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The Long-Term Growth Portfolio of the Exchange Fund
– Focusing on Future, Striving for Growth (2 of 2)


In an article earlier this week, I discussed the background to the establishment of the Long-Term Growth Portfolio (LTGP), the nature of its investments and its investment strategy.  In this article, I will briefly outline the investment process and how it operates, with particular focus on due diligence work.  I will also share some thoughts on the future direction of the Portfolio.

Bold Hypothesis and Careful Verification

In the midst of the turbulent alternative asset markets, not only is it necessary to proactively identify appropriate projects and make investment decisions in a prudent and decisive manner, we must also do our homework for the decision-making process and conduct adequate due diligence before that.  In addition to the pre-investment assessment, we place equal emphasis on ongoing, post-closing follow-up work.  In closely tracking the latest market conditions and project developments to ensure timely responses and decision-making, members of our investment team often work odd hours because of the time zone difference between the Asia-Pacific region and the countries where the key personnel of our General Partners are located.

Our business connections with many of the world’s leading investment managers enable us to conduct effective comparison in the due diligence process and to determine the credibility and feasibility of the investment projects concerned.  Indeed, for some projects, more than one investment manager may be involved.  Subject to applicable confidentiality agreements, we will do our best to learn more about the background of the projects through various channels, using a critical mind to review information obtained from different sources and looking at it from different perspectives, with a view to getting the real picture of the facts and identifying the most appropriate investment partners and investment approaches.

It is worth noting that in terms of the number of investment managers, more is not necessarily better.  Instead, we believe that forging a long-term, stable, constructive and strategic relationship with a relatively small group of outstanding General Partners is the right way to go.  This will help establish the requisite trust between both parties, and facilitate the mutual understanding of the mode of operation.  The reality is that with increased competition in the alternative asset markets, this mode of operation will allow the market to better understand our positioning and objectives for investments, which is conducive to the investment activities of the LTGP.

As mentioned previously, the LTGP invests in both the private equity and real estate markets which bring good synergy.  For example, through our understanding of the rental momentum in key property markets and the changes in business plans of some of the lessees, we are able to indirectly gain some insights into the development trends of certain industries.  In addition, by consolidating the market information we received through private equity investment (such as the latest developments in e-commerce and on-line trading), we are able to judge more effectively the growth potential of certain property investments such as logistics and warehousing properties.

The scope of due diligence work on our General Partners covers a wide range of topics, including the capability and stability of their investment teams.  The performance of some fund houses hinges very much on some individuals, so-called “legendary” or key men.  The associated risk is one of the foci in our due diligence work.  In one particular case, after we had completed our due diligence and internal approval processes for investment, the key person of the fund unfortunately passed away suddenly.  We informed our internal investment committee immediately and proposed to shelve the project to gain time to review whether the investment team has the ability to continue their investment operation.  The project was reactivated about a year later after we had confirmed that the investment activities of the team were not affected.

Due diligence work must be conducted in a pragmatic, cautious and critical manner, and we do not buy into abstract ideas.  In the due diligence process, we will take full account of the General Partners’ ability to adhere to their investment principles and implement their investment plans, as well as their experience in value creation and continuous follow-up of investment projects.  We will also thoroughly assess various aspects of each investment project, including financials, growth potential, exit mechanism and risk factors.  We have seen a number of cases where the investment concepts appeared quite attractive and the expected returns satisfactory.  But, after in-depth due diligence, we discovered that some of the risks or issues were difficult to mitigate or resolve.  As an example, some investment projects concerned the research and development of new drugs, which may bring attractive returns if the research and development work is successful.  However, if the drug fails to get necessary approvals from the relevant regulatory authorities, the investment will be rendered worthless.  In our case, the General Partner was not able to provide us with sufficient and objective expert opinions and information to project the success rate of the potential drug.  As the potential investment outcome is binary and beyond control, we decided to uphold our principle of prudent investment and passed on the project.  Regarding other investment projects, for instance high-end technology, our investment will depend on whether we can identify a reliable General Partner who will commit to the project on a long-term basis.

There are instances in the due diligence process where we encounter complicated technical issues.  For example, legal disputes over the “right of light” often arise in relation to real estate projects in London.  Simply put, this refers to the situation where a dispute, or even litigation, may occur if a property development project obstructs the natural light from reaching surrounding buildings.  In such cases, we will seek advice from our General Partner and local legal experts on what impact the “right of light” dispute will have on the valuation of the project concerned.  These experts will assess whether the seller has set aside reasonable compensation in the event of a dispute, and consider an array of factors in the context of the entire case before we arrive at an investment decision. 

We will also ensure that we have the requisite governance rights in investment projects, which are essential to our ongoing monitoring work.  If we are unable to secure these rights during the documentation negotiation stage, we would seriously consider abandoning the project.

In addition to pre-investment assessment, ongoing, post-investment follow-up work is equally important.  In line with common practices in private equity and real estate fund investments, we will have a commitment amount for each selected fund.  When an appropriate project is identified by the fund manager, capital will be drawn from the commitment amount for that project.  The HKMA’s Reserves Management Department will maintain close contact with the General Partners and closely monitor the pace and usage of the capital drawdowns.  It will also work closely with our internal legal counsels as well as the Risk and Compliance Department for post-deal monitoring work.  Regular reports will be made to the Exchange Fund Advisory Committee and its Investment Sub-Committee.

Investment Cycles

Similar to many other forms of investment, both private equity and real estate investments are subject to market cycles.  Thus, the timing of entry has a strong bearing on their performance.  The LTGP began at a time when assets were generally undervalued in the aftermath of the global financial crisis.  Driven by significant market recovery and a rebound in asset prices with the implementation of quantitative easing, the LTGP has thus far maintained a double-digit annualised internal rate of return since its inception.  If the LTGP had started when asset prices soared in the build-up of the asset bubble in 2006-2007, its performance would have unavoidably been hit in the short- to medium-term by the subsequent bursting of the bubble.

Against this backdrop, we believe that the right approach is to commit our capital at a steady and reasonable pace across different intervals to avoid excessive concentration in a particular market cycle and to diversify risks.  When looking for the right General Partners, an important factor to consider is whether they can achieve a relatively stable and good performance across different market cycles.  In addition, we have included certain assets with a relatively sustainable and stable cash flow in our Portfolio, which can help reduce the impact of market fluctuations on the performance of the whole Portfolio.

Looking Ahead

The LTGP has achieved satisfactory performance so far.  But considering its relatively short history of only some seven years and the extraordinary macro investment climate during the time, there is no room for complacency.

In fact, we are closely tracking some emerging trends in the market.  For example, excessive liquidity has generated keen interest in private equity and real estate investment, with fierce competition driving up the prices of those much sought-after projects and suppressing the expected returns.  Increasing uncertainties about the global economy and financial markets in recent months also meant that fund flows, exchange rates, interest rates and asset prices have become even more unpredictable.  Thus, following a period of high growth, it can be expected that the rate of return of the LTGP may return to more steady but sustainable levels in the future.

Nevertheless and as always, we will continue to explore new investment opportunities with great potential, especially markets and assets with less intense competition and more reasonable pricing.  In the face of a difficult investment environment in the future, we will make strategic planning, such as further diversifying our investments under the LTGP and conducting regular review of asset allocation, to minimise the impact of market fluctuations on asset valuation.  Our colleagues will continue to uphold a high level of professionalism and dedication in managing our reserves including the investments under the LTGP, with a view to capturing opportunities and tackling challenges in the future to strive for satisfactory long-term returns for the savings plan of the Hong Kong people.


Eddie Yue
Deputy Chief Executive
Hong Kong Monetary Authority

16 December 2015

Last revision date: 16 December 2015
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