Direct investment: Silent partners?

A United Airlines flight departed Sacramento at 8.11 a.m. Tuesday morning and touched down in San Francisco 50 minutes later. Onward passengers for Beijing then had a three-hour wait before the second leg of their journey, finally arriving in the Chinese capital at 3.15 p.m. the following day. The total travel time was just over 16 hours. It was one of just three itineraries that day offering a single stop.

For those journeying from California to Asia, China's eastern seaboard is a comparatively easy ride; Singapore and Mumbai are each about 23 hours and two stops away. Yet the California Public Employees Retirement System (CalPERS) has decreed that the individuals spearheading its latest push into direct private equity investments must do so from headquarters in Sacramento. Ever conscious of the real and political costs incurred in putting public pension money to work, the system requires these individuals fly coach.

"We see these guys come off the plane and they're half dead," says one industry participant based in the region. "They are here to do due diligence on co-investments but are in no state to work productively. If you can't invest in the infrastructure, you will make mistakes."

Direct investments - predominantly executed in partnership with fund managers, although a number of LPs are ambitious enough to go it alone - are not new to Asia, but they have grown in prominence in recent years, driven by a combination of demand and supply side factors. The motivations of different investor groups are broadly similar, but the on-the-ground resources they have at their disposal vary considerably.

If done correctly, co-investments add another dimension to relations between GPs and LPs, enabling the former to target deals beyond their fund size and allowing the latter to deepen their exposure to certain assets at a reduced cost. But deploying capital in a single transaction rather than across all the deals in a fund involves greater risk and requires keen oversight. Some LPs, it is argued, don't know what they're getting themselves into.

"There is a lot of reckless co-investment and direct investment taking place and a lot of people are going to lose a lot of money," says Monte Brem, CEO of StepStone, a global gatekeeper. "Apart from large and sophisticated investors who hire the right type of staff and set up the right geographical presence, LPs will ultimately realize it is better to use advisors and managers for these kinds of transactions."

Willing partners

According to AVCJ Research, direct investment by LPs in Asia - including co-investments with fund managers - came to $15 billion in 2011, down from $21.8 billion the previous year. Nevertheless, direct investment tracks wider private equity dealflow, so there has been increase in activity over the last five years. Sovereign wealth funds account for well over half total deal value for the period, with pension funds on just under one third and fund-of-funds on 4.5%.

Varieties in the nature and size of transactions shouldn't be overlooked. Deals such as CPPIB's $3 billion solo acquisition of Australia's Intoll Group in 2009 and Temasek Holdings' string of large-ticket pre-IPO and PIPE injections into Chinese state-run banks move the needle more than co-investments between GPs and their fund-of-funds LPs, but do they really count? Traditional PE players generally regard infrastructure deals as beyond their investment horizons, while a $1 billion-plus commitment to a bank is beyond their capacity for a single transaction.

Preqin's recent global survey of LP appetite for co-investment is more illustrative. Of the LPs tracked, 43% are actively seeking co-investment rights when committing to funds, and two-thirds of them already have at least $250 million allocated to private equity. Fund-of-funds are by some distance the most aggressive in seeking co-investments - nearly one quarter of the total. There is no dedicated category for sovereign funds; they fall under "other," which accounts for 15%. Public pension funds are the only other group to reach 10%.

A smaller survey found that the bulk of LPs are co-investing with fund managers on an opportunistic basis, and they are doing it at the expense of allocations to comingled funds. Nearly two-thirds of respondents plan on increasing their commitments to co-investments.

As a relatively unknown quantity, attitudes towards Asia are likely to be more conservative. Several industry participants say that most of the LPs they deal with are still wary of investing directly in the region. But the broad economic rationale for co-investment is the same everywhere.

"If you are giving your capital to someone else to manage and paying them a management fee and carried interest, your cost of investment is likely to be higher," says Mark McNamara, global head of private equity at Baker McKenzie. "A number of LPs see the benefit of a split approach - continuing to invest with credible financial sponsors but also looking at investment opportunities where people may need additional capital."

In some respects, the situation reflects wider developments in the GP-LP relationship. A more difficult fundraising environment has granted LPs leeway to extract concessions from fund managers, such as fee reductions, separate accounts and co-investment rights, in return for re-upping early on a new vehicle. Co-investment also presents the opportunity to become more familiar with an industry or geography - vital for less experienced sovereign wealth funds that may attach investment professionals to the GP as an educational exercise as much as for oversight reasons - and simultaneously build a comprehensive understanding of the GP itself.

"For us as a fund-of-funds, one of the single largest reasons to do co-investment is to get more insights into the GPs," says Doug Coulter, head of Asia Pacific private equity at LGT Capital Partners. "This increases the chances of us backing them next time."

Price of entry

Arguably one of the challenges facing fund-of-funds is accessing co-investments in the first place. Their commitments to larger vehicles tend to be smaller than those of pension funds or sovereign wealth funds, and GPs gravitate towards big contributors. "It's quite reasonable for an LP to ask for a $50 million co-investment on top of a regular $150 million commitment," says Michael Prahl, head of research at INSEAD's Global Private Equity Initiative. "If they commit to fund after fund, it makes life easier for the GP."

Others point out that it isn't so simple. According to StepStone's Brem, contracted co-investment rights were a feature of the last generation of funds but the trend is now away from this because GPs find them too unwieldy. Above all, it is up to LPs to prove they can be reliable partners and execute deals.

A typical institutional player based in the US might not be equipped for the speedy decision-making required in co-investment, and lack the capacity to participate in and share the costs of due diligence or the mechanisms to share expenses should a deal break down. A fund-of-funds, however, tends to be sophisticated, commercially driven and willing to commit investment professionals to a project.

One pension fund LP tells AVCJ that co-investment rights have never featured in its contracts in Asia - not because it wasn't an option, but because the preferred approach is to build strong relationships with GPs, show how they can add value, and then rely on opportunities being offered.

"Sometimes an entrepreneur who doesn't fully understand private equity, or a regulator who wants to know that the GP will support the company for a reasonable period of time, will ask where the money comes from," the LP says, explaining the value-add element. "The GP can bring us to the meeting and show that the money is good, that it's available and that it's there for the long term."

An entrepreneur might also welcome the presence of an established Asian sovereign wealth fund, such as Temasek or Government of Singapore Investment Corp. (GIC), purely for the cachet it brings to their business.

Opinion is divided as to whether maintaining a local presence is integral to effective deal execution. Conducting due diligence on a co-investment is different from assessing a fund manager, but LPs who act in congress with GPs that they already back have an added layer of comfort. An LP might conclude that, because the GP passed muster at fund level, work on an individual deal can be taken in good faith and requires minimal in-house checking.

Risk exposure

The counterargument is that the individual deal involves considerably more risk. HarbourVest Partners, for example, was an LP in Archer Capital's fourth fund and also came in as a co-investor in the $296 million buyout of accounting software firm MYOB in early 2009. According to AVCJ Research, HarbourVest covered about 20% of the deal, which implies a capital commitment of $60 million. If HarbourVest's investment in the Archer fund came to around $140 million - not an unreasonable expectation in a $1.4 billion vehicle - and there were 10 transactions overall, its average exposure would be $10 million per deal. Exposure to MYOB was six times greater.

A GP has two main options when addressing a co-investment deal: underwrite the transaction in full and then sell down exposure, or approach a small group of investors early on and gauge their interest in participating in a syndicate. The latter option is more common, and working with LPs is preferable to teaming up with rival GPs. While it is in the fund manager's interests to treat LPs fairly, there are caveats.

"If a GP shows you a co-investment, it may be okay, but there are lots of bad deals in Asia and a lot of managers are seeing portfolio volatility," says LGT's Coulter. "The worst situation is when the GP has fallen in love with a deal and the risk level is really quite high."

It is an issue of adverse selection: there is no guarantee a fund manager will share top quality transactions. A GP's primary objective might be to secure a close regardless, perhaps because a huge amount of time and expense has been put into a deal or because it is in rush to finish off a fund. In some cases, a deal represents a step outside the fund manager's comfort zone in terms of size, sector or geography. Or it may have looked good before negotiations with the seller started but has since been bartered into a shape that doesn't fit the original investment thesis.

Most pertinently, is an LP able to make sound judgments if investment professionals are flying from the US? StepStone's Brem says no. "Some of the LPs are just so far away from the markets in which they are investing," he says. "If you are a sovereign wealth fund from the Middle East, and your only office is in the Middle East, you are the last person to see the deals and you are don't know what's being said on the ground. Unless you are willing to invest in appropriately trained professionals, you are at a major disadvantage and you risk being taken advantage of."

One group of LPs perceived as able to hire local talent are the large Canadian pension funds, CPPIB and Ontario Teachers' Pension Plan.

While most US pension funds have relatively few staff devoted to alternative assets and only a fraction of these looking at Asia - a reflection of the fact that most of their assets are invested elsewhere - CPPIB employs 20 investment professionals in Hong Kong. It has won the fund a reputation as one of the most proactive direct investors in the region, readily bundled with the likes of Temasek, GIC, Khazanah Nasional and Partners Group.

These assessments aren't necessarily merited once large-scale infrastructure transactions are disentangled from corporate private equity activities. According to sources familiar with CPPIB's strategy, although the fund is open to co-investment, it has pursued barely a handful of such deals in Asia and only participates alongside portfolio GPs. Yes, CPPIB pays competitive salaries to its staff, but the primary reasons for maintaining an office here are twofold: showing a commitment to the region and meeting fiduciary duties to manage risks.

The next step

Examples of co-investments gone bad are plentiful, although they are outnumbered by the good: over half the respondents in Preqin's survey said they had seen better returns on commitments to co-investments than for comingled funds. The likes of sovereign wealth funds, which have a large amount of assets to deploy, are hardly going to slow their push into the area.

INSEAD's Prahl is concerned about what happens next. His view is that co-investment programs designed to mirror the main fund work best, and is wary of LPs cherry-picking deals when they don't have any specific selection skills.

"If anything, we have seen them ending up in too many of the large trophy deals of the last boom that are now struggling," he says. "LPs then have to renegotiate the fee structure on a large scale, which will and is already creating resistance from the GPs."

Not all participants will back off, however, and this could have consequences for the standard private equity model. Some institutions are talking about devoting up to 30% or more of their portfolios to co-investment; the average for fund-of-funds in Asia is currently around 10%.

For example, Partners Group notes in its most recent annual report that "direct and secondary investments offered the highest relative attractiveness during 2011 with over two-thirds of total investment activity in these two segments." Partners Group completed 40 direct deals during the period and several industry participants tell AVCJ that the firm is increasingly looking for transactions independent of GPs.

"The funds-of-funds say they only target areas in which they aren't already investing through traditional fund structures, but that only holds as long as direct investment programs are relatively small," says Prahl. "Once they get larger, they will inevitably encroach on wider territory. There is an inherent conflict of interest risk here and it will be interesting to observe whether LPs will be able to mitigate it over time."

Baker McKenzie's McNamara agrees there may be difficulties if funds-of-funds end up competing for deals against GPs that also receive commitments from their comingled funds. They would in effect be telling clients that the managers they previously championed as top quartile are not the best means of accessing a particular market. And regardless of whether the LP is a fund-of-funds or a sovereign wealth fund, a direct investment strategy that tramples on existing GP relationships is going to be disruptive.

These unresolved elements of LP attitudes towards Asia color the water. Bob Partridge, transactions and advisory partner with Ernst & Young in Hong Kong, sees increased co-investment as a natural and mutually beneficial development. In emerging markets that don't offer leveraged finance, this is an opportunity to de-leverage risk. While this assessment has merit, it remains in the balance.

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• Topics
• LPs
• Investments
• Greater China
• Southeast Asia
• South Asia
• Australasia
• North Asia
• Direct investment
• Co-investment
• LPs
• Asia
• CPP Investment Board
• Partners Group
• Temasek Holdings
• GIC Private
• HarbourVest Partners
• LGT Capital Partners