Analysis

ROUNDTABLE

SPONSORS DEBEVOISE & PLIMPTON • HARBOURVEST 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

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“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

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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 , 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.

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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. er teams and resources, who are usually “There’s clearly room for both syndication and co-underwriting, but the unable to offer other value-add.” current environment is playing more to the advantages of the latter – where The growth of large firms into dif- LPs can write bigger cheques, have an earlier look at the deal and receive ferent areas, such as consulting, is an the allocation they are looking for, while offering certainty of close to emerging area of potential concern GPs, who may be concerned about portfolio concentration risk in a more when it comes to alignment. “Many of challenging environment for fundraising, if a co-investment were not to be these divisions may play different roles fully syndicated. in the company during the life of the “We have seen some GPs being left holding syndication bridges and investment,” says Ashton. “There is we are still getting co-invest calls about deals completed months ago. The an increasing tendency to do affiliate downside to co-underwriting, of course, is that you don’t always win the transactions, for example, and then deal and then co-investors can be liable for broken-deal fees.” charge other fees beyond the expected And while some of this trend is underpinned by greater capability management fees – this is an area our and experience among LPs to co-underwrite, it is also being driven by co-investment clients are really focused regulatory concerns. on because if the GP has an addition- “There has been a lot more scrutiny by regulators – most notably the al cashflow coming in, that may well SEC – around the risk a GP takes in instances where, for example, a GP shape and drive the decisions being might over-commit and syndicate later,” says Ashton of Debevoise & made, especially in troubled assets. Plimpton. “They are also looking closely at how investments are allocated This also has the potential to weaken among LPs. This is playing a role in the move towards co-underwriting, expected returns to co-investors as cash but has particular relevance as we stand in a pandemic environment where is siphoned off through fees.” GPs want to reduce execution risk early on by going to large co-investors with opportunities.” A bridge to fundraising And, on the topic of broken-deal fees, Ashton says it’s vital to ensure The covid-19 storm may well have these costs are fairly shared and allocated, especially in a more challenging concentrated minds on current co-in- environment when failed deals will be more commonplace. She points in vestments, but it is also playing into particular to reverse transaction fees, which penalise buyers if they walk new opportunities and accelerating away and can amount to between 5 percent and 8 percent of the equity some existing trends. value. “GPs have been increasingly turn- “We may see more failed deals,” she says. “And as a co-investor, you may ing to trusted co-investors to support well be liable for a share of broken deal fees, even though you may have less their investment activities in 2020,” say than the GP about whether a deal goes ahead.” says Lane. “They seek responsive LPs who can act with speed, have the skill

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“There will be a flight to quality among GPs. They will consolidate and build the relationships with LPs they know and trust as opposed to breaking into new relationships”

KATHERINE ASHTON Debevoise & Plimpton

talk about blurring lines between sec- “In investments where there is no ondaries and co-investments. “These can present challenges for residual value, it’s simpler to walk co-investors, but also strong opportu- away; the more complex situations nities,” says Shafer. “This can play into firms that have both co-investment and arise when there is heavy lifting secondary programmes. We like these deals as they offer a very different risk required to recover value” profile from a traditional co-invest- ment. You don’t have the transition risk of a new owner coming in and you have JAMES PITT Lexington Partners continuity that provides a floor on the downside.” However, they can also have an in- built ceiling on the upside, he adds. sets to understand complex deal at- help them do deals and seed funds. “We pay a lot of attention to whether tributes and who can reliably support We’ve also seen an increase – and this there is a catalyst. You don’t want to be transactions by committing capital and has been true for a number of years – in in a deal where the sponsor will con- sharing risk.” the number of independent sponsors tinue to manage the asset on a busi- In the early days of the pandemic, that operate through deal by deal or ness-as-usual basis – there has to be a this translated into GPs tapping co-in- who invest without a fund in place.” clear value-creation proposition and vestors for funding to help companies Fernandez also points to the existing there has to be a shorter path to exit respond to the crisis – to shore up bal- trend of buy-and-builds as an opportu- than in a brand new buyout. ance sheets, repay debt maturities and nity for co-investors. “It’s a theme we “But you also have to look at how the finance M&A transactions using more continue to see in the market as GPs deal affects the economics for the GP. equity at a time when debt markets seek to accelerate their value creation Are they just doing the deal to crystal- stalled, for example. Now, the focus has plans in the current environment,” she lise carry? Or do they genuinely believe moved towards transactions that were says. they are the best owner for the next put on hold or on to new opportunities. One area of the secondaries market phase of the company’s development? And co-investors are increasing- that has seen significant attention over And you have to consider whether man- ly being called to support deals being the past few years has been GP-led agement remains aligned. If they are done by strong GPs that have fallen secondaries transactions. Yet related taking liquidity, you need to be com- prey to a more difficult fundraising en- types of investment, involving the re- fortable with how that is being done.” vironment. “We are seeing some GPs capitalisation of a single asset that rolls Buyers entering this market will have delay fundraising,” says Fernandez. over into a continuation vehicle, have to be highly selective. Lane points to “They are looking for solutions that attracted co-investors, leading some to recent deals where high-quality GPs

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“Instead of being available to only the highest performing, most

stable companies, GPs will consider deals continue to be done, co-investors should be well positioned in terms of recapitalisation and early liquidity dealflow over the next 12 months.” Prieto and Shafer see further oppor- opportunities across their portfolios” tunity in single-asset continuation fund deals. “We may even get to a situation IAN LANE where you see a GP doing a continua- HarbourVest Partners tion fund of a continuation fund for a strong growth asset in the not-so-dis- tant future,” says Prieto. “And while there will be interesting opportuni- ties for co-investments in the GP-led space, it will also be important that “You don’t want to be part of a good companies are put back into the market.” science experiment. You want to Shafer predicts “the next year will see single asset continuation vehicles ensure that the GP has built fund make a meaningful dent in the spon- sor-to-sponsor M&A deal markets, capital around the type and sector especially as mainstream investment of deal that you’re involved with” banks become more familiar with this and start adding this as an option for sponsors at the point of exit”. MATTHEW SHAFER And, while there will undoubtedly Northleaf Capital Partners be some tests along the way, the bridg- es already built between GPs and their co-investors may well be strengthened. “There will be a flight to quality among pursue a mid-life transaction with the the co-investment space, assuming in- GPs,” says Ashton. “They will consol- goal of extending the hold period for a vestment activity holds up. idate and build the relationships with high performing asset. “I predict that “We might see more buy-and-build LPs they know and trust as opposed to the scope of mid-life transactions will deals,” says Fernandez, “and there breaking into new relationships.” change over time,” he says. “Instead of might be increased complexity in deals, “It took five years for being available to only the highest per- such as carve-outs and public-to-pri- to work through the aftermath of the forming, most stable companies, GPs vates. GPs that are in between fund- 2000 tech bubble,” says Lane. “With a will consider recapitalisation and early raisings might look to warehousing strong response from central banks and liquidity opportunities across their port- solutions to enable deals to go ahead, government intervention, it took ap- folios, creating an increasingly common and a potentially more conservative proximately two years for private equity source of liquidity for private equity environment might lead to higher eq- to manage through the GFC. Today, funds.” uity ratios – all of these play into the the central bank and fiscal support has strengths of experienced co-investors.” been even more rapid. This, combined New opportunities “On the fundraising point,” adds with significant dry powder and the Caution will be the watchword of the Pitt, “there will be a raft of high-quali- quick return of credit and equity mar- coming 12 months as covid-19 con- ty managers that find their fundraising kets, has resulted in a fast bounce-back tinues to create uncertainty, but with plans disrupted. They will want capital in deal activity and record demand for many of the panel seeing record deal- to complete transactions, while ensur- trusted LP co-investors who can sup- flow over the summer, there looks set ing that at the same time their port- port GPs in securing and closing new to be plenty of opportunity to come in folios are well diversified. Assuming investments.” n

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