[ASK 2019 SUMMIT Panel Talks] Korean LPs uneasy at leverage of PE secondaries

The Government Employees Pension Service (GEPS) and two leading South Korean insurance firms have expressed unease about the excessive use of leverage by private equity secondary funds which they blamed for a capital call delay and cash yield decline.

They also showed concerns about bigger investment funds, questioning whether they can maintain their performance and stick to the original investment strategy, with KB Insurance Co. Ltd. leaning towards smaller-sized vehicles.

In evaluating PE secondary funds, GEPS will look at the leverage factor, and Hyundai Marine & Fire Insurance Co. Ltd. will compare not only their target IRR but also target multiples to steer clear of fund houses heavily reliant on leverage, their senior investment officials said on May 15.

For private debts, GEPS and other major institutional investors in South Korea are seeking to boost investment and diversify further by region and investment type. But they warned against a possible fall in recovery rates.

The following are remarks by senior officials of two pension funds and two non-life insurers in South Korea during a penal discussion of the ASK 2019 Private Debt & Private Equity Summit in Seoul on May 15.

ON PRIVATE EQUITY SECONDARIES

▶Government Employees Pension Service with $8.7 billion AUM (Woncheol Seo, head of private market investment division):

“An excessive delay in capital calls because of the leverage use distorts the IRR and may cause inconvenience to investors, although they may have enough reasons to do so. We will consider the factor in the evaluation of managers.”

“Differentiation is occurring in the secondary market, widening the scope of selection from the early stage to the tail end. We need to select managers with a good handling of various strategies. With the fund size growing sharply, we need to monitor if they can maintain their performance over time.”

▶Hyundai Marine & Fire Insurance with $30 billion AUM (Kyung Cheol Jeon, general manager):

“We have concentrated on secondary investment because it mitigated the J-curve effect and helped to make quick investment. LPs worry about the excessive use of leverage.”

“An excessive use of leverage results in a capital call delay and the cash yield decline, even though the IRR jumps to high levels. We need to look at both IRR and multiple. The higher the IRR, the longer period it takes to conduct due diligence and negotiations.”

“We used to look at GP-led secondary deals as a distress signal, but now we think it is an efficient tool for an GP with capabilities. We need to take interest in GP-led deals.”

▶KB Insurance with $24 billion AUM (Jae Hoon Jung, team head):

“We usually select general managers with good knowledge about the local market. But now that regulations continue to change on the insurance industry which incurs capital costs, I want them to make quick capital calls, instead of just offering a target return of say 8%.”

“We should find a way to share our needs even by mixing two strategies and lowering the target return. It would not be good for both of us to use subscription or bridge loans much.”

ON PRIVATE DEBT

▶Government Employees Pension Service (Seo, private market investment head):

“Give our short-term cash flows, private debts are fit for our strategy. They are still attractive because of their decent risk-adjusted returns compared with public markets.”

“Private debt investment will be differentiated by region and strategy. We have used mezzanine and opportunistic strategies with focus on North America. In Europe, we have been increasing investment in first-lien direct lending since we began the investment last year. They made big contributions to our performance.”

“The advantages of private debt investment are that we can make quick investment because there exists the refinancing need of the existing portfolios and we can reduce risk by investing in the companies we already knew.”

“Many newcomers are entering the market and active M&As are taking place between them. There is a gap between the incumbents and newcomers. It is important to look for a new lending opportunity, but we need to check about their capabilities of debt recovery in a distressed situation.”

“We like those paying a frequent visit to us, giving information on many sectors and helping us study them.”

▶Korea Scientists & Engineers Mutual-aid Association with $2.3 billion AUM (Chi Yeon Hwang, General manager):

“Since we started debt fund investment in 2015, we have committed 600 billion won ($505 million) to them. We are in the portfolio-building stage."

"By region, Europe and North America make up half and half. In Europe, our portfolio is focused on the UK and France which have plenty of deal sourcing opportunities and political and economic stability. In North America, we split investment into senior and mezzanine tranches.”

“For regional diversification, we are studying the Asian market with high GDP growth rates. Because of the difference by country in bankruptcy laws and relevant regulations and currency risk, they are not easy to invest in. But we are looking for an opportunity among those with strong fundamentals.”

“Up to now our investment had been concentrated on GP-sponsored deals. Now that non-sponsored deals continue to be introduced, we may invest in them in consideration of their track records, deal sourcing capabilities and post-investment monitoring system and covenant types.”

▶KB Insurance (Jung, team head):

“PDFs are attractive because of low fees compared with PEFs, quick investment execution and steady flows of capital incomes. They also support defensive asset allocation strategy. As the funds have grown by twice to three times as much in size driven by strong performance in their early years, we are monitoring whether they stick to the investment strategies they had proposed.”

“As an insurance company, we require detailed information on individual assets and consider risk-based capital requirement. As part of a financial holding company, we used to feel comfortable about adding mezzanine and subordinated tranches to our portfolio."

"But now we are moving to a more conservative strategy, we are looking closely at the level of leverage and covenant types.”

“What is important is that with the growth in covenant-lite lending, target returns will decline.”

▶Hyundai Marine & Fire Insurance (Jeon, general manager):

“PDFs are fit for conservative insurance companies. We will continue to increase exposure to them. We have concentrated on sponsored-deals because they involve M&As and thus their information is open to the public and fully reviewed by accounting and law firms.”

“In comparison, non-sponsored deals, despite high yields, take time to conduct due diligence and negotiate over terms and conditions. The gap between managers is wide. Thus we feel more comfortable with sponsored-deals.”

ON CO-INVESTMENT & PRIVATE EQUITY

▶Korea Scientists & Engineers Mutual-aid Association (Hwang, general manager):

“We are looking for co-investment opportunities by committing to blind-pool co-investment and buyout funds abroad. Domestic GPs continue to create co-investment opportunities using their global networks and trying to launch funds.”

“It may be natural for us to take more interest in those who come and introduce products on a frequent basis. There must be a difference between those who visit us once or twice and those coming three to four times.”

▶KB Insurance (Jung, team head):

“We have a slightly larger exposure to PEFs compared with other insurance companies with a similar asset size. We are considering raising their proportion slightly.”

“But because of high capital costs for PEF investment and high valuations, we will focus our PE investment on individual funds investing in individual value-creating companies at lower prices than the entry-level price, rather than big funds chasing large-size deals and auctions.”

By Dong-hun Lee

leedh@hankyung.com