Interviewers Opening Remarks

Ongoing turmoil in global financial markets is driving significant change across the industry. In particular, the alternative investment sector — including private equity, real estate and hedge funds—is undergoing fundamental structural change.

Joining me today to explore how these changes are transforming the alternative investment sector are Tax partners Chuck Walker and Greg Williams, with KPMG in the United States, Chris Abiss with KPMG in Hong Kong, and Peter Beckett, with KPMG in the United Kingdom.

Interviewer

I understand that KPMG members firms are seeing a trend that involves large fund organizations expanding their investment offerings. How is this trend playing out?

Chuck

Large fund organizations have historically offered one alternative investment sector, let's say private equity, or expanded their offerings into other investment segments like hedge and real estate. All the major fund platforms are looking at this; KKR, Apollo, TPG and Carlyle. While large global financial services companies have been diversifying from many years, the large fund platforms are rapidly catching up. Today's investment market is much more competitive and challenging and the search for the returns in the market is really driving institutional investors towards this alternative investment market.

Chris

I think that one of the other points that comes out of that is not only the type of investment they’re diversifying in but it’s obviously the geographies into which they’re investing as well. And certainly out here in Asia, I echo exactly what you're saying but we’re seeing people move towards markets which are less traditional markets. China and India, most are aware or of. But Indonesia and Vietnam, for instance, are becoming of interest to some of the private equity firms.

Chris

And the pressure to move to alternatives is going to continue as the pension companies that historically have relied on fixed income returns but those returns are not going to be significant enough to meet the growing liabilities that they need to have for their pensioners. They going to have to look for other alternatives to get higher yields to meet those liabilities.

Interviewer

So this means more capital is flowing into the alternative market. What are investors in the market looking for? Is it fair to say they’re more demanding than they were before the financial crisis?

Greg

Yes, I think today's investors are definitely more demanding and you can see that in the due diligence process that the LPs are performing on the fund sponsors as compared prior to the crisis. The due diligence process is much more robust and much more intense. They’re focused on the brand-named firms; what is their track record, do they have a proven track record that is transparent that they can see and do they have strong visibility across product types, across geographies? Do they have a global presence? Those questions are being asked in a much more focused manner than before the downturn and the results that they're demanding from a performance perspective: the yields that they're requiring are going up, the fee pressures on the fund sponsors are coming down, having to spend more time justifying ‘why do you need that level of management fee? Let's take that management fee down and then let's trade that for a performance fee. If you perform, we will reward you with a more hefty management fee.’ And they're asking them to focus on multiple investment options and prove that they have the skill sets and the people to do that. And that becomes a challenge for some of the funds and that's why you're seeing some of the Limited Partners look at managed accounts or co-investment models. And that way they can access multiple investment options without co-mingling into a fund that they're not sure has the skill sets to deliver across all those product types. That being said, there are others out there that want that one-stop shop. They want to work with a fund sponsor that has the skill set to invest across all segments and high-quality opportunities with the right expertise and the right global coverage to meet their investment options.

Interviewer

Sovereign wealth funds are traditionally a rich source of capital for this market. How are they reacting to the current investment climate?

Chris

We're seeing a lot of activity from the sovereign wealth funds, particularly here in the Asian market. We've seen a number of the bigger funds, not including sovereign wealth, the bigger pension funds which are state-owned setting up operations here in Asia with a view to changing their investment model, moving away from the co-mingled model that Greg just mentioned to want to get into situations where they can co-invest with, perhaps, their previous co-mingled fund managers and also looking at managed account types arrangements allowing them to be much more cautious about where they put their capital rather than co-mingling that with a number of other capital sources in a fund. We're also seeing the emergence of the Asian sovereign wealth funds. China with CIC, the Koreans are quite active, the Australians have been active for some time. These funds have large amounts of capital and, again, we're really seeing them being quite cautious investors coming in and preferring to co-invest and to go in to managed accounts scenarios over and above direct fund activity although they will, with the right manager, still make those co-mingled investments.

Greg

As the sovereign wealth look to come into the US, we've seen some of them try to come in and do direct investing and try to, as Chris mentioned, do more joint ventures. The challenge is going to be; are they going to have the internal resources to make those decisions or are they going to be able to access the joint-venture market without trying to team up with an experienced fund sponsor. So, I think that is going to continue to play out but I think you're going to see more of them try to do direct investment but they're still going to be looking to some of the brand-names to help them lead their investment platform in the US.

Interviewer

How are the larger fund platforms responding to the trend toward alternative investments?

Chuck

That's a good question. It really is a dichotomy. We're seeing both the diversification as well as consolidation so the large funds with greater brand-name recognition, better track records, economies of scale, more efficient infrastructure are getting stronger and this is happening geometrically. They're bringing new offerings, driving their clients to expand in other alternative asset classes outside their traditional expertise. At the same time we're seeing a consolidation with smaller funds not being able to make it, not having that infrastructure or proven track record and we see funds looking to acquire other fund platforms. So, we really see the larger getting larger and some of the more niche players, if they can't carve out a specialized area, are going to fail.

Interviewer

Historically, expansion beyond a firm’s core business into different geographies or asset classes can bring rewards. But it can also hurt investment results unless it’s done with care. Let’s look at these implications in turn, starting talent and expertise.

Greg

Yes, that's true. When funds expand their platforms into new asset classes they may not have the talent on their staff and so they may have to acquire the talent or specifically may not have it in a geography that they're looking to invest so it's going to require them to move talent and then to assimilate those teams and try to maintain that culture that’s made them successful in the past. And that’s very challenging to do that as you move to different countries, different cultures, because in a lot of these investment opportunities take, for example, real estate, it’s a local business. And to move people from one jurisdiction to another and for them to be successful can be a challenge. And then trying to hire people in the local markets and finding that talent that fits well with your culture; only the best in class can make that jump successfully. And then when you look about expanding across asset classes from a due diligence perspective much, much different skill sets and talent needed to, for example, understand the risk involved in investing in a hedge product versus investing in a building in Hong Kong. So, the diversification brings a host of risk with it and I think that the winners are going to be those that are able to effectively assimilate that talent into their culture and maintain a risk platform that has helped them be successful in the past and the bigger funds seem to be more active and have the resources to make those investment dollars to make that a success.

Chuck

Greg, I couldn't agree more. When you're moving into different asset classes, if your historical business has been private equity, certainly the large firms understand that and are very successful in that area. And you pointed out in real estate a completely different skill set and local knowledge is key. The same, really, is true when you get into global trading in the hedge space. You need to really understand the taxation of those financial instruments traded on multiple exchanges, multiple countries and those have a lot to do with the sophistication of the individual countries that you're trying to take advantage of; the macro economic trends.

Chris

That's right Chuck. It's what I witnessed out here in Asia. As funds go into new asset classes or into new geographies and often a combination of the two, the scramble for talent, of course, is paramount as Greg mentioned and you end up with relatively small numbers of people usually in the front office and the deal team with lesser numbers of closing individuals in those deal teams. And when it comes to tax, of course, your tax resource is very, very limited so there is a real risk stage as you move into new asset classes or into new geographies when you haven't got that tax resource available in the organization so you're reliant on outside advisers, you're reliant on the deal teams going to the right outside advisers who are giving that right advice. So, there is a lot of risk that’s generated from this type of expansion both across asset class and geography.

Peter

Yes, I think historically real estate businesses have been very domestically focused. For example, in the UK, a lot of the UK listed property groups, for example, tend to invest solely in the UK market; their expertise is very much limited to that market, that's the market they are familiar with and I think a lot of them have identified significant risks, to be honest, in entering into new markets where they don't have the local knowledge and they don't have local expertise. So what you’ve tended to see is a lot of UK focused businesses really focusing only on the UK and not willing to go outside of the UK because of the risks involved with that. Often what you do find is where you've got businesses going outside the UK, for example, UK-based fund managers, often opportunistic funds looking for better results; what you'll often find is that they will tend to work with a local joint-venture partner. So they're not prepared to go it alone, they want to work with a local partner who understands the local market in which they’re operating, not just from a property perspective but also understanding tax, legal, regulatory issues in the local market. And I think there is an issue, then, for finding the right local joint-venture partner who's got the right level of expertise and the right sort of talent to be able to provide what you need. I think, it's also true to say that where you've had some people look at trying to go it alone, there's a very big cost involved in doing that; you've got to set up your own back office, you've got to establish a local presence. That's not easy without having people in the know and I think where people have tried to do that, often, they’ve failed. I think the other thing that's worth saying is that a lot of people in recent years have been looking at emerging markets, particularly China and India and there was a big push, for example, outside of the UK a few years ago, a lot of funds were raised to invest in those countries and I think what people found was that, actually, it was much harder investing in those countries then you would imagine and part of that is the cultural change. I think that the investors used to operating in, say, Western European markets found it a very different scenario when they came to operate in India, for example. Hugely bureaucratic, it can take a long time to get transactions done, you're not talking just about planning but also talking about all sorts of levels of administration around carrying out transactions. So, what you found was a number of those funds that were raised to invest in those markets have been very slow to actually get deals done and to invest and they’ve struggled, really, to make investments largely because they've underestimated the, sort of, time and the process involved to get deals done.

I suppose one other thing I would just add is that there are other risks as well other than the talent and expertise. You've obviously got a lot of tax risk involved in other countries. Often tax systems are quite different processes and controls that will operate in those countries and that's completely different ball game for a lot people to understand. And one of the other things, I think, not forget is obviously currency risk, particularly pertinent at the moment with the Eurozone crisis. A lot of people who’ve invested in Southern Europe are looking carefully at those investments and they’re also thinking about what are the potential outcomes, if you like, from the Eurozone crisis. If some of these weaker countries were to exit the Euro or some other stronger countries were to exit the Euro there would have to be re-denominations of their contracts, there may well be change to their functional currency, increased default risk; all of those things are different scenarios that they need to plan for and they need to have some strategy in place for dealing with that and I think that’s another added risk that, you know, a lot of people don't always take on board when they start going into new markets which have got new currencies involved.

Interviewer

How will expansion and diversification affect existing systems and processes?

Greg

As you expand in different geographies and in different asset types it's going to require different types of systems, different types of analytical tools, different types of financial controls, risk controls and when you think about real estate and hedge and private equity, they all have their unique set of analytics and support functions that are needed even from a reporting perspective; how they report the results out of their investors. If you're just a real estate fund trying to invest into hedge and private equity, your back-office systems to support the reports that need to go to your Limited Partners on a quarterly basis, the management reports probably not going to be able to do that without some significant changes. And so I think there's going to be significant amount spent in the IT area to upgrade the systems to meet the demands of the Limited Partners. Because if we go back to the previous point, not only are the Limited Partners more demanding in their returns and in the performance but the transparency and the amount of information that they're requiring from the fund sponsors has grown exponentially and I think that's only going to continue. As they come out of this last cycle where a lot of them are feeling that they got burned and they were surprised by it, they’re going to want more immediate, transparent information on how is my investment doing? What do we think the future looks like as it relates to me? So I think for a typical fund sponsor, this is not an area that they spend a lot of time focusing on. They're focusing on where the investment opportunities are, how can I generate the highest yields and the back-office and IT support has kind of taken a backseat to that other area and I think it’s going to be more of a focus as we move forward.

Interviewer

We’re also seeing the emergence of cross-over products, like distressed assets funds. No doubt these products involve even more tax complexity.

Greg

You just read the headlines and there's a plethora of distressed debt out there in the investment opportunities in the US alone. If you look at the commercial real estate mortgages that are coming due over the next three or four years it’s $3.4 trillion with 700 billion coming due in 2012. And so there's going to be a lot of opportunities for these funds to recapitalize, investments to provide debt financing and also to purchase this distressed debt and from a tax perspective purchasing a debt instrument is much, much different than, for instance, if you use commercial real estate for purchasing a building. There's issues around, there may be income recognition or dry income or phantom income that you never anticipated if you're not on top of those rules because you're not buying a piece of real estate even though the fund sponsors may be using that as a way to get to the ultimate real estate.

Chris

That's right Greg and I think also when you look at the investment destinations on which a lot of this distressed debt is there are some very complicated rules, there's a lot of withholding taxes one needs to deal with, the gain on the distressed assets may be taxed quite a different way to the underlying gain on a real estate asset, for instance. So, there is a lot of work that needs to be done to ensure that the tax impact is what tax impact and the underwriting mandate is actually putting forward.

Interviewer

Thanks to each of you for sharing your views on this complex topic. Before we sign off, can you offer some insights on how the market will look, say, five years out? Who will be the winners and losers?

Chuck

I think it's fair to say that private capital and alternative investments are here to stay. And with the interest rate environment projected out to continue this trend to increase yield and meet the liabilities of the big institutional investors we are going to see more and more folks going to the large multi-segment fund platforms. So, I think it's fair to say that five years out things could look very different with large funds getting larger and some of the niche players disappearing.

Greg

Yes, I would agree with that Chuck, I think we may have a dichotomy. I think the large funds that can expand their global reach and have a multi-platform offering are going to be the winners. And then there is going to be this segment of niche players that have a specific skill set and a specific geography. I think they're still going to be those that are around but they're going to be fewer than there are today. And I think you’ve already seen a lot of the fund sponsors start to consolidate some of the smaller fund sponsors not able to raise their next fund that are merging with some of the larger fund platforms. And I think the challenge is going to be who can make that transition because it is a difficult transition to move from one specific asset platform to another. And it's a very, very difficult transition to move from one geography to another. So who are those who can execute on that transition, that can accumulate the right people in those locations. When we look five years from now, there's going to be more money going into alternatives, like you said Chuck, but I think that the players in the industry, I think, they're going to be much, much different

Chris

I think that it's a similar trend out here in Asia, Greg and Chuck. In reality we’re starting in a lot of the countries from many, many years behind. The LPs, in some cases, are smaller although there are exceptions that are very large. And there are a larger numbers of smaller players at the moment and a larger number, of course, of big players from the Northern Hemisphere looking to play in this market. But I think ultimately the trend will be the same; that the LPs as they get larger, the sovereign funds will become more dominant and they're only going to want to play with big players with track records who can handle large amounts of capital. So, I think, ultimately, were a bit behind in Asia and a number of countries from where you are but ultimately the trend will be the same.

Interviewer

Thank you Chuck Walker, Greg Williams, Chris Abiss and Peter Beckett.

Listeners can find more details on this topic in the February 2012 edition of KPMG’s frontiers in tax publication.

Our next podcast will focus on the US Foreign Account Tax Compliance Act, or FATCA, with special focus on its specific implications for private equity and real estate funds.

Thank-you and we look forward to you joining us next time.