February 20, 2013
Interviewed by: David Snow
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Co-Investment Done Right

A co-investment program gives an LP a “front-row seat” to the due diligence and underwriting techniques of GP groups, according to Nitin Gupta, a Partner at New York-based Caspian Private Equity. In a Privcap interview, Nitin discusses his firm’s direct-investment network and capabilities, tells what is driving demand for co-investmnet dollars among both GPs and LPs, touches on the “negative feedback” that club deals have received, and describes the limitations that many LPs have with regard to direct investing.

A co-investment program gives an LP a “front-row seat” to the due diligence and underwriting techniques of GP groups, according to Nitin Gupta, a Partner at New York-based Caspian Private Equity. In a Privcap interview, Nitin discusses his firm’s direct-investment network and capabilities, tells what is driving demand for co-investmnet dollars among both GPs and LPs, touches on the “negative feedback” that club deals have received, and describes the limitations that many LPs have with regard to direct investing.

Privcap: How have you successfully built out a network for co-investments?

Nitin Gupta, Caspian Private Equity: So you know, I mean, in my opinion I think the network is really a function of a number of things. One, I would say is the fact that our team has extensive background in the financial services, in the private equity space. I mean if I look at myself, I’ve been doing private equity now for over 15 years, and all in the middle market and growth sector. Two is the fact that we have a fund of funds program where we’ve invested in over 60 US focused private equity funds. Third is I would say is that we provide more than just capital. And then the GPs know that, they understand that, and most of our companies we help them either source or sell products into Europe or Asia. And so we are much more value added partner for many of the GPs.

And lastly, making co-investments is a direct focus for us. It is an independent fund by itself. It’s not a bucket of the fund of funds. And so I think combining all of those four elements is really what’s necessary to have a successful co-investment program.

Privcap: What’s driving demand for the co-investment model?

Gupta: So I think the demand is actually driven from both sides, from the GPs as well as the LPs. I think on the GP side what’s driving them towards more co-investment dollars is one, while the credit markets have come back quite robustly over the last couple of years, they’re still not as frothy as they were back in the ’06, ’07 time frame. So as a result of that, the amount of equity going into deals is higher than it was during the boom time. And as a result, they need more equity and they need more equity dollars from potential co-investors or minority investors into their deals.

Secondly, there has been a trend away from the club deals, and that might be due to a lot of negative feedback that many of the GPs have received from LP community. Which, they definitely did not like the club deal model. There’s also a lack of control in the club deals, and there might be also the fact that they’re sharing deals with other potential competitors of theirs.

And so all of that is actually also driving many of the GPs away from sharing their deals in the club deal model. And I would say that the third is that fact that many GPs, many times, invest in deals that are slightly larger than what their fund would allow in terms of size. And that, as a result, co-investment allows them to dial down some of the risk exposure on any one particular transaction.

On the LP side, I think what’s driving is the fact that one, it allows you potentially get higher returns without the fees. And secondly, it gives the LPs a front row seat into understanding how a GP does diligence and actually underwrites these investments.

Privcap: What qualities make a particular LP an attractive co-investment partner?

Gupta: So in terms of the LP base, I think there’s a few things there. And one is you need to have a very direct effort to make direct investments. For us it is a direct effort to do this. Secondly, I would say it’s that you need to be able to respond quickly to the GPs when they bring a co-investment opportunity to you. You need to be able to analyze it pretty rapidly, you need to be able to have a viewpoint on it and be able to go back with them and say, this may or may not work.

If it doesn’t work, have a list of things as to why there are potential risks in there that you may not want to go ahead with the investment. Where it’s not just saying, no this doesn’t work for us, it’s really here is the reasons why we’re not comfortable with this investment. And even if you do decide to go forward, you need to have a team set up where you can really respond to the GPs quickly. There are some LPs that basically drag the process out for very long time and at the end tell the GPs, we just can’t get there because our investment committee isn’t comfortable.

And again, that’s a function of the funds that are looking to do co-investments. Many times they are bucket of the fund of funds, and I think it’s because they are part of another fund it makes it tougher for them to really make the decisions.

Privcap: What resources does an LP need to be successful in direct investments?

Gupta: I think that depends on the type of co-investments that a fund wants to make. For instance, do they want to simply tag along on these deals, or do they do a lot of in house diligence? For us we do a lot of the in house diligence here and really go through the materials as if we’re making a lead investment to these companies and not just a co-investment.

The other aspect is how involved the fund wants to be post investment. So it’s a matter of whether they take board seats or not or whether they really help these companies grow. And as I said, I mean, for us we really help these companies grow internationally, so we are more actively involved.

The last piece is actually whether the focus of the fund is really doing more middle marketing growth deals or mega deals. The mega deals come much more prepackaged from the larger sponsors, so they are actually everything is done for you. In the middle market or the growth equity stage, many of these deals require a bit more legwork on the co-investment partner’s behalf. So they really need to do a lot more diligence themselves. So it really depends on where in the spectrum a fund wants to play.

Privcap: As an investor, what sectors most appeal to you today, and how would you describe the macro environment? 

Gupta: We’re a generalist fund, so we see a lot of deals across all different sectors. I think what is very interesting right now, we’re seeing a lot of deals in the business services space, in the food space, as well as the industrial space. Those three sectors have been fairly robust.

I think in terms of the overall deal activity, it’s lower than it was last year. But having said that, the multiples are much higher than they were in the past. And that’s just a function of the fact that there is a lot of capital, as everyone knows, kind of chasing deals in the private equity space. And the fact that the credit markets have been fairly robust. I think that’s driving up a lot of the demand for deals that are good. So we are seeing an increase in the multiple side.

Privcap: What does your research tell you about where we are in the recovery?

Gupta: So we mostly focus on smaller businesses in the US and they’re all US focused businesses. And what we’re seeing is there is an incremental demand there. I mean, as I said, we are invested in consumer goods, we’re invested in business services, and industrial companies. And in all of those spaces we are seeing pretty good demand in the underlying portfolio, where there is no financial engineering that’s being done to these companies. And it’s really more underlying volume that’s been increasing.

And so overall we think that the market environment is fairly stable in the US, particularly in the smaller inside where there is a good amount of demand for most of these companies goods and services.

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