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Direct approach

’Solo’ investing makes for good returns

josh lerner
Josh Lerner's research showed solo direct investments outperformed all private equity benchmarks.

Flying solo appears to pay off, at least in private equity investing.

Investors that make private equity investments directly in companies get better returns with lower costs than they would by co-investing alongside their private equity managers or investing in private equity funds, according to a new paper co-authored by Josh Lerner, the Jacob H. Schiff Professor of Investment Banking at Harvard Business School, Boston.

A growing number of large institutional investors have been ditching the private equity fund investment model to make direct investments. These investors are attracted by the lower fees and increased control over investment selection. While a few have been investing directly for more than a decade, a growing number of investors have been showing interest in investing directly over the past 12 to 18 months. Investors that have gone the solo direct route include University of Michigan endowment, China Investment Corp., Teachers Retirement System of Texas and Ontario Teachers' Pension Plan.

The C$117.1 billion (US$117.8 billion) Ontario Teachers is one of the most experienced. It has been making direct investments since 1991. In October, it closed a C$150 million equity financing of Canbriam Energy Inc. through its private equity investment division, Teachers' Private Capital.

The $113 billion Austin-based Texas Teachers' pension fund is also an experienced co-investor. On Oct. 23, it invested $200 million in restricted securities of Delta Topco Ltd., a sports media company that owns Formula One Group. Some 10% of Texas Teachers' $13 billion private equity portfolio is in similar investments.

Other investors such as China Investment Corp. are newer to direct investment, especially going solo. In May, Blackstone Group led a deal that included $500 million investments by a group that included China Investment Corp. and Government of Singapore Investment Corp. in Cheniere Energy Partners LP, Houston, which has a natural gas facility in western Cameron Parish, La.(CIC owns a $3 billion stake in New York-based alternative investment firm, Blackstone Group.)

Benefits shown

Research shows the benefits of solo direct investment.

According to the recently published paper, solo direct investment outperformed all private equity benchmarks used in the study by between 13% and 19% internal rate of return based on simple average and between 7% and 10% on a weighted average as of Sept. 30, 2011.

The paper, “The Disintermediation of Financial Markets: Direct Investing in Private Equity,” was co-authored by Lily Fang, a Singapore-based associate professor of finance at INSEAD, and Victoria Ivashina, associate professor of finance, Hellman Faculty Fellow at the Harvard Business School.

The researchers looked at 392 transactions over a 20-year period by seven large global institutional investors. Some 288 of the deals in the sample are co-investments. Those co-investments' IRRs, on a weighted basis, consistently underperformed the private equity benchmarks and also consistently underperformed solo direct investments by between 13% and 15% of IRR, the researchers found.

The differences between direct, solo private equity and fund returns are not just about fees, Harvard's Mr. Lerner said in an interview. Many direct, solo investors gain an advantage when they invest locally, and much of the solo investment analyzed in the research was local to the investor, he said.

“If you look at the kind of settings where direct investing does particularly well, it is when it is local investing and investing relatively near to where investors are based,” Mr. Lerner said

“Presumably, investors have advantages of having unique information” when they make direct investments locally, Mr. Lerner said.

Programs are cropping up to enable institutional investors to make in-state direct investments. In May, for instance, the $150.6 billion New York State Common Retirement Fund invested $12.9 million in Hicksville, N.Y.-based Sleepy's, a large mattress retailer. The investment was through the Hudson River Co-Investment Fund managed by Hamilton Lane; the deal was led by San Francisco-based Calera Capital.

'Lemons problem'

Also, co-investments might have a “lemons problem,” that cause them to underperform solo direct investments. General partners might be offering investors below-average quality deals for direct private equity investments, which would result in lower returns, the paper noted.

Private equity managers have a lot more experience selecting companies in which to invest than the institutional investors' internal staffs, whose experience is usually limited to selecting private equity managers. So, investors could be selecting these subaverage quality deals because they are less equipped to distinguish between a good deal and a so-so transaction. Added to this, general partners generally only give investors a short period of time to decide on each deal, that does not leave much time for due diligence.

The research paper also found that investing directly is cheap compared to the typical 2% management fee and 20% profit sharing charged by private equity funds. In addition, there is a mean annual internal cost for investing in private equity funds for investors of 0.1%, the paper found. The mean annual cost of direct investing was 0.91% of committed capital. But investors only pay additional fees in co-investments, which is generally lower than private equity fund fees.

The researchers found that institutional investors make direct private equity investments in companies, either on their own or by co-investing with a manager, not only because of lower fees but also because they have greater control over investments. The researchers found that some of the institutions pick less than 5% of deals available to them.

Investors also like to make direct investments because it gives them a better ability to time the market. “This is valuable because private equity funds' performance is highly cyclical,” the paper noted.

Voice of experience

One of the institutional investors with the most experience in direct private equity investments is the C$117.1 billion (US$117.8 billion) Ontario Teachers' Pension Plan, Toronto.

“We do direct investments, co-investments and fund investments, all for specific reasons,” said Deborah Allan, director, communications and media relations for Ontario Teachers, in an e-mailed response to questions.

Ontario Teachers' looks to invest C$75 million to C$300 million per direct transaction on its own. The pension fund focuses on leveraged buyouts, but it can also make balance sheet recapitalizations, private investment in public companies and growth capital investments, according to Ontario Teachers' website.

“We need to keep a healthy and appropriate balance of direct, co-investment” and general partner fund investments, she wrote. “Costs are relative — if we do not have expertise or relationships in a geographic market or industry, we mitigate our risk with funds and co-partners who do.”

Another executive at a large U.S. pension plan who declined to be identified, agreed with the paper's finding on fees, but added the downside to direct investment is that it is difficult to overcome staffing limitations. Few pension funds have the ability to pay enough to hire and retain the talent who can find and negotiate direct private equity investments, the investor said.

“You can't just hire your own private equity shop,” the executive said.

The California State Teachers' Retirement System, Sacramento, co-invests alongside its private equity general partners but does not do solo direct deals, said Ricardo Duran, spokesman for the $152.5 billion system.

CalSTRS is not permitted to do so by policy, he said in an e-mailed response to questions.

“The reason our policy prohibits (solo) direct investment is that, as a public entity, CalSTRS does not have the level of staffing nor the compensation levels required to adequately lead, review and monitor deals at the level required in the direct-invest environment,” Mr. Duran said.