May 13, 2014
Interviewed by: David Snow
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Digging for the Perfect Deal

Sourcing the perfect co-investment deal can be tough. Three experts in the field tell Privcap exactly what they look for in an investment partner, a deal structure and an asset. With Chris Stringer of Private Advisors, Rich Dunne of AlpInvest Partners, and Brian Gallagher of Twin Bridge Capital Partners.

Sourcing the perfect co-investment deal can be tough. Three experts in the field tell Privcap exactly what they look for in an investment partner, a deal structure and an asset. With Chris Stringer of Private Advisors, Rich Dunne of AlpInvest Partners, and Brian Gallagher of Twin Bridge Capital Partners.

Digging for the Perfect Deal

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.

All of you are co-investors, in addition to being part of organizations that also have significant investment programs. I’m interested to learn all about how you have built your co-investment programs—it’s a hot topic. One very important topic within co-investment is deal flow. If, as an LP, you want to be a co-investor, you actually need to see a lot of opportunities or you might not have the results you hope for. Let’s start with a question for Rich from AlpInvest. How important is deal flow to the co-investment process and how has AlpInvest built a substantial deal flow for itself?

Richard Dunne, AlpInvest Partners:

Generating deal flow and really widening your funnel is a critical component of our program and our success.  We work in a number of ways. Primarily, we source transactions through GPs we have a primary fund relationship with. As a primary fund investor, that’s deploying $2.5 billion a year in new-fund investments. Also, with a secondaries program, that’s investing $1.5 billion a year in new also LP investments. We have a wide funnel to draw from without too much proactive effort.

On top of that, we are extremely proactive with the GPs we’re invested with and, in some cases, in joint meetings with other groups in the firm trying to mine new GP relationships and see if we can develop those relationships through either a secondary or a co-investment prior to getting into a primary-fund relationship with them.

Snow: You would invest alongside a GP that you did not have a fund investment with?

Dunne: We think about it very carefully, but about 10% to 20% of our co-investment volume comes from GPs that we don’t have a current relationship with. We’re not in their current fund.

A lot of times, we have some sort of angle, some other way. Either it’s a legacy investment for us or there’s a potential secondary coming up or we expect them to come back for fundraising soon and it might be a target primary relationship. Either way, it’s usually through our own efforts, pushing out the message around AlpInvest and developing a relationship with us through one or the other of our programs and then trying to build a relationship.

Snow: Brian, how does it work at Twin Bridge by way of co-investment deal flow?

Brian Gallagher, Twin Bridge Capital:

We invest on the co-investment side only with sponsors we are invested with on the primary side. We spend a lot of time monitoring and mining what we think are the best GP relationships in the middle-market buyout space in North America. Our most important criterion to success in co-investing is quality of sponsor. We want to make sure that, when we’re investing in a co-investment, it’s with a sponsor we know exceedingly well and have fully underwritten. Once you underwrite that sponsor, then it’s a constant dialogue.

That constant interaction is what unearths interesting deal flow and you can get, on the frontlines, some interesting opportunities. We really like to be an extension of the fund.

We’ve had certain conversations where a sponsor will say, “We have an interesting deal and we’re one of three in the process; we think we have an angle but it’s quite large and we’re not sure it’s worth pursuing.” We will say, “Our bite size is ‘X.’ Let us look at that with you and perhaps we can collectively find the equity to pursue it.”

Snow: Chris, how does it work at Private Advisors as far as deal flow?

Chris Stringer, Private Advisors:

Similar. I’ll start by saying that we co-invest with managers where we’ve been in their primary funds and then, also with managers where we haven’t invested in their primary fund and it’s about a 60/40% split. The majority of what we do is with our underlying primary-fund managers. I mentioned that we’ve invested 90 funds historically in a very tight part of the market. That’s the lower-end of the middle market in North America—growth equity, buyout and turnarounds.

The main thing we’re doing is we’re on the advisory board on over 90% of the funds there. We’re very proactive. It’s amazing how much top of mind matters, even with your existing relationships. We have a systematic calling effort with our existing relationships to be top of mind for co-investment flow.

Aside from that, we cover a 900 to 1,000 fund-manager universe; we live and breathe the lower-end of the middle market in North America and have done so for 15 years. We do see a lot of opportunities for co-investment with pledge-fund managers or with managers where they’re looking to build a relationship with private advisors ahead of a fundraise.

We manage co-investing in primaries in different vehicles, so we eliminate the potential for a conflict of interest where we’re very clear on the front end of co-investment that if we make a co-investment, it cannot be tied to a fund investment and vice-versa. We do get a lot of flow because of that primary business and the desire to do business with us over time. It’s important.

Like Brian, we look at quality of sponsor first and foremost when we underwrite a co-investment. The main three things we’re looking for are, number one: quality of sponsor. Number two: we’re underwriting the fundamentals of the direct deal. Number three: the most important thing after that is we look for fit of sponsor. If I have a consumer and retail-oriented manager showing me an urgent care business that has a healthcare element to it, it might be multi-site retail and fit with their strategy, but it has healthcare. I’m not going to do that because that’s not a good fit with the sponsor. That’s a lot of what we look for when we’re outsourcing.

Snow: But to invest with alongside a sponsor whose fund you were not in requires double the due diligence, right? You have to spend time getting to know that sponsor’s overall track record.

Stringer: Absolutely.

Snow: That’s probably quite a lot of extra work.

Stringer: Yes. The bar’s higher. It’s more work. Our investment committee for co-investments has three components. Number one: we have the direct members of our co-investment team underwriting the deal on a primary basis. Number two: we actually include some of our hedge fund and corporate level folks because they have unique insights to industry data with some of our long/short managers on the hedge fund side. Finally, to your question about how we get comfortable with managers outside our primary base, we bring members of our primary team onto that investment committee. Their sole job is to assess quality of sponsor and that fit with sponsor in the transaction.

Snow: Rich, your chief economist Peter Cornelius recently wrote about this adverse selection in co-investing. When the subject of co-investing comes up, one often hears the term “adverse selection.” What does that look like in a co-investment context? How would an LP know they’re suffering from adverse selection and how would it manifest itself?

Dunne: First, the premise of the question on adverse selection is a bit unfair. The idea that a GP is going to syndicate their bad deals so to speak to their LPs is not really the case. What will happen is you will see vintage concentration that goes against what you’d want to do as a co-investor. That’s where selection comes in as being important. But, from the data that Peter put together, our deal set from our GPs actually compares favorably on a number of different measures relative to the total performance of the GP portfolio itself.  

There’s actually a much lower dispersion of returns; then, the median return is slightly higher of just the invitations that we see. For us, it’s about driving selection to improve from that point.

Gallagher: The adverse selection thing gets a lot of play and it doesn’t make a lot of sense. It’s very counterintuitive in a lot of ways. It can occur at some level when you have a sponsor going way outside their size range. A sponsor that’s doing middle-market deals and finds a company allegedly proprietarily that is a $2-billion enterprise and it’s outside the industries they know well. If you’re offered a big co-investment in that, that certainly can be adverse selection. But co-investment is so embedded in the culture of the entire private equity industry that if you irritate your LPs by purposely giving them a lemon deal… and we’re all very capable of determining how good or bad this deal is. In fact, we take an independent, dispassionate, objective point of view using the sponsor’s diligence and our own. We’re all accomplished investors and we can discern what a good deal is and what a bad deal is.

Snow: What are some initial reasons that all three of you would give a quick “no” to an opportunity? Talk about the initial screen you would use to look at a deal where—notwithstanding that you like the sponsor and you think they’re quality—it’s a quick pass.

Stringer: Fit with sponsor is an easy “no.” If we see a retail-consumer group show us a healthcare-oriented deal, we’re going to say “no” quickly. There are other reasons around valuation around the deal to the point made earlier—if the deal’s significantly larger than the typical deal a sponsor is used to doing, we worry about adverse selection and we may say “no” fairly quickly in that scenario. 

Snow: What would be a reason for a quick “no” at AlpInvest?

Dunne: All the same reasons. One of the first things we do is go through a full analysis of GP qualification in a transaction to make sure the GP has the track record and skills necessary to affect the investment thesis and the deal and then, also, valuation. You think about the market frothiness. We’ve seen a lot of deals that have been well overpriced, but relative to how companies in the space have traded in the past. As it relates to active transactions—because it’s the primary source of our deal flow—we think long and hard about getting engaged in transactions where it’s a highly competitive process. We try and understand the GPs angle across the board such that if we’re one of five or one of four in a deal that’s vying to win and it’s all financial sponsor thinking through whether there’s a strategic that might come into that process, what interaction does the GP have with the management team or other cohorts in the deal process to manage themselves—experience with the space, things like that? While we have a large team, with the opportunities we have, we can’t dedicate precious resources to every transaction we look at.  

There are always episodic reasons. If our portfolio is concentrated at the level we’re comfortable with in a given space, then seeing that next healthcare deal would be a pass.  

Stringer: It’s important to note that we actually sit in a unique seat relative to our underlying sponsors as well. From a pattern recognition standpoint, we’re invested in significant numbers of GPs and we see thousands of deals over the course of portfolios. We may see an inbound deal that’s great for a GP in the label-manufacturing space, but we have the benefit of seeing five private equity deals that have not gone well in that space historically. So, we may say “no” just because it hasn’t worked for others, even though it might be the best sponsor and best fit with sponsor that we’ve seen in a while. You want that quick “no” and you want the sponsor to come back to you again. You want to make sure they understand that.

Gallagher: I agree with all this. Fit of sponsor matters a great deal. Portfolio construction matters a lot to us and my colleagues. Any co-investor has to be very thoughtful on how they’re constructing their portfolio. You need to be diversified across time, industry, geography, deal type, etcetera. Sometimes a deal will come in and you just, flat out, have too much exposure. For us, we’d rather live through the fund investment we have with that GP. I agree with pattern recognition. We’ve been doing this a long time and we have scar tissue from deals that look like that one, but did not go well. We just don’t see it the way the sponsor sees it. As active co-investors, we try to meet management on every single deal we’re doing. Sometimes, the management team does not impress us and we don’t see it the way the sponsor does. Sometimes, the sponsor will come to us and say, “I think this is a very low-risk deal that we can comfortably get 1.7 to two times money.” That’s probably not the risk/return tradeoff we’re looking for.  

There are a host of quantitative and qualitative reasons to turn down a deal. Those are the largest ones but sometimes, capital structure is problematic. Sponsors putting a lot of debt on a deal and using lenders who are not relationship-driven—that gives us discomfort. The most important thing for success in co-investing is to take all of your experiences and the attributes you look for outside the sponsor and apply them. Only after all of that filtering has occurred should you feel compelled to do a deal. 


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