In This Together
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Analysis ROUNDTABLE SPONSORS DEBEVOISE & PLIMPTON • HARBOURVEST PARTNERS • LEXINGTON PARTNERS MORGAN STANLEY INVESTMENT MANAGEMENT • NORTHLEAF CAPITAL PARTNERS • SCHRODER ADVEQ All in this together Co-investments have seen massive growth over the past decade, but how will these deals fare as we navigate a covid-induced downturn? Toby Mitchenall and Vicky Meek look at how more uncertain times are shaping the co-investments of today – and tomorrow Long seen by LPs as a way of boost- and individual companies, it’s clear there are some GPs that offered co-in- ing returns in private equity investment some co-investments will be facing dif- vestments during the GFC that are no portfolios and forging stronger rela- ficulty, placing a potential strain on LP- longer around. And the second is that tionships with fund managers, co-in- GP relationships. Yet with challenge you should be fully aligned with your vestments have become an increasingly also comes opportunity – seasoned in- GP partner on all parameters of the popular form of investment over the vestors with capital are in a position to transaction, both economic and other.” past decade. support strong GPs in a liquidity-con- He adds: “In investments where While it’s hard to put precise num- strained environment, generating good there is no residual value, it’s simpler bers on co-investment value and vol- returns as well as goodwill. to walk away; the more complex situ- ume – many transactions happen off Against this backdrop, we caught up ations arise when there is heavy lifting market and between individual parties – with a panel of six co-investment vet- required to recover value – and it’s here Triago puts “shadow capital”, which in- erans over Zoom in early October to that alignment and quality of GPs real- cludes co-investment, separate accounts discuss the current and future state of ly matter because, as a co-investor, you and direct investments, at $206 billion the market and how LP co-investors have relatively little control and diffi- in 2019, of which 32 percent, or around can ensure strong alignment of interest cult situations can unwind quickly if not $66 billion, is co-investment capital. with GPs. managed well. We are now seeing pri- Appetite among LPs has certainly been Indeed, when it comes to weath- vate equity investments where it’s clear strong. A 2019 survey of LPs carried ering storms, alignment sits front and that co-investors will be losing money.” out by Private Equity International found centre for our co-investment panel. Yet alignment is clearly more com- 65 percent of respondents intended to “While, last year, a downturn was plex in co-investment situations than deploy capital through co-investments not so much on the horizon, 2020 has for fund investments. So what does over the following 12 months. served to reinforce the lessons we al- good alignment look like for a co-in- Yet much of the growth in co-in- ready knew,” says James Pitt, the part- vestor? In part, it comes down to what vestments occurred during a relatively ner who leads non-US co-investments Matthew Shafer, managing director benign economic period. As 2020 has at Lexington Partners. “The first is that and head of the New York office at unfolded and the pandemic and the re- you need to co-invest with the very best Northleaf Capital Partners, calls “fran- sultant lockdowns have had an inevita- GPs, who will be with you through the chise alignment”. ble impact on entire industries, sectors life of the transaction – for example, “The deal really needs to be in the 30 Private Equity International • November 2020 Analysis “When we assess co-investments, we put as much effort into looking at whether the investment thesis and GP capability fit squarely with what they are trying to achieve as we do analysing the asset and the deal “We may even get dynamics” to a situation where you see a GP doing a MERCEDES FERNANDEZ Morgan Stanley Investment Management continuation fund of a continuation fund for a strong growth asset in the not-so- looking at whether the investment the- global co-investments at HarbourVest sis and GP capability fit squarely with Partners. “The lead GP is actively distant future” what they are trying to achieve as we monitoring the investment as a board do analysing the asset and the deal dy- member, is deep in the day-to-day op- MARIA CLAUDIA PRIETO namics.” erations, and often overseeing negoti- Schroder Adveq Economic alignment is also an obvi- ations with lenders,” he says. “By the ous – but vital – part of the jigsaw puz- time financing and structure details are zle. “It all comes down to incentives,” finalised, co-investors may only have a says Pitt. “You want to invest at the few days to make a follow-on invest- same valuation as the GP and any oth- ment decision.” GP’s sweet spot,” he says. “You don’t er co-investors that may be involved. Maria Claudia Prieto, senior in- want to be part of a science experi- That way you maximise the chance that vestment director at Schroder Adveq, ment. You want to ensure that the GP the decisions the GP takes are the same agrees. “Information asymmetry is has built fund capital around the type ones that you would under the same set the biggest challenge for LPs in these and sector of deal that you’re involved of circumstances.” situations because the GP would have with so you know the transaction is naturally followed developments in the important to them. You also have to Negotiating asymmetries company closer and over a longer peri- visualise what the situation would be Follow-on situations can present even od of time,” she says. if the deal goes sideways and be clear more knotty issues, particularly when “In that context the most essen- that the individual partner has their the company is facing some degree of tial element of alignment is a strong personal track record and carry at risk stress. Some of the complicating fac- relationship through primary fund if it doesn’t go to plan.” tors here can be situations where the commitments. LPs also need to have Key to this is really knowing your deal is a particularly large investment reserves available for follow-on capital GPs, says Mercedes Fernandez, exec- for a GP – whose interest will clearly be injection despite the opportunity cost. utive director at Morgan Stanley In- in getting capital back – and where the Not having follow-on capital can put vestment Management and partner in GP relies on connectivity within the co-investors in a very bad position.” its alternative investment partners di- industry or is keen to maintain good Misalignments between co-inves- vision. “It’s really critical at this point relationships with the lenders. tors have come to the fore over the past to understand your GPs’ knowledge Further, there is often information year as some companies have become and capabilities. When we assess co-in- asymmetry in follow-ons, says Ian troubled, says Katherine Ashton, part- vestments, we put as much effort into Lane, managing director and head of ner and leader of the alternative asset November 2020 • Private Equity International 31 Analysis Katherine Ashton Partner Debevoise & Plimpton Ashton regularly counsels investors on private fund restructurings, recapitalisations and tender offers; listed fund transactions; purchases and sales of portfolios of LP interests; and complex co- investment transactions. James Pitt Partner Lexington Partners Pitt joined Lexington, one of the world’s largest managers of secondaries and co-investment funds, in 2006. Based in London, he co-heads the firm’s private equity co-investment business. Mercedes Fernandez Partner Morgan Stanley AIP Fernandez leads Morgan Stanley AIP’s European investment programme. Prior to joining, she was on the investment team at MCH PE and a management consultant at KPMG. 32 Private Equity International • November 2020 Analysis Maria Claudia Prieto Senior investment director Schroder Adveq Prieto covers Adveq’s investment activities in Europe, focusing on co-investments, emerging managers, club funds and turnaround investments. Before joining in 2013, she worked on co- investments and structured finance at Capital Dynamics. Ian Lane Managing director and head of global co-investments HarbourVest Partners Lane joined HarbourVest in 2003 and focuses on direct co-investments in venture, buyout and mezzanine transactions, and serves as the chair of the firm’s direct investment committee. Matthew Shafer Managing director Northleaf Capital Partners Shafer oversees the origination, evaluation and monitoring of Northleaf’s private equity investments, and leads the firm’s New York office. November 2020 • Private Equity International 33 Analysis and secondary investments group at between investors and affect co-inves- Debevoise & Plimpton. tor alignment,” she says. “Some areas of conflict we see are Co-investments continue to be around some investors having a big- completed predominantly on a no-fee, ger stake than others, some going in no-carry basis – our panellists were at different valuations and then there clear they resist attempts by GPs to are tax considerations, which can differ charge primary fund economics for co-investment deals. However, there may be exceptions. “Most co-investments in the mar- Deal mechanics ket are still on a no fee, no carry basis and GPs understand that this is an im- One trend that looks to have been accelerated by covid-19 is portant element of the overall LP-GP the increased prevalence of deals being co-underwritten by relationship,” says Prieto. “Where we co-investors rather than being syndicated by GPs. have started to see some fee pressure is usually in relation to balance sheet in- “In general, I would say that we have seen relatively less of the vestors who, in some cases, have a lower straightforward, post-close syndication opportunities in these uncertain cost of capital, or investors with small- times,” says Lexington Partners’ Pitt.