BLUEPRINT: Into the unknown

It’s an odd thing when your employer unwittingly opens the door to a future away from the company, but that is precisely what happened to Richard Yue, the founder of Hong Kong-based private equity real estate firm Arch Capital Management. 

In 2005, while working for American International Group (AIG), Yue participated in a company-sponsored leadership workshop in nearby Macau that culminated in the option to jump from the top of the 1,100-foot Macau Tower, the second highest commercial ‘base-jump’ in the world. He was one of just a very few AIG staffers to go through with it.

“In front of you is cement and water. The guy there said jump when you are ready. He wasn’t going to push me. I had to make the decision,” the now 50-year-old Yue recollects. “My takeaway from the experience was the decision to take a step into the unknown is the hardest thing to do.” Indeed, it was a defining moment for Arch Capital.

Yue admits he tells the story of his base-jump to institutional investors, perhaps in an effort to entice them to take the plunge and back his firm. Nonetheless, some evidently have listened. Since its formation in 2006, Arch Capital has become a partner of choice for about 20 investors, including Dutch pension administrator PPGM, fund of funds manager Composition Capital and clients of consultant Cambridge Associates, which together have backed the firm to the tune of $717 million over two pan-Asia opportunity funds.

As Arch Capital passes the 70 percent invested mark for its second fund, Arch Capital-TRG Asian Partners, PERE caught up with Yue and Charles Cosgrove, chairman of the firm’s investment committee, at its stylish Hong Kong headquarters at Citibank Tower in Central. Open-collared, these two men have a relaxed and light-spirited demeanor, perhaps indicative of the regard Arch Capital carries in the industry right now.

Sitting on sofas in a private meeting room more reminiscent of a modern living room than the boardroom of a private equity real estate firm, Yue and Cosgrove regale PERE with details on Arch Capital’s genesis, its current situation and its future direction. It is clear from their accounts that, despite its few years, the firm already has navigated through a lot, from tumultuous capital and property market conditions brought about by the global financial crisis to a very material change in its ownership. 

“One word to describe our journey so far?” ponders Yue. “I’d say eventful.”

Hitting it off

While Yue’s leap of faith was an essential ingredient in Arch Capital’s genesis, at least as important was the ambition of Cosgrove’s original idea to build an Asian property fund business while at his former employer, Ayala Corporation. A Japanese residential fund by the Philippines-based conglomerate in partnership with London-based Grosvenor in the late 1990s led to other direct investments in Singapore, Hong Kong and Australia during the early noughties. However, the decision to expand from investing off the Ayala balance sheet to growing third-party funds happened during a company planning session in Thailand in 2005. 

Recalls Cosgrove: “We had deployed hundreds of millions of dollars and had been co-developers, so we had a track record and thought let’s build on that and raise third-party capital for a fund.” To that end, Cosgrove was handed a seed commitment of $50 million (later to become $75 million) and mandated to build a team and raise more capital. 

“I made the decision fairly early on that I wasn’t going to run the fund but would oversee it for Ayala,” Cosgrove says. “I met many people, but Richard and I hit it off.” 

That is hardly surprising given that Cosgrove shares Yue’s carpe diem approach to extreme sports. Indeed, an Ayala corporate retreat to Sydney in 2003 saw him volunteer to abseil in the nearby Blue Mountains.

Over a beer at Hong Kong’s famous Peninsula Hotel, the pair agreed to form Arch Capital. “I was at a big corporation,” Yue recalls. “Ayala was reputable out of the Philippines but, besides Charles’ investments, they had not placed much emphasis outside. I was faced with a decision of whether or not to build something from scratch.” One Macau Tower jump later, Yue was on board and building out a team made up predominantly of colleagues from his time at AIG’s real estate platform and, before then, Citibank.

“When you walked into this office in 2006, you could hear an echo,” Yue recollects. “I remember one friend coming in and asking, ‘Are you really going to become a $1 billion company?’ I said, ‘Yes, we are’.”

Tale of two funds

Arch Capital got off to a quick start. Seed investments by Ayala and bullish capital markets meant the firm would exceed its initial $200 million capital-raising target. Indeed, it closed its first fund, Arch Capital Asian Partners, on $330 million in equity in December 2007, less than one year before the collapse of Lehman Brothers. It was the collapse of Bear Stearns in March 2008, however, that had a more profound effect on the firm’s investment strategy. 

“How do you roll out capital in the teeth of an emerging systemic crisis?” Cosgrove asks rhetorically. The answer for Arch Capital was that it did not. “We were expecting something pretty bad to happen,” he adds. Despite questions from its LPs, the firm stayed on the market’s sidelines with just 25 percent of its capital deployed until 2009. 

In April 2009, as the Standard & Poor’s 500 index bottomed, Arch Capital made its first commitment to an investment in China, an apartment development in Foshan called Emerald Collection. “From that point, the money went out hard,” Cosgrove reveals.

Arch Capital’s restraint ultimately was appreciated by its partners, particularly those that sat on its advisory committee. William Shaw, formerly a principal at fund of funds manager Composition Capital, which invested in both of the firm’s funds, recalls: “They were very receptive to input and advice and, as a board member, I liked that about them. They wanted to learn and, at the same time, showed real prudence, particularly in China.”

One investment advisor who declined to be named says: “That they stopped investing was a positive. They clearly didn’t think the market was right, even if it dragged on their IRRs. They maintained their discipline and today are returning capital. We appreciate what they did.” Even more so, investors are likely to appreciate that Arch Capital’s maiden fund is on course to produce a return on capital north of 20 percent from investments made in China, India and Thailand.

The story of Arch Capital’s second fund, meanwhile, marks a stark contrast. A drought in conventional lines of credit for Chinese developers prompted the firm to deploy capital swiftly. By the time Arch Capital held its final closing for its second fund, more than half of the capital had been invested. At press time, more than 70 percent was invested. “They started to see much more interesting deal flow, and that gave us real impetus,” Shaw says.

Yue explains: “This time, we felt we could underwrite good, solid development companies in China and ride out what we consider to be a difficult period with them – as well as secure the kinds of terms we think are both attractive to us and acceptable for them. It is so important for our ability to operate with these partners in the future that we are seen as a partner that shares risk but is compensated appropriately under the conditions that are prevalent at the time.”

Partners first

Yue underlines the importance of not “taking the last dollar off the table” when dealing with operating partners with a view to repeat business, a lesson he says was not heeded by some of the largest private equity real estate platforms leading into the crisis. Cosgrove adds that Arch Capital has taken great pains to source its partners in China and elsewhere in Asia and, as with its LPs, wants to preserve those relationships. 

“We’re currently looking at a deal with the same company we did a deal with in 2009 for Fund I,” Cosgrove notes. “He came back, so the goodwill is there. Perhaps our capital was compensated more than he previously was willing to accept, but everyone is happy in the end.”

Cosgrove adds: “We’re not incredibly opportunistic in that sense. We don’t think our LPs ultimately will benefit if we drive bargains. Breeding resentment in partners can come back and bite you.”

Yue offers another example of working through difficulties with a partner. “In Thailand, we just did another deal with a company we’ve done four deals with before,” he says, pointing to a brochure of a 43-story apartment tower acquired by Fund I. “The idea for that started in 2005 and, since then, the country has been through a least one coup, two major political crises, scores of people killed on the streets of Bangkok and flooding in the southern part of the country. Yet, the tower still sold out and we got all our money back. That is true of all our Thailand investments.”

Arch Capital operates by the principal that great property plus average partner equals lousy deal. “Obviously, we won’t take a lousy asset, but we’ve had plenty of experience where a good partner made the difference between really good money and a minimal return,” Cosgrove says.

To ensure that a partner stays ‘great’, Arch Capital says it will go the extra mile. Cosgrove recounts one occasion when he flew last minute to have dinner with a chairman in Chongqing for just 45 minutes. “Why? We had three or four issues to resolve on a face-to-face basis,” he explains. “We want him comfortable dealing with our people on a long-term basis, not just guys with fangs.”

A firm in transition

John Cahill, a partner at law firm Paul Hastings who has worked with Yue for more than a decade, says Arch Capital’s approach certainly has endeared the firm with its investors. “They are unbelievably client-focused. As with the structuring of all funds, there is a fair amount of protocol designed to deal with potential issues that are protective of the sponsor. However, on numerous occasions – even though the documents don’t require it – they have done certain things anyway for investor relations reasons.”

One example of going above and beyond came when Arch Capital seeded its first fund with assets originally acquired by Ayala at cost. “In that era – 2007 to 2008 – there were instances where seeded assets where placed into funds at fully marked-up valuations or with some small discount,” Yue notes.

A more poignant example, however, came in 2011 when Ayala sought to remove itself from the firm’s direct ownership structure. Mindful of impending regulation limiting financial institutions from owning large stakes in private equity platforms, the conglomerate negotiated the exchange of its half share of the business to The Rohatyn Group (TRG) in return for a greater share in the New York-based emerging markets investor. Yue’s 50 percent ownership stake remained constant but, for further consistency, TRG picked up Cosgrove’s contract, with the two men maintaining their key man status for Arch Capital’s two funds.

The TRG handover required a two-thirds majority vote, but Arch Capital insisted on collecting 100 percent investor approval. “We looked at the risk involved, but the fact that Richard and Charles remained to lead the charge gave us great comfort,” Shaw recalls.

As Cosgrove details: “Of course, the investors had questions, but the change was packaged in a way that all the success factors were still there. Really, what we added was additional stakeholding, and Ayala re-upped to Fund II with a sizable chunk.” With Ayala the second largest shareholder of TRG and a major seed investor with Arch Capital, its presence remains majorly impactful. 

Cahill advised Arch Capital throughout the process. “It went through almost seamlessly,” he says. “Richard and Charles went out of their way to be accommodating, and they ended up with unanimity.”

Pick of the litter

When asked whether any of its investments have suffered a loss, Yue and Cosgrove look to each other before shaking their heads in the negative. When pressed, Yue admits one investment in India has been a relative ‘underperformer’.  

Thumbing through another brochure of a swish-looking apartment scheme in Chennai, Yue explains that the asset was acquired in a special economic zone (a state-allocated zone enabling foreign direct investment), for which the Indian government has since revoked certain tax advantages. Coupled with permit delays, he reckons the return will be affected. “Add in inflation, double-digit interest rate hikes, currency issues – everything you can think of,” he says. “Despite all that, we’re still forecasting a single-digit return in local currency terms.”

Unsurprisingly, given the repeated support it has received from its investors, Arch Capital has managed plenty more hits than misses. Ironically, the pick of the litter was a deal that AIG rejected.

Arch Capital invested $70 million of equity in the joint acquisition of a 5.5 million-square-foot development site in Macau through a consortium with Hong Kong-listed developer ITC Properties and an influential Macau family. “The area is known as the Cotai Strip today,” Yue muses. “But then, you really had to understand the value proposition and direction Macau was headed.” 

Today, the consortium is well underway to developing 17 residential towers, and Arch Capital already has returned much of the capital from its initial outlay. “We have written contracts to sell more than $2 billion of inventory already,” Yue says, adding he expects the investment to generate a very attractive equity multiple of above 4x.

Cahill believes Arch Capital found itself a niche in the wake of the global financial crisis. An attractive alternative to the “big boys” that disenfranchised investors with impersonal service, the firm’s personable approach led to investors feeling empowered, he explains.

Cahill thinks Arch Capital will face increasing competition from other boutiques that have cottoned on to the formula, although the firm has a distinct advantage. “They have made returns,” he says. “It is going on to Fund III, has had phenomenal returns from its first fund and has deployed money sensibly for its second. Even though there will be increased competition, I see them leading the pack.”

It would have been hard for Yue to picture his current success when he was 1,000 feet up the Macau Tower, perched on the edge and contemplating whether or not to “take a step into the unknown.” Odds are he’s pleased with his decision. 

Arch Capital Management
Founded: 2006
Principals: Chief executive officer and chief investment officer Richard Yue, chairman Charles Cosgrove, chief operating officer Leonard Wei and chief financial officer Rosaline Ho
Offices: Hong Kong (headquarters) and Shanghai
Staff: 28
Funds managed: Arch Capital Asian Partners (2007), Arch Capital-TRG Asian Partners (2012)
Total equity raised: $717 million
Total assets under management: approximately $800 million