In this episode of China Money Podcast, guest David Pierce, CEO of Squadron Capital, a fund-of-funds manager with over US$1 billion-under-management, talks about China’s private equity industry in a slowing economy, lessons he learned from investments that have gone wrong, and why his firm doesn’t want to become a QFLP (Qualified Foreign Limited Partner) yet.
Listen to the full interview in the audio podcast, watch the shortened video version or read an excerpt.
Q: First give us a brief intro of Squadron Capital?
A: We are a boutique fund-of-funds manager, focused on private equity funds principally in the Asia Pacific region. We also have a separate account program that includes the private equity portfolio of our sponsor, The Research Investment Group, which is the family investment office of Mr. Robert Miller, a co-founder of the Duty Free Shoppers.
Q: What sets you apart from other fund-of-funds in the region?
A: I think it’s mostly our longevity in the market. My own experience of investing in private equity in Asia goes back to 1995. Most of the FoFs here, frankly, have arrived in the last few years. So we have a history with GPs (General Managers) in the region, so they are not fearful that we are carpetbaggers who are coming in for a bull market moment. So we are in for the long haul.
Q: You have been in the industry for a long time, so where do you think the PE industry in China is right now, and where is it headed, particularly considering the slowing economy?
A: Right now, there are a lot of uncertainties in the world, with China’s economy slowing and troubles in Europe and the U.S. All these make investors and companies more cautious. China’s private equity industry has also gone from the go-go period into a period of more reflection. Right now, people are thinking to themselves: Let’s think about (our strategies) more carefully. Let’s focus on how to create value for the long-term.
Q: Can you give us some examples of the funds that you backed and you are very proud of today?
A: China’s private equity market is much deeper and broader than other markets in the region, with strategies ranging from early stage investment to buyouts. So we have the luxury of choosing from different strategies.
At the later stage end, we’ve invested with Hony Capital for a series of funds now. We identified John Zhao and his team fairly early on before he was out raising money and became famous. Hony Capital has changed with the overall private equity ecosystem. It is focusing increasingly on the things that other private equity firms can’t do, such as having in-house consulting teams, and working with portfolio companies to transform the business. So they can do state-owned enterprise restructuring and controlled buyouts.
At the other end of the spectrum (on the growth capital side), we’ve long been a backer of Orchid Asia. It is a fund founded by Gabriel Li. It’s on their fifth fund now, primarily investing in smaller companies to provide growth capital. Their investment process involves finding the right entrepreneurs and finding a way to work with them to transform their businesses through persuasion, rather than control.
Q: Going forward, which strategy do you think will become more advantageous?
A: Eventually, controlled buyouts will become more important in China, but I think we are some years away from that. First of all, there aren’t a lot of companies for sale. Good companies that are established by first-generation entrepreneurs are never really for sale. The plan for them is to become a public company. So there are still lots of room for growth capital investing to continue to dominate. But we will see a maturing and deepening of the growth capital sector.
Q: What are your thoughts on the outlook of state-owned enterprise buyouts?
A: It’s a very difficult strategy to execute, but those who can execute it should have lots of opportunities. There are not a lot of private equity firms organized to do SOE buyouts. You have to be willing to invest significantly into your teams to be able to manage such transactions.
Also, I don’t expect lots of SOEs to be privatized or combined in the near future. Privatization is still a naughty word among SOEs. But firms like Hony Capital will find great opportunities, which include building up national champions by combining strong regional businesses.
Q: Give us some examples when you backed a private equity firm, but the result didn’t turn out as expected. And, what lessons did you learn from them?
A: Some of our investments have been disappointing in their ability to pursue the strategy they set out to pursue. It might not have anything to do with their own fault, but because of causes outside of their control. For example, one of our fund managers had one of their senior members tragically killed in an accident.
One of the things that we learned is that these are relatively small operations. A fund generally relies on three or four people to make the fund successful. When you choose to invest in a smaller fund, the key people are very important.
We have also been disappointed by the willingness of some members of the key team to stick it through. Again, it’s a judgment we make. We’ve learned a lot about what motivates people. We are careful with our due diligence process to make sure the alignment of interests are there. We also focus on the chemistry of the team. In one case, two key people of the fund had personality clashes and became irreconcilable over time. In the end, one person left the fund. We as investors were anxious about their ability to succeed with a diminished team.
So one thing I advise people when looking at smaller private equity funds is to try to deeply understand the team, the dynamics between the team members and the alignment of interests among the team members. A lot of the funds are quite new, so there isn’t a rich history or track record to rely on.
Q: How many funds have you invested in, and usually do you stay with the fund throughout their fund life?
A: Currently, we track about 400 private equity managers in China. We’ve invested in about 20 fund managers, usually across more than one fund cycle. In any given time, our portfolio would have between 15 to 25 Chinese private equity funds.
The manager selection process is absolutely critical for any investors in private equity. When you sign up, you are in for the duration. It’s not really until-death-do-you-part, but divorce is painful. We have fortunately not been in situations where we must get a divorce. One of things we always insist on investing in a fund manager is a no-fault divorce clause. It’s standard in many fund terms, but not so standard in Asia. We have been very proactive in negotiating and including the no-fault divorce clause.
Q: For those private equity funds that have only one to three years left in their fund life, what’s your outlook for their exit success?
A: The public market is difficult to access at this point in time, so this is the time that private equity firms are working with their portfolio companies to create value. But all of our fund managers are experienced, so they will find a way out. Sometimes they have put options. Also, we will see an increasing amount of secondary transactions.
Q: You currently only invest in USD funds, right?
A: Yes, we haven’t applied to be a QFLP (Qualified Foreign Limited Partners). We certainly know all the trial programs in difficult cities, but we don’t see the advantage of being in that program right now. There is still a lot of trial-and-error to go on. There are still differences in the programs of different cities. The recognition of one city’s program in another still needs to be seen. In addition, the best fund managers have both USD and RMB funds, so we can still participate with them through the USD funds.
Q: Lastly, what’s your outlook for China’s private equity industry in the next few years?
A: I continue to be optimistic that the best fund managers will continue to find attractive opportunities in the next phase of China’s economic development. Urbanization will continue, the middle class will continue to develop. But a lot of funds that raised money in the last few years will need to take time to realize returns. So the key question is: Will they be able to keep their teams together? So I think there might be some changes in teams for some funds, which will be a risk.
NEWS REVIEW WEEKS OF SEP 24 – OCT 7, 2012:
– China’s HSBC Manufacturing PMI (Purchasing Manager’s Index) came in at 47.9 in September, still below the threshold of 50 that indicates the difference between contraction and expansion. It extends the longest run of the PMI readings below 50 ever in the index’s history, suggesting that the economy continued on a weak footing in September. It also points to a weaker Q3 GDP growth, likely lower than Q2’s 7.6%.
– China’s once-a-decade leadership transition is slated to take place in early November, it was announced before the October 1 holiday. Once completed smoothly, it will remove uncertainties revolving around policies and political structure. Analysts are calling again one or two bank reserve requirement ratio cuts by the People’s Bank of China before or around the leadership transition.
About David Pierce:
David Pierce is CEO of Squadron Capital, a fund-of-funds manager focused on the Asia Pacific region with over US$1 billion under management. Previously, David was a partner at an international law firm in Shanghai and a managing director of a China-focused private equity firm. Pierce has rich experience in Asia, having first moved to the region in 1982, and has been based at various times in Beijing, Hong Kong, Shanghai, Singapore, Taipei and Tokyo.