May 13, 2014
Interviewed by: David Snow
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Riding the Co-investment Wave

Why has demand for co-investment surged in recent years? Chris Stringer of Private Advisors, Richard Dunne of AlpInvest Partners, and Brian Gallagher of Twin Bridge Capital Partners discuss their respective co-investment platforms and how these platforms have evolved with the rising interest in co-investment.

Why has demand for co-investment surged in recent years? Chris Stringer of Private Advisors, Richard Dunne of AlpInvest Partners, and Brian Gallagher of Twin Bridge Capital Partners discuss their respective co-investment platforms and how these platforms have evolved with the rising interest in co-investment.

Riding the Co-Investment Wave

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. Thank you for being here.

We’re talking about co-investing and it is a hot topic. All of you can share evidence that it is becoming increasingly popular among limited partners and an increasingly important part of the private equity landscape. I’d love to hear your perspectives with regard to how to structure the right co-investment program. We can start with brief descriptions about the various platforms that the three of you have built. Let’s start with Chris at Private Advisors. Can you talk about your co-investment platform?

Chris Stringer, Private Advisors:

Sure. Thank you. My name is Chris Stringer. I’m a partner at Private Advisors, head of our private equity group. We manage $5.3 billion in assets under management. We focus on hedge funds and private equity investments, specifically on behalf of endowment foundations, pension funds, and etcetera. Our private equity business is very niche-focused. We focus on growth equity, buyout and turnaround-oriented investors operating in the lower end of the middle market in North America. What I mean by that is sub-$150 million enterprise value, typically funds of $750 million and below.

We’ve made over 90 fund investments since the late ‘90s, since we were founded in that target market, and that is exactly where we co-invest. We’re very specifically focused. We offer our co-investments through distinct funds similar to a direct two-and-20 fund, just with a bit more diversification. We invest in 15 to 25 companies over a three-year period on behalf of investors.

Snow: Obviously, we want to learn more about your various programs but let’s move down the line and learn from Rich at AlpInvest. How have you structured your co-investment platform?

Richard Dunne, AlpInvest:

By way of background, AlpInvest is a global fund-of-funds manager dedicated completely to private equity. Now, we’re essentially the private equity fund-of-funds platform of the Carlyle Group and we operate on a completely independent basis from an information perspective. There are strong barriers with respect to any information on our investments that makes its way to Carlyle.

We serve on behalf of mostly large pension funds from our client base. Our former owners are still our primary source of capital, but, over the last few years, we’ve been very successful in bringing in some new investors to our programs, particularly with the secondaries fund and then, also on the broader platform.

In co-investment, the way we go to market is, our business is defined by product. We have a very large primary funds program—a team of about 25 professionals investing on that platform globally—and a similar-sized team in secondary investments and in co-investments.

I spend all my time in co-investments. I’ve been with the firm about 10 years.

Snow: Brian, you can talk a bit about the platform you’ve built at Twin Bridge?

Brian Gallagher, Twin Bridge Capital:

Sure. We’re based in Chicago. We manage about $1.5 billion. We invest exclusively in middle-market buyout funds, funds usually between $200 million or $1.5 billion in North America. One asset class, one geography. Unlike a lot of our peers, we manage structured separate accounts and we put funds and co-investments into the same vehicle. It’s about a two-third to one-third split right now. It varies a bit based on co-investment—

Snow: With one-third being on the co-investment side?

Gallagher: One-third being on the co-investment side. We only invest in buyout funds that we’ve underwritten our investors in. We’re fairly exclusive to that group.

Snow: I’d like to learn more about the thinking that’s gone into the way you’ve structured your co-investment programs. But first, can we talk a bit about the rising interest among LPs in having access to or directly investing in private equity deals? Let’s start with Chris:  what evidence do you see that this is indeed a sustainable trend and interest is rising? What is behind it?

Stringer: The interest is increasing due to a desire on LPs part to minimize fees or to average down fees. Private equity is a very expensive means of investing over a long period, with a 2% management fee, and 20% carry, typically. The ability to get exposure to direct deals and augment a portfolio of funds at no fee/no carry and average down that two and 20 is very appealing to a number of investors. We see a lot of the larger pension funds coming into the co-investment asset class, either through an outsource provider or through staffing up themselves with a desire to average down their fee burden.

As for other reasons for co-investing, certainly, there’s the concept of portfolio management. You can add to your diversification in a private equity portfolio and you have control on the co-investment over what industries and markets and geographies you put in the portfolio. Also, you have a bit of real options thinking.

Snow: Rich, what have been some primary drivers of the growth of the AlpInvest co-investment platform?

Dunne: For us, the program has grown around how the market has evolved over time. We started co-investing right about when co-investing became en vogue for larger pension funds and fund-of-funds. It was more of a syndicated market for co-investment.

But, essentially, the co-investment supply and demand is based on need in a transaction. We’ve seen that GPs have “clubbed” much less over the last few years, particularly in a strong deal-making environment. In past strong deal-making environments, you saw GPs “club” a lot more and you’re seeing GPs use LP co-investment in an active setting prior to a transaction being announced to help them secure a deal. For us, the largest part of the growth of our ability to deploy capital has been around developing capabilities and building out a team of a size such that we can pursue transactions like that.

Snow: Brian, you mentioned that about one-third of the capital that you put to work now is in direct situations. How did your co-investing evolve from the inception of your firm?

Gallagher: It can vary. Right now, purchase prices are quite high, so co-investment deal flow is not that robust. As our colleagues do, we invest with experienced sponsors—they know when prices are too high and you have to underinvest. There were times post-crisis where there was some interesting deal flow and it was a great time to put money to work. You tend to try to overinvest in the down markets. You can’t market time and we know that. So, that’s one approach.

Running off what Chris said, there are some obvious reasons to co-invest. There are the economics. There’s the minimization of the J curve, which is very meaningful. We ascribe a lot of value to the qualitative benefits. When you can work with a sponsor and see how they source, structure, manage and position for exiting a deal, it’s invaluable information when you’re getting ready to do the re-up decision. The qualitative should never be underestimated.

One theme you’re hitting on is that a lot of people are getting into co-investment under the guise that it’s embedded deal flow and it’s easy. It’s not easy. You have to think through how you’re building your portfolio. You have to mine exceptional deal flow. You’ve got to work with the best sponsors. But it’s a relationship business and you can screw up a relationship quickly if you cannot get there in time, move in lockstep with the sponsor, etcetera. It’s interesting that so many people are throwing their hat in the ring to be co-investors, thinking that it’s not hard. It’s not impossible, but it’s not easy.

Dunne: It does seem, as we’ve seen in past cycles, that the money flows in at the worst time. When transaction prices are high, deal sizes get larger and there are liquid debt markets. You see a lot of LPs get more interested in co-investment at that time, stub their toe, then pull back when it’s actually the best time to put the money out, to echo Brian’s comments.

Gallagher: Co-investment has evolved and matured a lot in the last five years. It’s a constant in our industry. LPs want it and GPs need to provide it. It’s a constant topic on the fundraising trail.

Snow: Chris and Rich, do you agree that having a co-investment platform actually allows you to also be better primary fund investors?

Dunne: Yes, certainly. It’s been a big help to our due-diligence process, particularly because, in many cases where we’re co-investing, we’re taking some sort of role at the board level. Not only are we there seeing the full deal-making process as it relates to the GP—the work they do in due diligence, the focus they have and also what sort of discipline they have when pricing a transaction—but then, once a transaction’s closed, we’re there to see their role in creating value and driving strategy at the firm. That drives benefits to our platform as well as to the other groups in our firm to be able to make informed investment decisions on those funds.

Snow: Without naming names, is it indeed the case that many GPs are very different and are noticeably different once you get into the actual deal with them?

Dunne: You see a clear difference between how large-buyout GPs operate versus middle-market GPs operate. That actually makes sense for the types of businesses they’re running.

On the large-buyout side, you’re buying companies that are much more mature in their growth profile. Chances are, if you’re striking a deal, you’re buying a company you believe to be undermanaged. So, there’s more to do from an operational perspective and getting involved in some key functions of the company—it just makes more sense at that end of the market.

In the middle market, you’re usually partnering with a management team and trying to help them take their company to the next level. So, it’s a softer level of interaction, but both have their role.

Stringer: I would agree with that. Our portfolio is lower-end market and mid-market focused. We’re assembling for our investors on the primary side of business a collection of specialists. We’re looking for actively sector and strategy-focused managers that can build better businesses, buy from a founder/owner or a family, etcetera, and systematically improve a business.  That’s’ the marketing spin during the fundraise process. You get into co-investment deal flow and you can really get underneath how specialized they are and how they approach these management teams. Can they systematically recycle them and improve these businesses? It’s tremendous information flow and, in fact, we entered the co-investment business directly for the information flow ahead of trying to actually offer a marketable product. It was an idea of getting an information edge and augmenting returns a bit.

Gallagher: We should draw a distinction. I agree with my panelists: large, mega buyout-type co-investments are very different from middle market. We should define middle market: we look for companies on the co-investment side and the fund side that are $50 to $500 million, plus or minus, in enterprise value. Like Rich, we are active co-investors. We take board seats where we can. We like to be at the board table seeing how these sponsors operate. If you are going to do a multibillion-dollar enterprise value co-investment, you’re probably going to get a book of diligence and an inquiry, “Do you want to do it and, if so, how much? We’ll get back to you.”  That’s a very different animal from what we do.

We like the middle market because it’s less competitive and there are more levers to pull on the operations side. There are greater returns in the middle market, especially relative to the risk. You want to be on the inside to see how theses sponsors create value.

This industry’s gotten extremely mature and competitive. It’s not easy to make money on the buy. You make most of your money over the term of owning that investment. We spend a lot of time with our sponsors at inception, asking, “What are your plans with this business?” Then, we see how they measure against that original plan.

It’s also very important what distinguishes the best sponsors. This is very notable when you’re making the re-up decision; deals don’t always go the way you think they will and sponsors will sometimes give a questionable CEO, who doesn’t seem to be performing, two years when they should give him or her two quarters. Being able to make the quick, decisive action and taking that action is very important to driving value, in our experience. In our experience, things have fallen down where people convince themselves that this is going to get better.

Private equity is such that you have a limited timeframe in which to drive value. Five- to seven-year holds is about as long as you have. If you start out the first couple of years with no real progress or even detrimental effects because value has been destroyed, that’s a big problem. Those are the types of things we look for when evaluating a sponsor on the inside of a co-investment.

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