Shadow capital's growth could change private equity, real estate

The growing popularity of direct investment and co-investment in private equity and private equity real estate is threatening to change the general partner-limited partner relationship.

When they co-invest or invest directly, institutional asset owners have a say on what companies or properties to invest in and the timing of the investment. Not so when they commit to blind pools.

Management fees, carried interest and other investors' costs in commingled funds and some separate accounts are often eliminated in a co-investment or direct investment.

But fiduciary responsibility shouldered by general partners could shift to asset owners in direct investments and co-investments.

Bo Ramsey, director of private equity with the $29.4 billion Indiana Public Retirement System, Indianapolis, said co-investors participate more in the deal due diligence than is done in traditional GP-LP relationships. “It makes us better investors,” he said.

Still, the allure of lower fees and greater control is prompting some investors to create allocations to direct investing and co-investing. Other asset owners are making it their primary mode of investing.

Officials at the Indiana fund just started a portfolio-wide co-investment program focused primarily on general partners the pension fund is backing, Mr. Ramsey said in an interview. He said he expects co-investments to make up 10% to 15% of the total of $440 million in private equity commitments this year. The Indiana system has a 10% target allocation to private equity.

Some in the industry call direct and co-investment “shadow capital” because its existence in deals is often kept secret from everyone other than the LPs involved. These days, it is playing the role once played by club deals (the combination of two or more private equity firms) that were popular before the financial crisis.

Institutional asset owners like to co-invest — that is, investing alongside a fund or a firm they already invested with — and invest directly — investing solo or alongside a firm with which they do not have a relationship — because they have more control and save about half the fees of a fund.

Solid numbers are hard to come by, but about 36% of private equity managers have received requests for co-investment rights from more than half of the investors in their latest fund, according to Preqin, a London-based alternative investment research firm.

Among global investors, 52% planned to increase their direct investment in private equity in 2014, up from 28% in the first half of 2011, Preqin said. And 56% indicated they planned to increase their co-investments, up from 30% in the first half of 2011, according to Preqin.

Co-investing is a hot-button issue with the Securities and Exchange Commission. The SEC is examining private equity firms over possible inequities between limited partners and other investors.

Andrew J. Bowden, director of the SEC's office of compliance inspections and examinations, said in a May speech the commission has noted the growth. “These accounts, which invest alongside the main commingled vehicle, are often not allocated broken deal expenses or other costs associated with generating deal flow,” Mr. Bowden said.

Even so, investors are seeking opportunities to co-investor invest directly.

Neil Randall, senior director, private equity for the $130 billion Teacher Retirement System of Texas, Austin, said officials there have not done many direct investments, but they like to co-invest to reduce expenses and build relationships with private equity managers.

Co-investors gain greater insight into transactions because they choose the deals in which they invest rather than invest in blind pools, Mr. Randall said. Plus, they can make more tactical private equity investments through co-investment, he added.

Texas Teachers has more than $14 billion in private equity; no breakout of direct investing and co-investing was available.

The $300.6 billion California Public Employees' Retirement System, Sacramento, has a portfolio ofprivate equity direct investments and co-investments with a net asset value of $900 million. CalPERS data showed that portfolio earned a net internal rate of return of 12.8% as of June 30, 2013, the most recent data available, compared to an 11.4% net IRR for its portfolio of commingled funds and customized investment accounts that had a net asset value of $27.3 billion as of the same date.Looking for co-investments alongside existing funds and existing general partners is a main tenet of CalPERS' private equity strategic plan, according to a review of its $31 billion private equity portfolio.

Textron Inc., Providence, R.I., with $10 billion in total retirement assets, has focused on direct investments in real estate. Some 80% of its $600 million in real estate is in direct investments, said Charles Van Vleet, assistant treasurer and chief investment officer.

Most co-investments or direct investments do not have management fees or carried interest, said David Fann, president and CEO of private equity consulting firm TorreyCove Capital Partners LLC, San Diego. Properly managed and executed, co-investments and direct investments can provide greater returns while allowing investors to participate in deal due diligence, Mr. Fann said.

However, not all investors define the terms the same way and that can lead to confusion, said Michael Moy, managing director in the Mission Viejo, Calif., office of investment consultant Pension Consulting Alliance Inc.

Elements of the relationship, such as the amount of control the investor has and whether the general partner has fiduciary responsibility, can become unclear.

There generally is no fiduciary responsibility on the part of the GP with direct investments, Mr. Moy said. A better solution for investors would be for general partners to stop offering co-investments and simply cut their fees, he added.

Private equity firm executives like the so-called shadow capital that direct and co-investments provide because it allows the firms to invest in deals or properties they otherwise could not afford. “There's more co-investment dollars associated with the deals,” said Jeffrey Bunder, global private equity leader at Ernst & Young, New York. “Investors are playing more of an active role and are at the table with the funds.”

Direct and co-investing enable investors to double-down on investments they like, said Gentry Hoit, partner at New York-based real estate placement agent Park Madison Partners LLC. More investors are interested in co- or direct investment in real estate today than 12 months ago, she said.

“Still, general partners continue to control the deals, including decisions such as when to sell or refinance, Ms. Hoit said. “In direct, control rights are negotiable.”

She added: “If the LP is putting up the majority of the equity, we have seen them require and get very significant rights.” She declined to name investors.