The long game: Merchant banking-style PE
Tim Burroughs | 23 September 2015
Ascendent Capital Partners’ China strategy involves advising companies first and raising the prospect of investment second, perhaps with a sizeable gap in between. Does this signal change in the middle market?
"That was probably the most widely asked question in the reference calls," the LP says, having been invited to name a China GP with a similar strategy to Ascendent Capital Partners. The LP avoids giving a straight answer because he can't. "They are one of the harder groups to comp against," he admits. "But that's why they are attractive. There's no one else doing what they do to the same degree."
The LP served as a referee for investors conducting due diligence on Ascendent's second fund, which closed a few months ago at the hard cap of $600 million. Heavily oversubscribed, it easily exceeded the $500 million target and the $365 million raised for its predecessor in 2012.
Ascendent brings what has been described as a merchant banking-style approach to private equity, providing companies with capital in conjunction with advice and solutions. Casting around for a GP of comparable size and strategy, industry participants offer a range of suggestions, from captive investment teams within Chinese banks to special situations players.
Liang Meng, a former M&A banker with J.P. Morgan and investor at D.E. Shaw, who set up Ascendent in 2011 with ex-Goldman Sachs executive Kevin Zhang, has another idea: "A lot of what we do well-established Silicon Valley VCs are doing with start-ups - they are the mentors and guidance counselors." He sees few advisory-plus-capital approaches in China's middle market.
Entrepreneurs increasingly recognize they need close working relationships and industry expertise from their investors. They are looking for partners rather than investors - Anthony Zhao
At a time when PE firms are rushing to differentiate themselves along sector lines, Ascendent appears to be an anomaly. It is sector-agnostic, pursuing deals on a largely opportunistic basis, often but not always including a high degree of structuring; it does not champion the presence of an in house operating team (although people are brought in as and when required); and it claims to add value as a strategic advisor to entrepreneurs with whom it has cultivated long-standing relationships.
Has Ascendent found a unique twist on the middle market GP model or is it repackaging the kind of support already provided by many investors as a strategy? Opinion is divided among GPs, LPs and service providers that spoke to AVCJ.
"It does not sound all that unique," says Bob Partridge, managing partner for Greater China transaction services at EY, in reference to the advisory model in general rather than Ascendent in particular. "A number of PE firms in the early days of China private equity would see the future value in a target and help steer the founders in the right direction to the point where they needed capital to meet their ambitions. Some of them continue to work that way today."
The counterpoint is that private equity firms may say they provide these services - it is not uncommon for GPs to perform some kind of pro bono advisory work, personally or professionally, in order to secure a deal - but not everyone operates at the same level. Marcia Ellis, a partner at Morrison & Foerster who has worked on many of Ascendent's investments, argues that there is something different to the firm.
"In a lot of deals you do the investment and then you hear nothing more. With Ascendent, I will hear from them constantly," she says. "They will be bringing in strategic investors, deciding a business needs to consolidate assets onshore, or talking about acquisitions. What also happens - and you usually see this with buyouts rather than minority deals - is we end up moving over to the company side. They convince companies to bring us in as counsel in situations where Ascendent is initiating something."
This happens, Ellis argues, because the GP is executing a minority growth strategy but the nature of its involvement with companies is more like a buyout fund. It is appropriate to middle market companies that may lack executives capable of addressing strategic challenges.
Ascendent targets businesses with enterprise valuations of $100-500 million, typically committing $50-75 million per investment. Such companies face an array of challenges: tougher commercial environments; rising costs and balance sheet pressure; cross-border expansion or domestic consolidation imperatives that are beyond their operational or financial resources; and the transfer of ownership to a younger generation that may not have the will or skill to lead operations on their own.
"These companies are generally less sophisticated than their peers in the US or Europe and they might not know exactly what they are looking for," Zhang says. "A large investment bank might help them achieve only part of their goal. These companies also don't want to pay a large fee for that advice, particularly when it comes in the form of a 40-page presentation that does not really address the issue."
Meng adds that investment banks tend to be very transaction-focused. They need to complete around six deals each year, as opposed to the 1-2 targeted by Ascendent, so they may lack the patience to become a CEO's trusted advisor.
This represents an opportunity for PE, and it underpins the investment thesis for numerous GPs operating in China's middle market - but they have to provide solutions to the challenges companies face.
"Entrepreneurs increasingly recognize they need close working relationships and industry expertise from their investors. They are looking for partners rather than investors," says Anthony Zhao, a partner at Zhong Lun Law Firm. "This is why we will see more concentration on particular sectors or deal stages within the private equity industry."
In terms of fundraising, differentiation - and ability to show it - is crucial. "You might have a solid, mid-market growth fund but a lot of LPs would say, ‘We've got five solid mid-market growth funds, why do we need another one?' It's a fair question," says Kallan Resnick, managing director with placement agent Park Hill Group.
Ever since the shutdown in China's IPO market in 2013, middle market private equity firms have increasingly highlighted their operational capabilities. This is intended to convey that they are active rather than passive investors, with enough influence over portfolio companies to improve performance and perhaps open up potential trade sale exits in addition to IPOs.
"Operational value-add is important and a bit of a given," says Vincent Ng, a partner at Atlantic Pacific Capital, another placement agent. "At the same time, a lot of funds, no matter what they say, are a bit reactive: here is a company that needs an up round, or here is a sector and these are the top three groups we'd like to back. You want GPs to be bottom-up as well as top-down."
Ascendent's strategy of establishing a dialogue with companies and presenting them ideas before proposing investments could be seen to fulfill these criteria - although several industry participants question whether it could work this way for every single deal.
Morrison & Foerster's Ellis says the approach served Meng well at D.E. Shaw in the wake of the global financial crisis. There was a sense that legal downside protection, while important, was not enough: a GP can only ensure its advice is heard by a controlling shareholder if there is long-standing relationship between the two.
The origins of the firm's investment in Shuanghui International - now a publicly traded company that goes under the name WH Group - go back about a decade. Meng was part of the J.P. Morgan team that worked on the transaction that saw CDH Investments and Goldman Sachs back the company in 2006, while Zhang was a Goldman representative on the board. They remained unofficial advisors to the chairman of Shuanghui and were invited to invest when an opportunity came up in 2012.
"We do have situations where we invest in companies and entrepreneurs we have known for a long time - and in the case of WH Group it was a very long time," says Meng. "We rarely do deals just because someone pitches to us; months or years might pass before we make an investment. We only do 2-3 deals a year, and we've had deals that failed and then came back a couple of years later."
He notes that if a company trusts Ascendent it will likely be upfront about a problem, rather than hide it. "Our fraud ratio is close to zero because we are very close to the companies," he says.
WH is one of Ascendent's two exits so far. The other is Nano Resources, a components manufacturer for high speed trains. For a number of years, the team had been advising some entrepreneurs who own a Hong Kong-listed company and who focus on the railway industry. They studied the high-speed rail sector, concluded that the downturn it was experiencing did not reflect the market potential, and this led to a joint investment in Nano.
Ascendent invested $31.8 million in Nano in 2012, taking a 40% stake. Earlier this year, the company agreed a reverse merger with a Shenzhen-listed entity at a valuation of RMB3.3 billion ($520 million).
For LPs, the question was: Is this strategy replicable? According to one investor that came into the first fund, a couple of deals were lined up that demonstrated how relationships could be brought to bear. Further encouragement came as the founders of companies the principals had backed earlier in their careers made LP commitments to the fund. Yet there were lingering doubts as to what the GP would do if and when opportunities available through Meng and Zhang's personal networks were exhausted.
"There is a lot of low-hanging fruit and it is executable on day one," the LP says. "The problem is, once they have been through the rolodex a couple of times, can they continue to generate deal flow from outside? The verdict is still out."
Ascendent can claim it has more levers to pull. First, the network of relationships is not static: new entrepreneurs enter the GP's orbit through referrals. Second, an internal research team has been created to conduct top-down analysis of sectors and identify potential investees.
According to a source familiar with the GP, the research team was integral to investments in a hospital and a dairy company in 2014. The former is a control deal and the latter involved the sale of a significant minority stake, but both represent partial divestments by A-share listed companies experiencing financial pressure. Ascendent was interested in the dairy industry, so the research team started scouring the books of companies that might have non-core assets to unload. The eventual seller was a listed department store.
Asked to identify a limitation to the merchant-banking model, most industry participants cite bandwidth. "You can't send in a vice president to cultivate that strategy - it needs to be a senior guy building the relationship so it can then become the kind of deal you want it to be," says Atlantic Pacific's Ng. "Do you have the resources to be so entrenched so early on and how many deals can you do at that level?"
Ascendent has been in expansion mode and now has 18 people in Hong Kong and Shanghai, including six managing directors and seven professionals on the research and portfolio management team. Nevertheless, there is a general acceptance that relationship-building is a labor-intensive process and the success rate can be low, which means portfolios are likely to be concentrated.
"There has to be a trade-off," says Zhong Lun's Zhao. "They aren't doing a lot of deals; rather, each one is done carefully. It is not the kind of private equity where you do quite a number of deals and wait to see if a few turn out well. More effort is required, but if you do it right the returns should be good."
Issues of size
For this reason, LPs were concerned that strong investor demand would result in Fund II becoming too large to sustain the strategy. They were encouraged that Ascendent stuck to the original hard cap. Labor intensity is also offered as an explanation for why other China middle market GPs are not yet being forged in Ascendent's image. Execution relies not just on relationships, but on time and resources.
It is therefore unclear where the strategy sits in the broader context of China private equity: the first in a new breed of GPs emerging as financial professionals move through the ranks; a niche approach that is too high maintenance to go mainstream; or a tweak to an existing model.
For one LP, Ascendent was the right strategy at the right time in a middle market he feels is underserved by quality managers. GPs are being pulled to either end of the scale - established players have increased fund sizes and soaring valuations in the tech space have prompted an explosion in early-stage activity - which allows for innovation in the traditional center.
This LP declined to back Fund I due to a general discomfort with first-time funds, but opted to invest in Fund II. He notes the strategy is not fully proven but it is important to get behind potential outperformers.
"If Fund I turns out to be a 3x and Fund II tracks well early on, then you aren't going to get into Fund III," the LP says. "It was a bit about wanting to start a relationship with these guys - they are young enough and hungry enough that this is the sort of franchise that could run to five funds."