, activist family offices could be seen by courts and regulators as part of management.
While partnership agreements and local law mandate a certain amount of financial information is provided to limited partners (which typically includes rights to regular management accounts and management books and records) significant investors can negotiate preferential information rights to better understand how fees are calculated and investments are valued. Managers and sponsors, however, will often resist these requests on the basis that the information is confidential and could be used by competitors to set up similar funds and trading strategies.
There are plenty of tools available for the prudent, activist investor. Cornerstone investors often underestimate the leverage they have to negotiate preferred terms. This leverage will likely increase as alternative sources of funds disappear amid volatile markets as occurred after the global financial crisis in 2008. Agreements are there to be negotiated and substantial investors can investigate ways to adjust returns and increase levels of control and transparency over their funds.