May 13, 2014
Interviewed by: David Snow
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Navigating the Co-invest Allocation Process

Co-investment experts tell Privcap about the right and wrong ways for GPs to offer co-investment opportunities to LPs and external investors. With Chris Stringer of Private Advisors, Richard Dunne of AlpInvest Partners and Brian Gallagher of Twin Bridge Capital.

Co-investment experts tell Privcap about the right and wrong ways for GPs to offer co-investment opportunities to LPs and external investors. With Chris Stringer of Private Advisors, Richard Dunne of AlpInvest Partners and Brian Gallagher of Twin Bridge Capital.


Navigating the Allocation Process

The Rise of Private Equity Co-Investments


David Snow, Privcap:

Today, we’re joined by Chris Stringer of Private Advisors, Rich Dunne of AlpInvest Partners, and Brian Gallagher of Twin Bridge Capital Partners. Gentlemen, welcome to Privcap. Thanks for being here.


There’s a very important aspect of co-investing that happens when a deal becomes available. It’s called the “allocation process” and some people even call it the “allocation game,” where a GP will approach potential co-investors about an opportunity. I’m told there’s no one way of doing this and, in fact, it has led to some head-scratching in the industry that there’s not more process or policy in place to go through the allocation process.


Brian, as a long time co-investor at Twin Bridge, investing both in primary funds and in co-investment opportunities, what have you seen as the range of allocation methods GPs use? Are there any that are better, in your mind?


Brian Gallagher, Twin Bridge Capital:

It really falls into one of two buckets. If there’s a deal that needs 40 of investment and that sponsor has 10 LPs that theoretically want co-investment, they’ll show it to all 10, see who comes through and then, allocate based largely on allocation to the underlying fund. That’s the most common.


Some GPs will do it sequentially, where they’ll show this deal to three LPs or five LPs who want it, then, the next deal to the next three to five LPs. Either way, it can work. In the co-investment world, a lot of GPs will tell you they have 10 or 12 LPs who theoretically want co-investment, but five are very reliable and three are exceptionally reliable. If you are a serious co-investor, you want to be in one of those latter categories. That’s what we try to do.


There are policies that people are starting to put in place. But one key in my mind is you need to have co-investors who are responsive and the GP needs to have flexibility in how they allocate because, ultimately, they’re trying to put capital together to get the deal closed and they need LPs who can get across the finish line.


Snow: AlpInvest has shown a lot of co-investment opportunities. Do you have a view on certain allocation policies that tend to be better or fairer among GPs?


Richard Dunne, AlpInvest Partners:

The range actually goes one step further but, fortunately, it’s more in the past. It’s that some GPs have actually gone to every LP in their fund and allocated transactions on a pro-rata basis. To us, that doesn’t work very well. Many of the LPs can’t respond to the deadlines or aren’t even really interested in co-investment to begin with. Then, when you’re going through your investment process as a serious co-investor, when your range of outcomes is between $3 million and $30 million, it’s tough to get oriented properly around the transaction.


On the flip side for us, what we do to improve our position with respect to allocation is really participating in transactions before they’re announced. Getting involved in a deal at the first management meeting or right when the GP gets the information memo on a transaction really helps you to secure better allocations as you move forward.


If there’s anything that frustrates us, aside from the process where it’s run to sort of all LPs, it’s when an LP tries to game the system. Our check sizes go up to as much as $125 million or so in a given transaction. We’re very deliberate over sizing, whether we want to do a mass check or do half that amount or somewhere in between. When we say we want “x” million, that’s actually what we want to hold. But a lot of times, where it’s competitive allocation, process-limited partners will say they want $50 million and really they want all of $20 million and they’re designing themselves around getting to $20 million. It makes it harder for the GP to figure out how to allocate and we understand their pain.


Chris Stringer, Private Advisors:

From our perspective, the ideal allocation policy is where it’s GP discretion and that’s what it says in their limited partnership agreement. We write small checks and raise small co-investment funds. Our ideal deal is one where we round out a capital structure with a small check, maybe one or two other co-investors in there, but not large syndicates. We want to get the co-investment and get the allocation through being top amount with the manager on the front end of the deal at the LOI stage.


Frankly, we get disappointed where the lenders offer more leverage, the check size shrinks at the end of the deal, we’re the only there as a co-investor, and we get cut out of the situation. That is the situation we get most frustrated with, at least in this market environment.


But, from a trend standpoint in the lower end of the middle market where we focus, we are seeing some investors get aggressive through side letters when they invest in primary funds looking for priority allocations to co-investments. We really don’t like going into funds where that’s the situation.


Snow: I’m glad you mentioned LPs gaming the system. That indicates an increasing demand to co-invest and a huge interest in co-investing among more and more LPs. Isn’t that going to create more situations where you have all these LPs clamoring to be part of a co-investment? It just makes the allocation process that much more difficult for a GP to show discretion because discretion could also mean you’re granting a favor to one group where another group feels left out and egos are bruised. How do you mitigate against that happening?


Gallagher: There are a lot of co-investors who say they want to do deals, but cannot get there in time. They just can’t. If you are a good and serious co-investor, you should be able to move in lockstep with the sponsor from time zero. We always get in on the ground floor. We do diligence alongside the sponsor. If they have an issue with the deal or we have an issue on the deal, we’ll pull out and usually they’ll pull out, because we’re seeing things the same way. But we want to be adaptive, too, because capital structures do change, circumstances change and purchase prices change. The way you distinguish yourself as a co-investor is to be timely, responsive, flexible and adaptable. You can really improve your allocation by being a reliable and trusted partner.


There are certain rights we need, legal and otherwise, but they’re fair and reasonable and our sponsors understand that. We don’t agitate for something that’s utterly unfair. Some co-investors do and that’s to their detriment in the long term.


Snow: Are these side letters that are popping up granting guaranteed access to a certain level of co-investing? Is that bad for co-investing because it might give greater co-investing muscle to an LP that maybe shouldn’t have it?


Gallagher: We don’t see too many side letters seeking out co-investment because most of the sponsors will say, “I’m giving it to everybody.” You can have a side letter, but so can everyone else. If that makes you happy, great. It doesn’t change the dynamic at all. Side letters still do exist, but in our experience, most GPs and even most LPs are trying to get away from that process because it can consume a lot of time, money and effort with the attorneys. So, we don’t see too many side letters.


I will concede that, early in a fundraise or to get a first close, there can be things that are done through side letters. But, at this point, co-investing is so common and so embedded in everything going on in the LBL world that it’s just understood for a new LP: Are you interested in co-investing, or are you not? I need to be able to check that box. If you are, what’s the typical profile deal? Sponsors are sizing all of this up. At the final close of the fund, they know exactly what the landscape is.


Snow: What are all of your views on GPs offering co-investment to LPs who are not currently their LPs? Does that sometimes rub you the wrong way because you say, “Hey, they invested in your fund and now you’re giving allocation to someone who’s not in your fund?” Does it ruffle feathers?


Gallagher: We don’t see that much. On the part of most sponsors, there’s more than sufficient demand among their LP base. The corollary to that would be a sponsor of a $500-million fund has a deal that requires $110 million of equity; they want to hold $50. Instead of going to their LPs, they go to another sponsor and share the deal.


Now, that brings up a question: Did you really need to go outside your LP base to get this done? It comes back to what makes a co-investor. If you don’t think there are enough LPs in your investor base who could get across the finish line in the timeline needed, then maybe they had to go outside. We don’t see too many funds doing that. It does exist, but we don’t see it often.


Dunne: From a commercial perspective, if you’re trying to be a good and flexible partner to your GPs, if they’re toward the end of the life of a fund and see the need to bring in some new investors or potential new investors to help the next fundraise along, you can put up a fight, right? But, at the end of the day, you’re not going to win and it’s not going to benefit you or the GP or the relationship. As long as you’re not disadvantaged materially, there should be room to make those situations work.


We’ve actually had two examples recently where one deal we were already invested in. It was a follow-on round. The follow-on round was actually much larger than the original investment. We were able to step for more than what our pro-rata amount would have been, and then, the rest of the co-invest was brought in by new LPs actually on a promoted basis and we don’t pay fees or promote a co-investment.


It was a challenge to tell this GP to not develop a relationship with two brand-new LPs and take economics on the transaction.  It was a small deal overall and, from our perspective, it helped incentivize the GP more. Bringing in a promoted co-investment just made their economic stake in the deal that much more important.


Stringer: I’ve seen third parties come in where they can do something unique like backstop a syndicate ahead of a sell-down to the LPs to give the GP certainty, but it’s rare. It’s only in the situations where you’re at risk for a potential failed next fundraise and you need to broaden your LP base. It’s where we as co-investors then worry about quality of sponsor in those situations.


Snow: What drives you crazy about the allocation process? Is there anything that has happened that annoys you and you want to make sure GPs or other LPs out there should avoid?


Dunne: Not much, speaking on behalf of the other panelists, given the comments already. The way we get around the things that would make you crazy in the allocation game is by getting into transactions early. We’ve had a few side letters in the past. That hasn’t really been a focus for our business. We don’t think it is the best way to differentiate your co-investment capabilities. It’s really just doing transactions with the GP.


Snow: So, by the time the sixth deal in a fund comes around and you’re not getting the phone calls, an LP, there’s probably a good reason you’re not getting phone calls?


Dunne: GPs will still call, because they care about managing their LP relationships and it makes a lot of sense to me. We’re the same way with our LPs who are interested in co-investment. You keep getting “no’s” or you get slow responses, but you want to still make those calls to manage the relationship. You’re operating on the expectation that these five calls aren’t going to go anywhere, but these five calls are the ones I’m going to have to follow up on.


Gallagher: This is human nature at some level. You can advantage yourself. It’s hard to quantify, but you need to be smart, responsive, likeable and adaptive, because when you get into a deal, sometimes things don’t go well. Are you a supportive co-investor or are you griping and walking away?


Stringer: The human-nature element of top of mind drives me crazy. You’ll have a great relationship with a set of sponsors, and unless you’ve been interacting with them recently, you haven’t reminded them about your co-investment program and your co-investment bite size. Sometimes, you’ll hear about a deal getting done and you weren’t in the mix and just how powerful top of mind is in our business. It’s why we have to be so systematic about sourcing and use our entire private equity team and track the interactions.


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