Abstract: On January 14, 2017, taking the news conference on the new book Private Equity LP, the 1st Seminar of Green Legal Global Alliance came to a successful end in Beijing DOCVIT Law Firm and established the first batch of research topics and set up the project closely related to the development of the private equity market. Afterwards, Green Legal Global Alliance has continued to undertake the research work of follow-up legal issues and published supporting books interpreting private equity LP from the perspective of the law field in 2017, making constant contributions to the industrial development.

On the afternoon of January 14, 2017, News Conference of Private Equity LP (a book redefining LP) & "Capital Allocation Strategy, Investment Practice and Operation" Charrette sponsored by CITIC Press Group China Road Research and Publication Center and Green Legal Global Alliance and co-organized by LP Think Tank came to a successful end in Beijing DOCVIT Law Firm, the 56th floor, Fortune Financial Center (FFC). The book Private Equity LP "redefines LP".

Liu Guangchao, secretary general of Green Legal Global Alliance and director of Beijing DOCVIT Law Firm presided over the meeting. Mr. Chen Chao, vice president of China Investment Research Institute, addressed a keynote speech.

Distinguished vice president Wang Zhongmin, Doctor Lu Yuebing, director Liu Guangchao and all guests:

I'm very pleasant and honored to take part in the news conference of Doctor Lu Yuebing's new book concerning private equity LP and discuss the topic of large institutional investors and private equity investment. The most important LP in the private equity investment market is large institutional investors, including such institutional investors as sovereign wealth funds and pension funds. Since the financial crisis in 2008, large institutional investors have been playing an increasingly more important role in the private equity investment field. Therefore, I would like to talk about three issues, i.e. transition of large institutional investors' asset allocation, new characteristics of private equity investment by large institutional investors and the market, institutions and strategies of leveraged buy-out-type private equity funds. In spite of the wide range of these three issues, it is not permissible to talk about all of them due to tight time. I would like to present certain of my views for your reference.

I. Four kinds of typical allocation modes of large institutional investors

The concept of asset allocation was raised in the 1930s. The Mean-Variance Model raised by H.M.Markowitz has been extensively employed by institutional investors for analysis. Under this analytical framework, the pension of Britain and America has seen the formation of the first generation of asset allocation mode, i.e. "60:40" asset allocation mode based on their own preference to risk earnings. That is, 60% assets are allocated to invest in stocks in open market and the remaining 40% in products with fixed earnings. Such an allocation mode seems to help investors gain stable and lower investment earnings but has rather high potential risks.  For example, in a period when the majority of the market suffers drastic fluctuation, such an allocation mode may lead to great downside risks. In particular, in the period of financial crisis, the market expects tremendous downside tail risks and various assets are positively correlated, leading to failure of the allocation mode and great losses of assets.

In the 1980s, the investment talent David F.Swensen joined in Yale University Endowment Fund. Swensen established the second generation asset allocation mode, i.e. alternative asset allocation of endowment funds. This mode is a precedent for alternative investment of institutional investor.

I believe there is asset function combinatorics behind the methodology of alternative allocation mode supporting endowment funds. Regardless of the seeming complexity of investable assets, all assets can be divided into three kinds from the perspective of asset functions: The first kind is the assets achieving value maintenance and increase of the portfolio. There is no doubt that only the equity investors can share the bonus of enterprise growth and also gain value maintenance and increase through capital gains and asset re-valuation. Both stocks in the open market and private equity investment fall into the category of such assets in essence. The second kind is assets hedging macro risks. The macro economy is prone to two kinds of major risks, including inflation risk and deflation risk. In an era when the inflation is severe, most assets overcoming rising prices are physical assets, including real estate, infrastructure, staple commodity, inflation-linked bonds in the open market and real estate investment trust (REITS). Deflation is generally accompanied with economic downturn and sustained falling price and both stocks and real estate are depressed. Under such a situation, only products with fixed earnings can sustain after deflation. Therefore, many institutional investors hold certain products with fixed earnings for a long term. The third kind is decentralized assets. In spite of the stronger stock-leaning feature of some categories of hedge funds, as a kind of assets, it is evident that hedge fund is to hedge the beta risks on the market and strive to gain neutral alpha earnings on the market. Therefore, as a unique kind of asset, hedge fund usually expects stable earnings in periods when the market has greater uncertainty.

Under the framework of this methodology, main features of the alternative allocation mode of endowment funds are as follows. First, a considerable part of assets are allocated as those with lower liquidity, including such long-term assets as private equity investment fund, real estate and infrastructure. Second, hedge funds with lower correlation with allocation and traditional stocks and bonds are added to facilitate the realization of decentralized function. In the investment field of hedge fund, Harvard University Endowment Fund adopts a more radical way. Third, domestic allocation is gradually transforming to global asset allocation to further realize decentralized investment. It has become a common practice of institutional investors under the context of globalization at present. Fourth, outsourcing investment is given the priority to realize allocation through external managers, which is also a practical option given the small scale and less personnel of endowment funds.

Ray Dalio from Bridgewater Associates became the biggest winner in the hedge fund industry in the international financial crisis in 2008. The "all-weather fund" in the mode of Risk Parity employed by Bridgewater Associates rendered excellent performance. However, the higher leverage, complicated application of derivatives and dynamic rebalancing have constrained the application of such a mode by institutional investors. On such a basis, Cambridge Associates has developed the third generation of asset allocation mode applicable for institutional investors, i.e. risk allocation mode.

The methodology of risk allocation mode has completely subverted the traditional Mean-Variance Model and aims to assess risk/earnings balancing based on the historical conditions and predictions of the capital market and given resources and risk-bearing capacity resources of individual investors and construct an asset portfolio with the optimal rewards under certain risks based on the level of risks contained in various assets. The target of this mode is to increase the rewards of the portfolio, decrease the fluctuation of the portfolio, hedge macro risks, reduce fluctuation of foreign currencies and increase positive returns. In combination with the risk allocation in a risk-sensitive environment and constraints of long-term asset allocation portfolio, the framework of risk allocation is to make dynamic monitoring over risk allocation and the performance attributions. Such a concept has gradually developed to be a consensus of many institutional investors. In addition, the risk allocation mode has also been applied in pensions.

However, for large institutional investors, especially for sovereign wealth fund and large pension fund, simply imitating the practice of endowment fund and hedge fund is only an expedient in the early stage. After years of exploration, some large institutional investors have developed the direct investment mode focusing on long-term investment and direct investment with continuous efforts. I would like to call such a mode as the fourth generation of allocation mode of direct investment.

Typical institutions applying the fourth generation of direct investment mode include Temasek in Singapore and Canada Pension Plan Investment Board (CPPIB).

First, let's have a look at the investment performance of Temasek. Since its founding in 1974, it has achieved 15% of annual return on investment and such a proportion ranks at the top in the same industry.  Almost all investment of Temasek is made by the direct investment mode. Specifically, it has followed the asset allocation strategy of expanding to Asia and the world while setting its foot in Singapore. In terms of regional allocation, Temasek has allocated 1/3 assets in Singapore, 1/3 in Asia and 1/3 in other regions around the world based on its own advantages and the trend of global economic development. As a result, it has gained a certain share in the emerging Asian market and especially seized the investment opportunities in China. In addition, since the financial crisis in 2008, it has gradually cut its allocation in emerging markets but increased investment in the US. Second, theme strategy has been applied to pursue portfolio. In recent years, Temasek has given its investment focus on economic entities in transition to grasp the development potential of them, such as China, India, Southeast Asia and Latin America through making investment in the fields of financial services, infrastructure and logistics; the growing middle class to make investment by focusing on the ever-increasing consumption demands of the middle class and make plans for the fields of telecommunications, media, science, consumption and real estate; regions and enterprises with special intellectual property, technology, brand and other competitive edges by intensifying comparative competitive edges; emerging leading enterprises to make investment in companies gaining a leading position in domestic market and enterprises with the potential to be the regional and even global best ones. Third, individual items are assessed by the economic value added and minimum capital returns. Each project of Temasek is designed with the minimum capital return and assessed by its economic value added. Temasek's investment criteria have become a benchmark gradually for large institutional investors to make direct investment.

CPPIB is a rising star from institutional investors in the recent 10 years. Regardless of its annual returns being 7.1% in the recent 10 years, it has made vigorous efforts in such alternative investment as PE and real estate since 2006. In particular, in the field of direct investment, it has changed its mode of following external managers to such more proactive modes as Co-underwriting and Co-Lead. As a result, it has become a benchmark for large institutional investors around the world.

II. New characteristics of large institutional investors in the private equity investment field

Among institutional investors, large institutional investors represented by pension fund and sovereign wealth fund show the distinctive characteristics of low demands for liquidity and long investment term. Therefore, large investors' investment in the private equity investment field featuring low liquidity and long payback period has become an important development trend of the industry. By bearing liquidity risks, large institutional investors gain greatly higher investment earnings than in the open market.

In addition to potential high earnings, in the past 5, 10 and 20 years, the earnings of private equity fund are far higher than S&P 500 Index. Regardless of risk dispersing by diversified investment, private fund investment has poor capital liquidity, long payback period and higher management fees. In addition, the selection of private fund is rather important. For instance, from 2000 to 2010, the difference between the 25%PE annual return rate before the period and 25%PE annual return rate after the period is as high as 15%. Thus, stringent requirements are imposed for the capacity of institutional investors in selecting private fund. Moreover, despite of downturn economy, some private funds are also well protected against downside risks. For example, private fund made by the dilemma investment strategy and secondary market investment with shares of LP are properly protected in the downturn period of the market.

In the past five years, large institutional investors have seen some new changes in the private equity investment field.

First, private equity assets are increased to respond to the impact of low interest on returns. Under a context with low interest, earnings in the open market significantly decrease and many large institutional investors turn to the private market for higher returns and greatly increase their allocation to private equity. For example, in 2015, about 2/3 large sovereign wealth funds with top rankings in scale raised the proportion of their alternative asset allocation to 15% and above, in which private equity assets were given the priority in allocation. The reason why private equity assets are greatly favored lies in that it can provide returns and have different risk features from assets in the traditional open market. Therefore, increased private equity investment can improve the overall earnings of portfolio and intensify the stability of earnings. However, it is a disadvantage for LP making investment in private equity.  Some private funds with stable and excellent investment performances have a rather strong bargaining position and thus more particular in selection of LP. Moreover, the law also gives much more preference to GP.

Second, much more attention is paid to long-term investment to tap differentiated investment opportunities. Given the low demand for liquidity of large institutional investors and long investment term, extending the investment term and tapping the opportunities of differentiated investment have gradually become the priority of large institutional investors. On the one hand, large institutional investors choose to allocate more capital to assets with longer investment term. On the other hand, large institutional investors take the initiative to choose investment assets with a longer term that can bring in higher earnings. For instance, the investment term of CPPIB in the infrastructure field lasts for 25 years, holding term of core real estates for about 15 years and investment term of private fund for about 10 years.

Third, much more importance is attached to post-investment management and value creation. Some large institutional investors, such as CPPIB, GIC and Temasek, have been attaching greater importance to the post-investment and value creation competence of the invested companies and also taking the initiative in value management in their investment in both stocks in the open market and private equity. We can draw on from all the above experience. China's sovereign investment institutions are backed up by China, the world's second largest economy and a tremendous market with 1.3 billion consumers. If we effectively integrate overseas investment with the Chinese market, proactively help the invested companies to settle in China and take the demands of 1.3 billion consumers in China into account, we cannot only propel the transformation and upgrading of China's economy but also gain higher earnings from investment.

In the private equity investment industry, enterprises mainly create value by increased profits from improved operation level of the enterprise, expanded transaction times and interest arbitrage and increased equity earnings by gradually decreased cash flow of the enterprise by making use of financial leverage. According to analysis of Boston Consulting Group, in the 1980s, the high return from private equity transactions was mainly owing to high leverage and multiple arbitrage and the value-added management contributed to only less than 1/5 of returns. This also explains why private fund transactions were criticized as the "game of financial engineering" and private fund as "Barbarians at the Gate". However, from the perspective of present, more and more investment earnings of private fund are from operation improvement rather than the expansion of transaction multiples. In particular, since the financial crisis in 2008, improved operation performance of private fund accounts for more than 50％ of the overall return contributions and as a result value-added management has become the most critical factor for successful private equity investment.

I think the criteria to choose funds can be summarized as "5P", including People, Philosophy, Performance, Process and Provision. First, we attach the greatest importance to People. The stability of People, especially of the core management, is of critical importance. Whether the strength and resources of the investment platform are sufficient, whether the investment experience of team members is abundant and meets the market demands, the investment ratio of profits allocated to the team, incentive mechanism and the investment team in the fund as well as the interest consistency of GP and LP are all given top priority in consideration. Second, we focus on Philosophy. We attach importance to the stability and sustainability of Philosophy, including competitive edges possessed in the industry or field specialized in, whether the Philosophy is attractive, adaptability to the market conditions and new investment opportunities, situations of the targeted investment market, the attractiveness of the market itself and risk yield characteristics and whether the investment project sources are sufficient. Third, we attach importance to Process. Important investigation factors include whether the Process can help effectively screen projects, whether the investment decision and execution process is rigorous and consistent and whether the post-investment management ability of the project is excellent, etc. Fourth, we focus on Performance. We pay attention to long-term historical returns of funds and performance of exiting projects, whether satisfactory earnings were created for investors in a sustainable manner in the past, performance of non-exiting projects, whether the fund has the ability to grasp the market dynamics and respond to the business cycle, risk management capability, especially whether there is enough control over risks in case of overheating market and whether the ability of value creation has sustainability. Fifth, we focus on Provision. We will compare whether the Provision meets common practices of the industry and we will take all the following into account before making any judgment, including whether the fund is willing to provide corresponding preferential provisions, share much more information concerning the market, transaction and fund management,  whether the fund is willing to provide more opportunities to follow for investors and whether the fund is willing to establish a long-term cooperation relationship with investors.  

Leveraged buyout fund, venture capital fund and growth fund have significant differences in investment strategies. Typical features of the investment criteria of leveraged buyout fund are to invest in leading companies with continuous competitive edges in the industry and invest in defensive market and business mode.   What is defensive? In spite of economic situations, in particular in case of downturn economy, such a business mode can provide satisfactory protection. What kinds of companies have such features? Leading companies with competitive edges in the industry, or companies without strong periodic characteristics of the industry or companies with certain protection and strong pricing power all have such features. The third typical feature is to invest in companies with growth potential and that the capacity of the market where the companies conduct business or the companies' market shares are expected to increase with follow-up merger and acquisition change and expected operation improvement. The fourth is reasonable price. Most private funds prefer the attractive price after risk adjustment of high-quality companies to the lower price of poor-quality companies. The fifth is an excellent management team with sound incentives. The sixth is controlling interest and the dominant right of company governance. A majority of private funds expect to gain the controlling interest and absolute control in the Board of Directors. The last is the diversified withdrawal channel of the invested companies, especially available feasible withdrawal channel in the period of economic downturn.

The core of earnings from leveraged buyout fund lies in value creation. In recent years, many leveraged buyout funds have been intensifying post-investment management and attaching great importance to value creation. Many funds have established special post-investment management team and developed systematic methods to help invested companies to improve value. For example, various systematic methods have been employed to help invested companies to improve value from such aspects as company governance, IT architecture, cost control, pricing strategy, product development, market expansion, optimization of capital structure and business mode reform.  

In the end, I would like to say that China's enterprises have ushered in the best time of going out and making cross-border merger and acquisition, especially making investment in the European market. First, the continuously sluggish economy in Europe and greatly decreased demand has forced many small- and medium-sized enterprise in Europe to sell their equity to China's enterprises for market shares so as to gain the opportunities to enter into the Chinese market with medium- and high-speed growth. Second, after the European debt crisis, the tightening monetary policy in the banking system makes it tough for small- and medium-sized enterprises in financing and forced to sell equity for financing. In addition, some family-run enterprises are also confronted with no heirs in their fourth and fifth generations. Third, the economic stagnation caused by the crisis has made some large enterprises trapped in financial difficulties or the dilemma of business development. As a consequence, such companies need to re-organize their service line and sell non-core assets to reduce their liabilities or achieve core businesses. For example, Philips has spun off LED lighting, automotive lighting and general lighting in recent years to be specialized in the life and health industry. Siemens has made continuous efforts to sell its non-core assets, such as Siemens hearing aid. Fourth, the declining open market has caused that many quality listed companies undervalued, proving opportunities for private equity funds to privatize such companies. Fifth, in addition to normal withdrawal projects of private equity fund, in the face of financing pressure and performance pressure, some private equity funds are forced to sell immature quality assets, thus bringing good opportunities of acquisition on the secondary market for private equity funds with the strength.

Cross-border mergers and acquisitions are of great potential. China's large institutional investors have unparalleled advantages in the fields of private equity investment and cross-border merger and acquisition. We should give full play to the advantages in the Chinese market, join hands with excellent PE, investment banks and industry investors home and abroad to explore cross-border merger and acquisition, integrate global resources and achieve win-win outcomes.

My speech comes to the end here. Thank you!