To co-invest or not to co-invest?

When Jim Leech, senior vice president of Teachers’ Merchant Bank, the private equity arm of Ontario’s Teachers’ Pension Plan, gave a talk at the Super Return conference in Munich earlier this year everyone thought, as a successful and active co-investor, he would stick purely to extolling the virtues of co-investment programmes. He didn’t. Lisa Bushrod finds out why he is not a lone voice.

Shortly after leaving the podium, Leech began to gauge the reaction to his presentation. Amid the subsequent discussions he received several invitations from pension fund mangers eager for him to come and repeat his speech to their board of trustees. Leech’s message is no frills: “My warning is that it’s not for the faint of heart. There has to be a cultural change within an organisation. Once in direct investing, you’re going to have more losers. It’s one thing to invest in a fund and one investment goes under because you’ve got diversification protection. If a direct goes under, can your company even deal with that?”

One of the reasons so many pension fund trustees are putting their fund managers under pressure to undertake co-investment programmes is the perceived high cost of private equity investing; typically 2% management fee plus a 20% share of any upside on the investment, known as carried interest. Co-investment, by contrast, can come minus promote; the term used to encompass both carried interest and annual management fees.

“One in ten deals that we see has some sort of promote in there. We have never paid a fee upfront, it’s usually some sort of back end profit share such as 2.5 times capital plus a 15% IRR before they can have promote,” says George Anson, managing director, HarbourVest.

“There are sensitivities as to whether a GP can or cannot charge something [for a co-investment right.] There is always discussion about whether it should be given for free or that some sort of fee be associated with it. There is no set model,” says Mounir Guen, CEO, MVision. The give-it-for-free discussion usually centres on the idea that co-investment rights should be a value added product the GP offers an LP as a way of cementing their long term relationship, particularly if the investment goes well and the LP’s overall return on its relationship with that particular GP is enhanced by the absence of fees and carried interest on part of the overall commitment.

Perhaps one reason for the feel-your-way rather than structured approach to co-investment fees is that most co-investment arrangements are informal, rarely even being written down and certainly not included as part of the fund documentation. However, Bain Capital has a structured co-investment programme, which is a separate fund of $600m that can invest alongside its $2.5bn main fund (fund 7.) It charges 20% carried interest and annual management fees are charged on dollars invested, not committed. It is also did not require that investors in the co-investment fund also committed to fund 7, although that may change for fund 8 given the interest generated by the structure.

To call Bain Capital’s parallel fund a co-investment fund is, however, slightly misleading as regards the relationship between GP and LPs. The co-investment fund follows the investments made by fund 7 and does not require the investor to be actively involved, unlike traditional private equity co-investing. In fact in some ways it matches what Leech fears many investors imagine traditional co-investing is about. “A lot of people think co-investing is like buying into the syndicate of a public deal,” he says. In fact co-investing is closer to home than the public markets. “The only difference between co-investment and direct is how it’s been sourced,” says Leech.

By this he means co-investment opportunities are generally deals a VC has pre-screened and priced and, subject to a satisfactory due diligence process, expects to invest in. The institutional investor is then expected to engage in the same manner as the VC. Anson says: “By the time we see a deal it has already been priced and structured generally speaking. Price, management and sector are the three typical things that knock a deal out of the box for us.”

HarbourVest has a dedicated direct investment team to work through these transactions, which it needs to source a reasonable number of given that it runs a parallel co-investment fund alongside its fund-of-funds. Likewise, Teacher’s Merchant Bank has a number of dedicated professionals. Leech, who has worked extensively with BC Partners and to a lesser degree with Phoenix Equity Partners and Rhone Capital in Europe, says: “Once they have done a screen on an investment then they call us and we send a three person deal team to work with them for as long as it takes.”

It’s having a dedicated direct deal capacity that sets aside the serious co-investors (see boxed item) aside from the wannabes. It’s this capacity that amounts to what it widely termed deliverability. “There are a lot of LPs that pay lip service to co-investment. They think they have as much time to look at a direct deal as they do say a fund, but they might have only as much as a month to commit to a deal,” says Anson.

VCs can’t complain too vocally when they are let down since they need those same LPs’ fund investments, but they are unlikely ever to offer them a co-investment opportunity again. Anson remarks on the most oft cited carps. “The two things GPs complain bitterly about are firstly, LPs who cannot make up their minds and ultimately say no because they didn’t like the sector when you should know that upfront and secondly, the naivety. [For example,] one investor nearly scuppered the William Hill IPO because it could not keep up with the timetable for reviewing all the documentation,” he says.

This highlights the point about co-investing being a parallel to direct investing, where not only the ability to invest is important but exiting too. If that were not enough LPs that engage in co-investing suddenly have to contend with all sorts of deal structuring terminology and practice that requires professional experience, such as negotiating tag and drag along rights, voting arrangements and rights of first refusal.

For many institutional investors, particularly pension funds, the idea of training people to be competent direct investors and familiar with all of the attendant structures and terminology is not viable where those funds are not able to offer their employees performance related pay. Without performance related pay as soon as the individuals become competent they will begin to see how green the grass on the other side of the fence really is and jump ship, leaving the fund back at square one.

Unfortunately most fund advisers and gatekeepers do not have the capability to provide direct investing skills on a consultancy basis, partly for the same reason but mainly because they are set up with a fund-of-funds business model and competencies. However, plans are afoot that mean one ex private equity banker and investment consultant may be about to plug that gap by launching a new firm, based in New York, that will focus areas such as consumer products, manufacturing, and distribution, with the aim of enhancing the operations strategy of businesses. Rather than raising a private equity fund, at least from the outset, it’s likely the team’s expertise will be offered to LPs, enabling those investors to outsource their co-investment opportunities. This could work either on a consultancy fee basis or perhaps by way of a sweat equity fee arrangement, given the operational relevance of the team. Certainly this would involve pension funds with a significant capacity to do co-investments, rather than smaller funds, which may be better off with a more diversified fund-of-funds approach anyway.

In the GPs shoes

While there are obvious risks for GPs the advantages of engaging in co-investment activity can be quite dramatic. John Snook, managing director, Close Brothers Private Equity, says: “Fund 6 was not big enough for the scale of transactions we were writing so we needed some placing power. There were always two or three investors in each fund willing and keen to do that.” An LP co-investing partner can be less problematic in the long run, assuming the partner has the expertise to do co-investments effectively, since there is no dispute over who led the deal, something that frequently happens when two or more GPs invest alongside one another. Such disputes can be harmful when a GP is looking to raise a subsequent fund since it may call into question particular performance aspects.

Viewed like this co-investment is not likely to be a long-term strategy. Rod Selkirk, head of private equity, Hermes points out: “If you have got an investment strategy that supports the need for [a co-investment] vehicle, why not raise a larger fund? You are limiting the upside in co-investment fund.” Snook says of Close Brothers Private Equity most recent fund raising: “There is less pressure on fund 7 [to do co-investments], because it’s a bigger fund.”

However, sometimes the decision by a GP to opt for ongoing co-investment arrangements is a strategic move. “Our strategy is that we like to manage core funds that are half the size of the big guys, yet opportunistically we want to have the capability to

go for bigger deals,” says Bear Albright, investor relations, Bain Capital. This allows Bain Capital to go fishing for opportunities in the mid market and upscale as and when it sees a larger deal that fits its criteria. And, given the fee and carried interest based structure of Bain Capital’s co-investment vehicle it’s easy to see why this has a long-term future for both LPs and GP.

Offering co-investment can also be an incredibly useful precursor for a GP and LP, rather like meeting for a drink before agreeing to have dinner together. Many LPs report having co-invested in opportunities brought to them by GPs in which their wider organisation has never previously invested. Having invested they are aware that the GP regards this as a useful way for the LP to get to know them and their investment practice, which ought to make the due diligence on fund raising easier to cut through when that GP next goes into the market. GPs for their part, however, can only offer such opportunities as and when they have a genuine need for fear of upsetting the apple cart with their existing LPs.

Given the seemingly ad hoc nature of some co-investment activity it is not surprising to hear many LPs, particularly those with fund-of-funds operations, caution that it is simply not on to commit to a fund with a view to the co-investment arrangements this might bring. Not only may they never materialise but also the right fund and the right team always come prior to any potential to stimulate returns through co-investment activity into the life of the fund investment.

Co-investment it not for the faint of heart and without the right culture – to understand and work through failures -, people and pay co-investment is, broadly speaking not a good idea. Given the magnification effect of a direct investment, a lack of understanding could see all private equity investing called to a halt in some organisations, as Leech cautions: “[Co-investment activity] could put your entire private equity portfolio in jeopardy if things go wrong.”

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