Private equity firms are relying less on their competitors and more on limited partners to finance leveraged buyouts these days.
Even private equity managers that invest in middle- and small-market companies are looking to limited partners for additional capital for deals, rather than tapping like-minded private equity firms for cash, as would have happened before the financial crisis.
Recent examples of co-investment deals include:
- the C$117.1 billion (US$114.1 billion) Toronto-based Ontario Teachers' Pension Plan and Chicago-based private equity firm Wind Point Partners' acquisition of Shearer's Foods Inc., a manufacturer of private-label snacks;
- the $112 billion Austin-based Teachers Retirement System of Texas' $200 million investment in Formula One racing holding company Delta Topco Ltd. alongside CVC Capital Partners, one of the system's private equity general partners; and
- the C$152 billion Toronto-based Canada Pension Plan Investment Board and Los Angeles private equity firm Ares Management LLC's $1.6 billion acquisition of 99 Cents Only Stores.
Private equity firms are hitting up their limited partners and other institutional investors for a number of reasons, but mostly because club deals have become a hard sell.
“Limited partners let it be known that they are not fans of club deals,” said Jeffrey Golman, vice chairman and head of the investment banking group at Mesirow Financial Holdings Inc., Chicago.
Investors dislike club deals — transactions in which private equity firms join together to buy a company — because they can become overexposed to a single deal. Also, returns for pre-crisis deals are expected to be lousy because the prices were high.
Kevin Albert, partner and member of the partnership board of private equity firm Pantheon Ventures (U.S.) LP, New York, said there has always been skepticism and dislike for club deals.
Often investors are in more than one of the general partner groups involved in a deal. “It's the old phrase — "too many cooks in the kitchen spoil the broth' — and I think there is some validity to that,” Mr. Albert said.
“There's been a push and pull effect (driving co-investments). The pull is from general partners, being less willing to syndicate with other general partners,” said Delaney Brown, head of the Americas in the Boston office of Hermes GPE, which has $10 billion in global private equity and U.K. infrastructure investments.
The push is from limited partners that want to co-invest to drive down the cost of investing in private equity and to gain control over investments, Mr. Brown said.
Private equity firms also are eager to distance themselves from club deals because federal regulators have been investigating whether there was any collusion among the private equity firms in past deals.
Put all that together, and co-investments are hot.
According to a survey released in February by London-based alternative investment research firm Preqin, 43% of institutional investors expect to increase their co-investments this year. Some 52% would like to increase their direct private equity investment in companies. (The survey of 100 institutional investors was taken in December.)
In February, for example, the $10 billion New Mexico Educational Retirement Board, Santa Fe, committed $100 million to BlackRock (BLK) Inc. (BLK) to make private equity co-investments. This is the second $100 million commitment to BlackRock for a co-investment fund in which the board is the only limited partner, said Bob Jacksha, chief investment officer of the fund.
The pension fund gets better terms on fees and carried interest compared with private equity fund investments and has veto power over investments, he said.
Also last month, the $152.9 billion New York State Common Retirement Fund, Albany, allocated $250 million to Farol Investment Advisers LP for private equity co-investments through the pension fund's emerging managers program.
Many large institutions are clamoring for co-investments because most co-investments are made on a no-fee, no-carried-interest basis, said David Fann, president and CEO of San Diego-based consulting firm TorreyCove Capital Partners LLC. Megadeals such as the $24.4 billion Dell Inc. management buyout announced Feb. 5 and led by Silver Lake Partners “is a chance for them to co-invest in scale,” Mr. Fann said.
“I think that if the buying group needs to bump up its bid, one source of equity capital will most likely be from Silver Lake's limited partners,” Mr. Fann added.
Said Mesirow's Mr. Golman, “I would not be surprised if Silver Lake passes the hat among its limited partners” to get investors to fill out its $1.4 billion slice of the Dell deal.
Co-investments these days are not just in megadeals. Investors increasingly are pushing middle-market private equity firms to include them as co-investors, said John LeClaire, partner and chair of the private equity group in the Boston office of law firm Goodwin Procter LLP.
There have been co-investments in the middle market in the past, but not on a regular basis. Now, investors are asking for the opportunity to co-invest at the fundraising stage, Mr. LeClaire said.
Indeed, with private equity firms having a hard time raising funds, co-investments can preserve what is left of a firm's latest fund.
“It's a difficult fundraising environment and so firms want to extend the dry powder (unspent commitments) in their funds,” said John R. Wolak, West Conshohocken, Pa.-based managing director and co-head of the $10 billion private equity funds-of-funds business at Morgan Stanley (MS) Alternative Investment Partners, a unit of Morgan Stanley Investment Management.
“General partners would prefer to offer up co-investment to limited partners,” because they don't sit on boards, don't expect to lead transactions and often cede governance rights to the general partner, Mr. Wolak said.
Co-investments can also work as an enticement to get limited partners, both existing investors and new prospects, into a firm's next fund, Mr. Wolak said.
Mr. Wolak added that he has seen the co-investment flow increase and he expects the trend to continue.
“I think when general partners consider the pros and cons ... they would strongly prefer to bring in limited partners, all things considered,” he said.
This article originally appeared in the March 4, 2013 print issue as, "Co-investing deals blazing a comeback trail".