HONG KONG/SINGAPORE – When Arral & Partners raised the $170 million Arral Pacific Equity Trust II in 1990, expectations on the part of its managing directors and Western limited partners were understandably high. After all, Asia’s economies were growing rapidly, and the fund’s managers were a top-flight team.
Nearly a decade later, however, the vehicle has failed to impress investors with lofty returns, and the fund was handed over to a new division of Schroder Ventures in 1993 following the demise of Arral & Partners the year before.
A review of Arral’s collapse is noteworthy as private equity investors once again cautiously turn to Asia, a region where traditional business practices have made Western backers nervous.
Although those involved in the fund did not see warning signs at the time, Arral now serves as a lesson to limited partners considering new investments or to fund managers establishing new practices. By all accounts, Arral II was well placed to take advantage of Asia’s developing economies; it was headed by managing directors Louis Bowen and Anil Thadani, both of whom had excellent business credentials and had invested together for nine years – an eternity in the nascent Asian private equity area. But what investors did not foresee was a very public, yet somewhat mysterious, breakup of the firm that took place two years after Arral II was raised.
The reasons behind the duo’s fallout remain cloudy. Mr. Bowen referred to a “breach of trust” but declined to provide details, and Mr. Thadani claims no knowledge as to why he was forced out by the firm’s board of directors. Limited partners, including Jon Vanderploeg, Wisconsin State Investment Board’s private placements investment officer, and Kevin Delbridge, managing director of HarbourVest Partners, said the fund managers simply did not get along. William Wood Prince, chairman of the holding company F.H. Prince & Co., said the pair had strong differences of opinion about management practices and asset groups. Press accounts at the time – citing unnamed sources – also pointed to conflicts between Messrs. Bowen and Thadani over the selection and management of deals.
What is certain, however, is that both limited partners and Messrs. Bowen and Thadani learned valuable lessons from Arral II, including the importance of implementing key-man provisions and scrutinizing a firm’s management structure, as well as the dangers of devoting too much capital to one investment category.
When Arral & Partners split, Arral II investors were put in the awkward position of having to decide who would inherit the portfolio. The vehicle slid into suspended animation for more than a year, and it made no new investments while the advisory board decided how to proceed, said Rhoddy Swire, chairman of Pantheon Group and member of Arral II’s advisory board.
Ultimately, investors turned Arral II over to Schroder Capital Partners, run by Mr. Thadani, who along with many of Arral’s former vice presidents had established an Asian unit for Schroder. Arral II became Mr. Thadani’s first project at Schroder and was renamed Asia Pacific Trust.
For Schroder, Arral II was an entry point into the Asian market beyond Japan. And, despite his problems at Arral & Partners, Mr. Thadani offered Schroder his considerable private equity experience and many strong contacts in the Asian business world.
Although Arral II had garnered $170 million in commitments, it ended up as a $145 million fund: $120 million had been invested by Arral’s breakup, and investors allowed Mr. Thadani to use $25 million for follow-on investments. No new deals were permitted.
Heavily vested in the hotel industry, Asia Pacific Trust suffered badly when the Asian economies slowed and high-end tourism waned. The economic difficulties of the last two years also made exits difficult.
At present, the fund’s portfolio has only three remaining major holdings. When Mr. Thadani took over Arral II in 1993, the vehicle was $50 million to $60 million under water, but he told investors he would see it through to liquidation. He hopes to wring out “a marginal IRR.”
“It’s going to be a lousy fund any way you look at it,” he acknowledged.
Conflicts of Interest
Arral II reminded Mr. Delbridge that a region’s strong gross domestic product does not automatically grant success to any one private equity firm or to its porftolio companies.
Mr. Delbridge, who represented Hancock Venture Partners Inc. (now called HarbourVest Partners, L.L.C.) on Arral II’s advisory board, said Hancock insisted on a key-man provision that gave investors authority to decide who would oversee the fund if a manager left the firm. That was a key issue in the Arral II fund, and HarbourVest continues to pay close attention to key-man provisions when investing in other private equity partnerships.
Further, the HarbourVest managing director pointed to the conflicts of interest that could arise when a management company has an independent board of directors working parallel to a fund’s advisory board, which is composed of limited partners.
Arral & Partners’s board of directors, comprising Messrs. Bowen and Thadani’s business acquaintances, pressed Mr. Thadani to resign from the firm. Arral II’s advisory board was not part of that decision, although the fund was affected by the move.
Pantheon’s Mr. Swire offered advice to future advisory boards that may find themselves locked in the same predicament as Arral II’s: “For God’s sake, sit around a table, compromise, get 90% of the deals sorted, and don’t reach for the lawyers.” He also suggested that advisory board members keep information flowing to other investors to ensure that “everyone is singing from the same hymn sheet.”
Mr. Swire noted the importance he now places on the distribution of power among firm managers when making investments. In Arral’s case, neither Mr. Bowen nor Mr. Thadani owned more than half the firm, meaning a third party who had a minority stake could side with one of the two partners and have control of Arral.
Lessons in Diversifying
Oregon Public Employees’ Retirement Fund and the San Francisco City and County Employees’ Retirement System first ventured into Asian private equity with Arral II.
For Jay Fewel, a senior investment officer at the Oregon pension, Arral II’s fate demonstrated the value of diversifying a pension’s portfolio. Both Oregon and San Francisco now limit their initial involvement in new regions to funds-of-funds, said Mr. Fewel and San Francisco Analyst Brewster Wyckoff.
Mr. Prince was no newcomer to investing in Asia when his family holding company, F.H. Prince & Co., backed Arral II. The Prince group had been investing in Asian deals since 1985, even alongside Arral & Partners.
Arral II showed Mr. Prince the danger of concentrating too much money in a single industry because the fund had 30% to 40% of its money tied up in hotels, Mr. Thadani said.
Additionally, the fly-by-the-seat-of-your-pants investment style and minimal reporting to L.P.s that had been common among Asian investment professionals – and tolerated by their American and European backers – fell out of favor after the demise of Arral and other Asian firms, Mr. Prince noted. Indeed, several Asia Pacific Trust limited partners have praised the quality of feedback that Schroder now provides them.
Arral II’s problems did not leave Messrs. Bowen or Thadani without lessons of their own.
At his new firm, ACL Holdings, Mr. Bowen insists on a more formal decision-making process than Arral had employed. Mr. Bowen also steers clear of capital-intensive industries such as hotels.
ACL Holdings, with backing from F.H. Prince, among others, makes private equity investments in Asia in a wide variety of industries and also engages in corporate finance work. The Arral management company’s dealings are almost fully wrapped up, Mr. Bowen said.
At Schroder, Mr. Thadani makes sure he has more control than he did at Arral over his own management company and the positions he takes in portfolio companies. Asian private equity has become more disciplined over the years, including the use of deeper, more sophisticated due diligence, he said.
Mr. Thadani is looking forward to the final liquidation of Asia Pacific Trust, which will take place when the Asian economies improve enough to allow exits from the last portfolio companies. When Schroder took over the fund, Mr. Thadani agreed to accept whatever management fee the limited partners would offer. They reduced the fee to $350,000 from $1.6 million per year, forcing Mr. Thadani to take out loans to cover the practice’s overhead, he said.
Mr. Thadani subsisted on Asia Pacific Trust’s management fees until 1994, when he raised Asia Pacific Fund II under Schroder’s umbrella. The $225 million vehicle, which is about 85% invested, had its first close in 1994 and wrapped in 1995. As of last November, the fund had a gross IRR of 14%, Mr. Thadani said. Given the battering the Asian economies have taken, this is probably the best performing fund investing in the region, he said.
In February, Schroder Capital Partners began circulating an offering memorandum for a new private equity vehicle, Schroder Ventures Asia Pacific Fund, which will target $350 million to $400 million, Mr. Thadani said. He hopes for a first close in April.