February 21, 2012
Interviewed by: David Snow
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Middle-Market Co-Investment

A long-term trend in private equity is for LPs to seek to co-invest directly in deals alongside their GPs. This trend has made its way to the U.S. middle market and, according to TJ Maloney of Lincolnshire Management, Terrence Mullen of Arsenal Capital Partners, and John Coogan of Duane Morris, LP co-investment capital is very welcome.

A long-term trend in private equity is for LPs to seek to co-invest directly in deals alongside their GPs. This trend has made its way to the U.S. middle market and, according to TJ Maloney of Lincolnshire Management, Terrence Mullen of Arsenal Capital Partners, and John Coogan of Duane Morris, LP co-investment capital is very welcome.

David Snow, Privcap: When talking about financing, it’s not only debt financing. We’re talking about bringing capital to bear to get a transaction complete, and there’s been a trend for investors, for the limited partners, who are investing in the private equity funds to want to co-invest alongside of their GPs.  I’m wondering if any of you can talk a bit about how that’s made itself manifest at your firms? Maybe starting with T.J.?

TJ Maloney, Lincolnshire Management: Well, certainly a number of our limited partners, a number of our investors have wanted the right to co-invest, and that’s great.  We think it’s terrific. We do see opportunities from time to time where we do need co-invest, so the fact that the limited partners are looking to that kind of opportunity plays in to the deals that we’re looking at, so we think that’s a good thing.

Then the question becomes sort of execution, getting co-invest partners to act on the timeline that you have to act on is always a challenge, and I think to the extent that they can stop up and sort of meet that timeline, that will differentiate them from the other LPs that are also vying for a co-invest opportunity.

Terrence Mullen, Arsenal Capital Partners: I think everyone’s seen the Canadian model, right? CPP Ontario teaches others, migrate from true LPs to hybrid, very active co-investors, and strategic partners, and no direct really function of the GPs. Everyone’s seen that, everyone’s upset about the level of fees and expenses in this industry, and if returns are compressing, driving co-investment with no fee, no carry, which is what most people expect, and is really the market these days, that’s a great way to drive higher net returns.

T.J. pointed out some of the hurdles and issues that many of these investors are not well-staffed or organized and don’t have the turnaround time to do deals.  But at least for us, it’s been an important driver for us to help us. We’re a smaller fund, and our first fund was three hundred million. This current fund is five hundred million, and we had thirty-five cents of co-investment for every dollar we invested in the first fund and this second fund, we’ve had sixty-five cents of co-investment. So it’s been a really large activity for us. It’s been great to have our LPs work along us side-by-side, enable us to buy businesses. Our target is fifty to two-fifty enterprise value to start, but really continue to scale businesses beyond that. It’s contributed to us having a lot of three X plus multiples, and even double-digit multiples of capital, because they can scale alongside of us and go outside our target range from hold from a portfolio risk-management perspective.  So we love it, and we actually are seeking more investors who want to co-invest.

Snow: But certainly the coordination and communication that is involved in that process must be quite a bit?

Mullen: Not as much as you think. Because we spend a lot of time upfront on our strategies and tell people what we’re looking for in our investors, our LPs advisory board calls are a lot about these things. I know in meetings, people know what we’re doing and where we’re going, and so when we show deals to them, people say, “I really like what you’re doing in special industrials, your chemicals, your materials franchise is exceptional.  I really like what you’re doing in healthcare and driving business information services deals.  I like those areas.” They’ll tell us what they like, and so we’ll pre-screen them, and when we find deals that fit in our three-segment areas, we’ll try to channel those towards the right group.  So it takes a little bit more upfront work, but when they understand what we’re doing and why and they understand our edges and advantages and we articulate those, we found them to be extremely helpful in helping us win deals, and really step up and commit to do things quickly.

Snow: That also mitigates the risk of the slow no, right? The LP who kind of doesn’t know what they want and takes a long time to get back to you and say, “No, thanks.”

Mullen: I think the market has become competitive enough, capital was exceedingly scares in ’08, ’09, and it was very difficult to get fund commitments let alone co-investment commitments. As the market for co-investment has become more competitive with more LPs seeking to co-invest, they recognize they need to staff these efforts. The fund-to-funds have been quite good at that, and have dedicated co-investment funds, and other LPs have developed staff or at least a number of people on their staff that are primarily allocated to do this.  So they have staffed up, like the Canadians, in many cases, as I mentioned, the big pension funds. So the market is a more liquid market, and it’s a more responsive market than it was a year or two ago.

Snow: Jay, what have you seen across the deals that you work on as far as co-investment is concerned?

Jay Coogan, Duane Morris: The further you get from the funds that rely on the substantial blocks of pension and actively managed capital, the more you get a higher mix of family office than with individuals, the easier it is to fend off the co-investment demands, and also, the more you can be selective in going to LPs and LP advisory board members who can bring a value add. I think among our smaller PE firm clients, it’s a good idea, actually, if you can spice up a deal a little bit, support the balance sheet a little bit with some money from an LP who’s going to be an activist with this particular company, because they understand the space, or the macro industry that they’re playing in, and perhaps they can bring some sort of other value add like connections or start power, sales leads, what have you. So you try to spot those things in as you can, and that’s one area where I think we’ve seen a little bit of LP investor involvement. Again, just as Terry and T.J. have said, the further you get up the food chain, the more likely it’s less of a choice, and sort of the arch of size I think has something to do with how often the LPs are involved, and the method of their involvement.

Mullen: I agree with the brand very much Jay, the level of brand recognition and reputation. One of the challenges of being on a lower brand market fund is how do you separate yourself from the noise, or the jambog as everyone calls it.  There literally are thousands of private equity firms, and so the resources and capabilities of global networks, the access across different industry sectors, these are all very helpful, but one of the big ones is brand name reputation. So when you have a blue chip LP or a couple of them come in alongside you in a deal, that helps. That’s persuasive with the management team; it’s helpful when these companies are trying to market themselves amongst their competitors too. So there’s a lot of ways to win there.

Expert Q&A with Gary Levy, Partner, J.H. Cohn

Privcap: How do your clients understand the private equity opportunity?

Gary Levy, J.H. Cohn: I would say that we have a growth concept companies as clients or what I call ‘emerging concept companies, ‘and those are really ideal for middle market private equity funds because they want growth concepts. Our clients, they are unbelievably curious about the whole private equity arena. Who wouldn’t be? You hear all these stories about people getting piles of cash and what they do with that and the capital gain benefit of doing it. But do they know a lot about it? I don’t think so. I think that’s part of our job is to educate them on that opportunity and introduce them to the right private equity funds that would be a good fit.

When you’re talking about what that right fit would be, those are funds that financial capital, I think, is all equal. All these funds have lots of money. But what you really want is intellectual capital that you don’t have to grow your company. Intellectual comes with guys who have done it before. They get you the right team. They can show you, “This is where we go with the business. These are the right hires. This is how we structure this type of stuff.” I like to say that people have already made those mistakes.

Privcap: What do you mean by ‘growth concepts?’

Levy: One of the areas of expertise we have is in the hospitality in the consumer arena, so growth concepts in the hospitality arena are restaurant companies that are easily replicated, that the math works in terms of the investment to build the units and how quickly they pay back on that investment. You could take a company that has five, ten, fifteen, twenty units, and with the right financial and intellectual capital, very quickly turn that into 50, 80, 200, 300 and get to some point of an exit where obviously private equity funds really like that.

What’s that 5-year time horizon? When I’m introducing my clients to private equity guys, I say, “Yes, you’re going to like them. They’re very smart. But as they’re talking to you, they’re thinking down the road of who they’re going to be selling you to in five years.”

Privcap: Has capital become a commodity, and if so, what can private equity firms do to distinguish themselves in the eyes of business owners?

Levy: That’s a great question, and I don’t want to pigeonhole that all the – is the financial commoditized? There’s going to be differentiators, just staying on that topic, about how a private equity fund is going to present a deal. They’ll more or less be pretty close on valuation of the company, but how they structure that investment could be remarkably different. Some will let you take money off the table, some won’t. Others will want control of the board. Others will be the minority and let you do whatever you want.

To answer your other question about how can a private equity fund differentiate themselves? Again, they have to demonstrate intellectual capital in that industry that they can bring value added to the table. In the end, if they’re all the same from a math point of view, then it’s going to come down to, “Is this the guy I believe is gonna quarterback me and get me into the end zone in the long run?” I tell my clients a lot, when they’re looking doing a deal with a private equity fund – and we have several that talk to lots – don’t look at the valuation of the first offer. Look at the guy and say, “Who is going to be the one that’s going to really maximize the value of this company in the long run?”

That’s the bite of the apple you really want. The first bite is nice, but that second bite, that could be generational wealth changing events, certainly something that could be a legacy for the right type of company.

Privcap: How do investor introductions fit into the J.H. Cohn business model?

Levy: I think that’s a very unique differentiator between us and so many of the other firms out there. We work very hard to provide proprietary deal flow introductions to private equity funds that we know we work well with and we know that are the right match for our clients. That works pretty well because our clients are curious. They want to learn more about it. They want to meet these people. They don’t know much about the arena, and then we’re finding them funds that are really going to help them protect their business.

Getting someone to sell a business or take a new partner on, that’s like a child to these people, so it becomes a very emotional event for them. You’ve got to find them the right partners, people that are really going to have the same values and help you build something that’s great.

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