LPs going direct: In the shadows

When asked to explain the rationale behind a re-up in an Asia-based GP that had raised substantially more than in the previous vintage – and whether this larger amount of capital could be deployed efficiently under the stated strategy – one LP gave an intriguing response: “But [the manager] has performed so well for us. For every $1 we put into the fund we’ve got $1 in co-investment.”

Judging a manager based on co-investment allocation rather than the performance of those investments is a sign of the times: As has been repeatedly observed, LPs want to consolidate their GP relationships, placing more capital with a smaller number of managers, and getting a sizeable portion of each increased commitment in the form of zero-fee co-investment. On a net-net basis, even if the return is no more than adequate in private equity terms, for most LPs it still betters both their benchmark return and what they are getting from other asset classes.

LPs will address this in their own ways, based on investment mandate and internal resources. While some institutional investors have built up global-focused sector teams that complement work done by investment professionals in different geographies, enabling them to participate early and fully on deals as a co-underwriter, others will be restricted to downstream syndication. Speed and reliability are what GPs value the most: respond quickly to an opportunity; and if there is a desire to participate, provide the money under the agreed timeframe. Adding particular value to a deal would be considered a bonus.

A number of factors could contribute to LPs stepping back from co-investment in Asia: a few high-profile failures, a macroeconomic shift that impacts risk exposure; a substantial rise in interest rates that influences risk-return preferences within portfolios; and with longer term hindsight, perhaps the recognition that the current co-investment frenzy didn’t necessarily translate into better returns.

For now, though, private equity firms are getting used to the new normal. In the industry survey that forms part of Bain & Company’s 2017 regional private equity report, GPs were divided as to whether “shadow capital” represents an opportunity or a risk. That said, more than three quarters of respondents already offer passive co-investment rights, about one quarter allow co-underwriting and just under one fifth run separately managed accounts. A sizeable majority expect the same amount or more of this activity in 2017.

However, it is not just about co-investment and the trade-off between building relations with prospective LPs and getting extra firepower for deals on one hand, and reduced fund economics and increased administrative headaches on the other. Shadow capital is an umbrella term that covers direct investment by LPs as well, and the risk is that investors will bypass GPs altogether. The same LP that spoke glowingly of getting $1 of co-investment for every $1 in the fund was also far more bullish than before about the prospect of club deals in Asia with sovereign wealth funds and other groups comfortable with a long hold.

And it remains a prospect rather than the reality. The Bain survey found that the three top causes for concern among GPs are a mismatch in valuation expectations, a lack of attractive deal opportunities and the ability to sustain a high level of returns. But rising valuations – and the picture really does vary, depending on the geography, industry and transaction size being targeted – are not the result of a critical mass of LPs deciding to go solo and bidding up the pricing.

Rather, it is the amount of capital entering the asset class through funds and co-investment, and through channels that fall outside the norm. In China, for example, the definition of shadow capital could be stretched even further to include corporate investment units and government sponsored investment vehicles, chiefly on the renminbi side. Recognizable and unrecognizable names appear on filings for take-private transactions and in announcements of late-stage funding rounds for technology companies, but the size, scope and ambition of this investor constituency is largely unknown.

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• Topics
• LPs
• GPs
• Fundraising
• Asia
• Co-investment
• Direct investment