Are You Ready to Co-Invest?

Analysis

ROUNDTABLE

SPONSORS BLACKROCK PRIVATE EQUITY PARTNERS • DEBEVOISE & PLIMPTON • HAMILTON LANE HARBOURVEST PARTNERS • LEXINGTON PARTNERS • NEUBERGER BERMAN Are you ready to co-invest?

LPs are raising their hands to snatch a piece of the co-investment opportunity, but are they prepared for what follows? By Adam Le and Victoria Robson

here is no doubt the co-in- year,” says Nick Kavanagh, vice-president vestment market is now well at Hamilton Lane. The response is telling. established. LPs are clamour- “They say of all those LPs that ask for co-in- ing to access the co-invest- vestment, less than a quarter consistently ment dealflow valued as high transact. Plenty are dipping their toes in the as $60 billion by Cambridge water and doing the odd transaction but not TAssociates, and accounting for around 20 in the structured way you need to build a di- percent of market activity. We asked our ex- versified portfolio.” pert panel, given the extraordinary level of When assessing co-investment capabil- appetite, what proportion of LPs are truly ity, our panellists agree it depends on the equipped to take part? deal. “Over the past 10 years, the market “It depends on your definition of taking has separated into post-close syndications, part,” says James Pitt, partner at Lexington which are relatively accessible to most LPs, Partners. “Most LP co-investments are now and the co-underwrite market,” says Cor- made into a partnership and, if an LP can entin du Roy, managing director at Har- close a fund commitment, they can close an bourVest Partners. “The co-underwrite LP co-investment. The ‘taking part’ is fairly market has grown in line with the capa- easy. However, the considerably more com- bilities of LPs and taken greater share as a plex task is sourcing a high-quality stream portion of all co-invest capital deployed, but of co-investment opportunities, evaluating co-investment co-underwriters are few and them in real time, constructing a well-diver- far between because the execution, resource sified portfolio and the monitoring it over and investment requirements for these op- time. Running a process end-to-end is con- portunities are much higher.” siderably more difficult.” Du Roy also points out that determining “We ask our GPs this question every if an investor is adequately set up to partici-

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PHOTOGRAPHY: JULIAN WINSLOW

Corentin du Roy Kate Ashton Raja Hussain Managing director, HarbourVest Partners Partner, Debevoise & Plimpton Director, BlackRock Private Equity Partners Corentin du Roy joined HarbourVest Kate Ashton is a corporate partner at in 2003 and focuses on direct co- Debevoise & Plimpton with a broad Raja Hussain is a member of BlackRock investments in buyout, growth equity international practice, including Private Equity Partners’ investment team, and mezzanine transactions around the extensive experience in Europe and based in London. He is responsible world. At HarbourVest he has worked on the US in private equity transactions, for co-investment and co-underwrite deals including Deliveroo, Eaton Towers, corporate finance, debt and equity transactions in EMEA across a range Klarna and Marle. He joined the Firm offerings and restructurings. She of sectors and deal sizes. Hussain from AXA Investment Managers, where counsels private equity and other previously worked in the private equity he was an equity and high-yield debt investment funds on corporate and coverage team at Citi. He began his research analyst focusing on the telecom securities matters. Ashton is dual- career at Ernst & Young where he was a sector. qualified in England and the US. chartered accountant in the M&A team. .

James Pitt David Morse Nick Kavanagh Partner, Lexington Partners Managing director, Neuberger Berman Vice-president, Hamilton Lane

James Pitt is a partner of Lexington David Morse is a managing director of Nick Kavanagh is a vice-president on Partners responsible for international Neuberger Berman and the global co- Hamilton Lane’s global investment co-investments. Prior to joining in 2006, head of private equity co-investments. team. Based in London, he focuses Pitt was head of the London office of He is also a member of co-investment, on co-investment transactions. Prior AXA Private Equity. He was previously private debt and private investment to joining Hamilton Lane in 2017, he a managing director of JH Whitney & portfolios investment committees. Morse worked on co-investment transactions at Co and a vice-president in investment joined Lehman Brothers in 2003 where Temasek International and at Pantheon banking at Morgan Stanley. Pitt has a BSc he helped raise and invest Lehman Ventures, as well as at Gresham Private (Hons) in Management Science from City, Brothers Merchant Banking Partners Equity. Kavanagh has a BSc from University of London, and an MBA from III. He was also previously a founding Cardiff University and postgraduate INSEAD, France. partner of Hampshire Equity Partners. qualifications from Warwick University.

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pate in the co-investment market can come In co-underwriting situations, more down to the health of the broader economy. “[Co-investors] need deals fail, Ashton says. “They may be [equipped to take part] “Particularly with the trend [in Eu- in a market that is only going well and with to take the bruises rope] toward public-to-private transactions, an economy that is supportive. I advise our which are inherently less predictable and LPs when they tell me they want to get into with the rewards. riskier, the deal may collapse. Co-investors co-investment that they need to have the re- need to assess the likelihood of a deal not sources to cope with a crisis, and a market Provided your proceeding and the cost. Some are not set in which a number of their companies may up to do that and won’t take that risk. Syn- struggle,” he says, adding the co-investor are portfolio is sufficiently dications are less time-pressured – the deals likely to be called upon to make tough deci- arrive more slowly, are calmer and frankly sions on whether to provide follow-on cap- diversified and you the co-investor has less negotiating power.” ital in situations where they may no longer In public-to-private transactions, where be fully aligned with the lead investor. have that breadth the disclosure burden can be heavy for companies in regulated industries and legal costs Public to private of dealflow, you can can soar, “the bar is high and I think for “The co-underwriting world has become these deals we often don’t see other co-in- more exciting and interesting,” says Kate potentially take the hit vestors than the ones around this table or Ashton, partner at Debevoise & Plimpton. similar organisations participating”, says du “Particularly with the larger stakes that of broken deal costs on Roy. some co-investors are taking, LPs can’t just It is surprising how many co-investors put their money in and wait. Even when a transaction” are not positioned to participate in pub- investments are not in crisis, unexpected lic-to-private transactions, notes David events occur, and if you have a significant Morse, global co-head of private equity RAJA HUSSAIN stake in a company you need to monitor that BlackRock Private Equity Partners co-investments at Neuberger Berman. and pay attention to it. I’m not sure every- “Those co-investors who want to play in the one in the co-investment market is equipped co-underwriting space typically need to ex- for that.” ecute equity commitment letters, as well as

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be willing to stand up for dead deal expenses plex. Du Roy notes that HarbourVest will and reverse break-up fees. There are lots of supply equity to “warehouse” a transaction significant co-investors who cannot or will on behalf of a GP that may be in between “I can think of only not subject themselves to that.” fundraises. Raja Hussain, director at BlackRock Pri- Morse says Neuberger Berman will of- one GP that charges vate Equity Partners, agrees. “Executing a ten agree with a GP to syndicate part of its pre-bid co-underwrite requires a different co-underwriting stake post-close. “Just as carry to their capability and skill set than a completely long as we’re guaranteed on a minimum signed-up deal with price validation, lever- hold, we’re generally comfortable doing it. fund LPs on age structure and terms in place. A mean- And we better be ready to hold all of the ingful percentage of transactions we see stake if their subsequent syndication is not co-investments” are co-underwrite. Then it’s a question of successful,” he adds. what resources the co-investor can bring to However, Ashton cautions: “These sort JAMES PITT the table to help enhance the due diligence of creative strategies are not for everyone. Lexington Partners process. There are a lot of LPs coming into You need to have a team that can do the the market trying to source deals but don’t analysis and the due diligence necessary to have the capability to co-underwrite and ex- take that level of investment.” ecute.” That said, the syndication market poses its challenges too. “Securing an allocation is getting tougher,” says Morse. “LPs don’t do the work expecting to get winnowed down. [In contrast] when you co-underwrite, you pretty much get what you ask for.” The biggest difference between co-underwriting and syndication is that “the GP is not trying to sell you into the transaction”, says du Roy. “On a co-underwrite they don’t know yet if they want to proceed with the deal. Their primary focus is on establish- ing a valuation. As a co-investor, you have a more transparent relationship with the GP and in return, you need to be flexible. A GP can come to you at the 11th hour and you need to act fast.” Ashton agrees the pace to close a transaction has picked up considerably. “We are talking days [to assess a deal]. It’s really important for our [co-investor] clients to have a large and dedicated team. And as service providers we need one too.” For a co-investor seeking to maintain a good relationship with GPs, it’s crucial to be able to turn down an opportunity very quickly to free them up to talk to another potential interested party, adds Ashton.

Picking up the pace Tighter timeframes are crucial, says Morse. “You can’t say my board meets once a quarter or the next one is at some point in the future. Neuberger Berman Private Eq- uity has two standing investment committee meetings a week. We have our IC wired to be available when they need to be.” In an increasingly mature market, deal structures are also becoming more com-

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Fees and returns warrant navigating that cost dynamic.” demand for co-investment persists large- Should a co-underwrite deal fail, the allo- Hussain takes the view that co-investors ly unchallenged. “I can think of only one cation of broken deal expenses is an issue “need to take the bruises with the rewards. GP that charges carry to their fund LPs on co-investors grapple with. Panellists say Provided your portfolio is sufficiently diver- co-investments,” says Pitt. co-investors generally take their pro rata sified and you have that breadth of dealflow, But that might change. “The majority of share of monitoring, refinancing and exit you can potentially take the hit of broken the market is still no fee/no carry provided fees. deal costs on a transaction, which we would you’re an LP of the fund,” says Hussain, “There’s scope to negotiate on those fees consider selectively on a case-by-case basis”, adding that “at the margins certain GPs are particularly if, as a co-investor, your involve- he says. testing the market by trying to overlay some ment is critical to that deal,” Kavanagh says. In the broader fee landscape, just like element of economics to rein back some of “If you are an enabler there’s likely enough the “two-and-20” regime applied to funds, that supply of co-investment capital”. value add from you as a co-investor to try to the no fee/no carry arrangement driving And there are other less obvious costs.

“We are talking days [to assess a deal]. It’s really important for our [co-investor] clients to have a large and dedicated team. And as service providers we need one too”

KATE ASHTON Debevoise & Plimpton

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“Looking at the total drag of economics ently outperform some of the best GPs out on a deal, the management incentive plan there? You might get lucky occasionally. As “Co-investment is usually a meaningful part, and there are long as generally you’re able to source quali- certain GP costs and expenses that are im- ty dealflow from a top tier group of GPs you co-underwriters plemented onto the portfolio company, like should do well. But if you’re consistently top monitoring fees that can result in dilution,” decile, I’d be very surprised.” are few and far he says. So, given the effort required, does co-in- Competition between because the vestment actually boost returns? In the quest for co-investment, capital is not “What’s missing from the question is, everything. Would-be co-investors need to execution, resource at what risk?” notes du Roy. “That’s the stand out from the crowd. One way to do element that is often underestimated. Yes, that, says Pitt, is by “being proactive and and investment you can aspire to top decile performance by highly responsive”. trying to build a more concentrated portfo- “Repeat business with GPs is hugely requirements for lio. However, our advice to our clients is to helpful. You’ve not only got to provide fund build a well-diversified co-investment port- capital yourself, but also help with things these opportunities folio to achieve strong performance that is like making capital introductions to new accretive, but without taking undue risk.” prospective LPs.” are much higher” Some co-investment fund managers go a Nothing can replicate repeat business, step further and claim they can outperform says Kavanagh. When positioning GPs on plain vanilla co-investments, says themselves to see dealflow, how early and CORENTIN DU ROY Pitt. “I think, really? Desktop research, per- frequently a co-investor can engage with the HarbourVest Partners haps not meeting the management team and sponsor, and specifically who at the manager never really getting properly under the skin they talk to, are important, he says. “We of a business and you think you can consist- are engaging more with GP sector teams

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Downturn? What downturn?

“The prevailing general wisdom every year for the past five business underperforms and hits covenant levels is yet to be years has been that we’ve got another 12-18 months before we tested, but our view is they will take a different view relative to enter a recession,” says Pitt. Lexington’s response is to focus on the banks and be more collaborative with GPs.” diversification, limiting single investments to 1-2 percent of its portfolio and ensuring “right business, right capital structure Defensive portfolios and right sponsor – one you clearly think can manage through Ashton stresses that as a potential downturn approaches, it’s a downturn. important for co-investors to have the resources to continually “You’ve got to be adequately resourced. It’s going to be monitor investments. extremely interesting to see how those more recent co-investor “The people who are going to do best are the ones who are entrants react come a market downturn. Their institutional willing to commit the time and energy to figuring out what can experience is much shorter.” be done. There may be companies that face temporary periods When Hamilton Lane assesses a deal, it’s looking not only at of distress and can be pulled out of it, but it will take a lot of whether the sponsor is the right owner of the business, but how dedication and effort.” reactive or pre-emptive that sponsor has been historically in For Morse, defensive portfolio management is key. “We’ve preserving value, says Kavanagh. been building a defensive portfolio for four years now. We seek “With the amount of dollars people are investing, the to avoid cyclicals, heavy capex businesses and heavy working natural inclination [for a co-investor] might be to roll up your capital businesses,” he says. Buying larger businesses can help sleeves and see if you can engage with a business yourself, but weather the storm, he adds. we believe that it is important to maintain trust in that GP and “We would prefer to buy a $150 million EBITDA business consider such a potential scenario carefully when choosing to over a $15 million EBITDA business if they are going to invest. It will be interesting to see how harmonious that co- trade at that same multiple based on our expectation that a investor/GP relationship remains going forward.” larger business would have a deeper management team, better However, the rise of covenant-lite debt financing and the access to capital markets and would be national not regional, proliferation of private debt funds means “there’s a significant international not domestic,” Morse says. amount of de-risking in the market now, relative to pre-financial Such businesses are typically in industries with more barriers crisis”, says Hussain. “How these funds will react when a to entry and as such have a reason to exist, he adds.

“We are engaging more with GP sector teams to ensure we’re front of mind when they look at situations”

NICK KAVANAGH Hamilton Lane

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“Securing an allocation is getting tougher. LPs don’t do the work expecting to get winnowed down. [In contrast] when you co-underwrite, you pretty much get what you ask for”

DAVID MORSE Neuberger Berman

to ensure we’re front of mind when they keeping an eye on trends. look at situations. For example, if we do a “Software, financial services, healthcare, TMT deal with a sponsor and it’s a good anything heavily regulated, we have people experience for both sides, going forward who have gravitated to those sectors and it we’re increasingly getting a call from that certainly helps,” says Morse. However, he deal partner directly.” adds, “co-investment is an opportunistic At the portfolio company level, underly- business and you don’t know if the deal is ing management teams are curious to get to going to be a retailer one day or a business know the investors and are requesting meet- services company the next. You have to be a ings early in the process. generalist at some level”. “We can overlay some diligence into And then there is the issue of resources. that, so it’s mutually beneficial and it’s also “There’s GP overlay and geographical over- good courtesy to show management teams lay,” says Pitt. “The reality is, co-investing who you are.” is a complex matrix and there are certain Mirroring increased GP specialisation, sectors where there is sufficient volume to co-investors are becoming more adept in make specialisation worthwhile. But our certain sectors, learning the language and teams, at the end of the day, are finite.”n

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