Perspectives Issue 13 October 2014 Key Commentary - the truth about co-investments The ‘adverse selection’ argument There is some “received wisdom” that co-investing should be avoided A private equity co-investment is a direct investment in a company because of so-called “adverse selection”, the assertion that co- made alongside and on the same terms as a lead general partner investments, either because of their greater size (and hence being (“GP” or “sponsor”). A co-investment opportunity generally arises outside the scope and expertise of the lead sponsor) or for other when the amount of capital required to make an investment is larger reasons, will generally under-perform the average private equity than usually provided by the lead sponsor alone. Sponsors generally investment, including all of the opportunities that are not offered as co- prefer to invite their LPs to co-invest rather than share the opportunity investments. A deeper analysis of the adverse selection argument with another, perhaps rival, sponsor in order to retain control and raises the question as to whether, if adverse selection does indeed maintain track record attribution. However, LPs need to respond exist, why does it exist? It could be owing to either or both of two quickly to an invitation to co-invest and demonstrate both the reasons: (i) co-investments offered are inherently of lower quality; expertise and experience necessary to evaluate the target company, and/or (ii) the co-investor chooses poorer investments systematically. assess the financial structure, analyze significant due diligence material and review and agree relevant and often complex investment As to whether co-investments offered are of inherently lower quality, documentation. there is little, if any, industry-wide data to support this somewhat cynical view. However, this hypothesis can be tested by simply Co-investments are an efficient way of maximizing returns from a looking at a sponsor’s historical track record and comparing it to the portfolio of private equity fund investments. As co-investments do not performance of investments where co-investors were brought in and generally incur fees and carried interest charged by a sponsor, they where they were not. Anecdotally, GPs state that they would not reduce overall costs and, other things being equal, improve the net deliberately offer less attractive deals to an LP co-investor, if only to returns to the LP. However, co-investments also offer other benefits to preserve the relationship with the LP and ensure a commitment to the portfolio construction such as shortening the J-curve, controlling the next fund, which is a GP’s lifeblood. As one sponsor stated, “Why investment pace and emphasizing particular geographies, industries would we want to spend the first hour of a fund-raising meeting talking or lead sponsors. Diversification by lead sponsor can be particularly about the co-investment that went wrong?” There is some evidence important. that very large syndicated transactions are on an under-performing trajectory and this has certainly been evident with some large-cap Committing to a co-investment buy-outs undertaken in the period before the financial crash in 2008. The concept of co-investing does not translate into a part-time This trend has been documented in a recent article by Professor Josh endeavor; it requires the same dedication as direct investment. Like Lerner1. all investment activity, co-investment should be undertaken in a rigorous way by an experienced team and not carried out on a part- Co-investment at Capital Dynamics time basis by individuals who have multiple responsibilities such as Capital Dynamics’ approach to co-investment involves a dedicated evaluating multiple LP commitments to private equity funds. Spending and experienced team that sources opportunities from the firm’s just part of their time on co-investment will likely lead to poor network of approximately 800 GP relationships. The opportunities investment decisions and may also disturb the relationship with the selected for investment are typically held in a co-mingled fund which is sponsor if it causes delays to the process, thus frustrating transaction managed by the firm on behalf of its clients. This approach has the execution. benefit of pooling sponsor relationships, not only to increase the number of opportunities but also to maximize the amount of co- “Here lies an issue; all investments must be made on their merits investment made available to Capital Dynamics’ co-investment alone and not based on a sponsor relationship the LP is seeking platform. A sponsor will often allocate co-investment based on the to preserve” size of an LP’s commitment to its fund as well as favoring LPs with dedicated, experienced teams to minimize execution risks. These potential pitfalls demonstrate the need for dedicated and smaller Capital Dynamics refines its approach to co-investment further by investors seeking the cost advantages of co-investment should pool focusing on mid-market companies with an enterprise value between their resources with other investors and mandate a dedicated external EUR 50 million (USD 65 million) and EUR 1 billion (USD 1.3 billion). team to undertake co-investment activity. Although this has a cost, it This approach has two advantages: (i) avoidance of large-cap or should avoid poor decision-making and has the added advantage of mega-cap transactions where the equity capital required may be a experienced investment professionals, suggesting that increasing the pool of sponsor relationships from which to source coinvestment opportunities, so improving selection. 1 ‘Nurturing Innovation’, London Business School Coller Institute of Private Equity, Issue 9 Winter 2013/14, pages 6-8 London | New York | Zug | Beijing* | Tokyo | Hong Kong | Silicon Valley | Sao Paulo | Munich | Birmingham | Seoul | Brisbane | Shanghai* | Scottsdale 1 multiple of the GP’s normal investment size; and (ii) focus on The results of this approach suggest that it can produce attractive situations where the opportunity is close to the core expertise of the returns with the added benefit of lower costs which may potentially lead sponsor where the particular deal requires, say, 30% more lead to higher net returns to investors. capital than usually provided by the sponsor alone, thus avoiding socalled “style drift”. Various investor surveys echo Capital Dynamics’ experience with coinvestments. For example, a recent survey of 132 global investors The co-investment team also focuses on five broad industry groups: conducted by Advent International, 20% of which have dedicated co- energy/power, consumer, investment teams, indicated out-performance of co-investments 2. 55% healthcare/financial services and industrials. This sector-based of respondents reported co-investments have out-performed fund approach has the advantage of ensuring that investments are made in investments on a net basis and for about 30% of respondents, it was areas of proven expertise. Regarding the approach to any particular too early to judge performance. technology/business services, mid-market opportunity within the industry groups mentioned above, the team considers the following features of each transaction in In conclusion, a well conceived co-investment strategy focused on the investment selection: mid-market coupled with careful, disciplined execution can be an attractive addition to a private equity investment portfolio. Analysis of the lead investor’s track record in the sector Complexity of the transaction/consortium Barriers to entry and pricing power Favorable growth trends in the respective sector Key market observations – global buy-out Fund-raising 300 400 350 250 300 Attractive entry valuation for a quality business Positive sector momentum/cyclical upswing Favorable macro environment Experienced, driven management team Alignment of interest through incentive structure 250 150 200 150 100 Funds USD bn 200 100 50 0 US 50 2004 2005 Europe 2006 2007 Asia-Pacific 2008 2009 2010 2011 2012 2013 H113 H114 0 Number of funds Source: Capital Dynamics; based on Thomson One, Asian Venture Capital Journal (AVCJ) Halfway through 2014, global buy-out fund-raising continues to improve at a steady pace. 120 buy-out funds raised USD 74 billion during the first half, being 10% more than the figure for the same Market dynamics Emerging markets growth Acquisitions period last year. As the chart above illustrates, fund-raising demonstrates stable investor interest in traditional buy-outs. There are no signs of investor over-allocation to this asset class as we saw during the prior buy-out boom in 2005-2008. Since 2009, buy-out IPO, trade sale to a strategic or financial buyer funds have raised USD 530 billion or almost half of the amount raised during the previous five years, thereby alleviating the connected problems of so-called “dry powder” surplus, new deal pressure and competition. During the first half of 2014, buy-out funds in Asia-Pacific attracted significant investor capital with the region boasting four billion-dollar plus closes, including USD 3.5 billion secured by TPG A disciplined investment selection approach underpinned by proven, Asia. The region is on track to have its fifth consecutive year of growth documented and repeatable processes is key. in fund-raising. 2 Advent International “LP Co-invest Survey Highlights” June 2014 London | New York | Zug | Beijing* | Tokyo | Hong Kong | Silicon Valley | Sao Paulo | Munich | Birmingham | Seoul | Brisbane | Shanghai* | Scottsdale 2 remain relatively robust. M&A exit volume increased 60% to USD 139 billion; including large trade sales such as the USD 13.5 billion exit Investments 900 from Biomet and the USD 6.5 billion realization of Oriental Brewery. 3,500 800 3,000 700 USD bn 500 2,000 400 1,500 300 Deals 2,500 600 Performance (Net IRR since inception as of March 2014) 25 1,000 200 0 US 2004 2005 Europe 2006 2007 Asia-Pacific 2008 2009 2010 2011 2012 2013 H113 H114 0 Number of deals Source: Capital Dynamics; based on AVCJ, Dealogic, Thomson One, Unquotedata 20 Net IRR in % 500 100 19.6 16.4 15 12.4 10.6 10 7.6 6.8 5 Buy-out investment activity increased at a moderate pace during the first half of 2014. Buy-out funds invested USD 145 billion or 7% more than the same period last year across 1,240 deals. Invested capital increased across regions. A 10% increase in the number of deals relative to a year ago is an encouraging sign of deal flow improvement, which, in turn, has a positive effect on coinvestment deal flow. In particular, private equity firms have dominated deal vendor activity for several quarters in Europe, resulting in a surge of secondary buy-outs. In H1 2014, deals sourced from private sellers accounted for nearly half of all deals announced, reflecting improving confidence across the wider deal-making community. Buy-out acquisition prices climbed further, driven by public market valuations, the availability of attractive debt financing and strategic M&A. However, acquisition prices vary across 0 Upper Median Lower Mid-cap buyout funds (USD 0.3bn-2bn) Large-cap buyout funds (USD 2bn+) ,Source: Capital Dynamics; based on Preqin buyout funds of vintage years 2001-2010 Buy-out performance continued to improve, driven by improving trading of portfolio companies, elevated exit activity and a rise of comparable market valuations. Large-cap buy-out funds benefited most from the low interest rate and high equity pricing environment as indicated by short-term returns. However, mid-cap buy-out funds continue to out-perform large-cap buy-out funds. According to our analysis of Preqin data, the top quartile return since inception of midcap buy-out funds formed during the last decade exceeded that of large-cap funds by 3.2 percentage points in terms of net IRR. sectors, deal sizes and regions, thus demanding more than ever global co-investment deal sourcing and rigorous selection ability. Exits 400 350 300 USD bn 250 200 150 100 50 0 M&A 2004 2005 Public 2006 2007 2008 2009 2010 2011 2012 2013 H113 H114 Dividend recapitalization Source: Capital Dynamics; based on AVCJ, S&P Capital IQ, Thomson One, Unquotedata Private equity is on track to achieve the best exit year since 2007. As we commented in our 2013 issues of Perspectives and Private Equity Insight, “Private equity is currently in the distribution cycle. Exits gained speed in 2014 with multiple exit options available”. In the first half of 2014, record-breaking IPO activity and robust dividend recapitalization, driven by the availability of debt financing, was complemented by the return of corporate buyers. As demonstrated in the chart above, private equity-backed IPO proceeds increased 172% to USD 63 billion, the highest semi-annual volume on record. Dividend recapitalizations declined 6% to USD 32 billion from a year ago but London | New York | Zug | Beijing* | Tokyo | Hong Kong | Silicon Valley | Sao Paulo | Munich | Birmingham | Seoul | Brisbane | Shanghai* | Scottsdale 3 Meet our specialists Andrew Beaton is a Managing Director and Cohead of Co-investment at Capital Dynamics. He has 29 years of private equity and investment management experience. Prior to joining us, Andrew co-founded a private equity firm focused on mid-market consumer companies. He also held a number of senior positions in Europe and the US with GE Capital before becoming chief executive of GE’s European private equity activities. David Smith is a Managing Director and Cohead of Co-investment at Capital Dynamics. David and Andrew have worked together closely since meeting at GE Capital in 1990. David is also Chair of the firm’s Clean Energy and Infrastructure Investment Committee and a member of its global Investment Committee. He serves on the Board of Directors of the Major Projects Association and is a member of the Institution of Engineering and Technology. David has over 26 years of experience in private equity and infrastructure financing. Oliver Schumann is a Managing Director of the co-investment team at Capital Dynamics. Oliver has 20 years of experience in private equity and investment management. Prior to joining us, Oliver held positions with Arthur Andersen, GE Capital, Sal. Oppenheim and Resurgence Asset Management. Luca Giacometti is a Director of the coinvestment team at Capital Dynamics. Luca has 26 years of experience in private equity and has been at the heart of Italian private equity since its inception. Prior to joining us, Luca held positions with Citibank, Banca Commerciale Italiana (now Banca Intesa), GE Capital and the Ferrero organization. Luca has an extensive network of contacts of Italian business professionals, entrepreneurs and intermediaries. Andrew Bernstein is a Director in Investment Management at Capital Dynamics. He has over 15 years of experience in private equity and principal investing. Prior to joining us, Andrew worked in mezzanine as a vice president at TCW/Crescent Mezzanine and as a director at Canterbury Capital Partners. Earlier in his career, he worked for multiple groups within the Fixed Income, Currency, and Commodities Division at Goldman, Sachs & Co. In addition, he has served as a board member for multiple middle-market companies. Andrew holds a Bachelor’s degree in Management from Binghamton University and an MBA from Columbia Business School. Capital Dynamics is an independent, global asset manager, investing in private equity and clean energy infrastructure. We are client-focused, tailoring solutions to meet investor requirements. We manage investments through a broad range of products and opportunities including separate account solutions, investment funds and structured private equity products. Capital Dynamics currently has 3 USD 19 billion in assets under management/advisement . Our investment history dates back to 1988. Our senior investment professionals average over 4 20 years of investing experience across the private equity spectrum . We believe our experience and culture of innovation give us superior insight and help us deliver returns for our clients. 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In the United States, this document has been issued by Capital Dynamics Inc., a registered investment advisor. Redistribution or reproduction of this document is prohibited without written permission. 3 Capital Dynamics comprises Capital Dynamics Holding AG and its affiliates; assets under management/advisement, as of March 31, 2014, include assets under discretionary management, advisement (non-discretionary), and administration across all Capital Dynamics affiliates. Investments are primarily on behalf of funds managed by Capital Dynamics 4 Average years of experience held by Capital Dynamics’ 20 most-senior investment professionals * Capital Dynamics China is a legally separate company operating under a strategic cooperation with Capital Dynamics. London | New York | Zug | Beijing* | Tokyo | Hong Kong | Silicon Valley | Sao Paulo | Munich | Birmingham | Seoul | Brisbane | Shanghai* | Scottsdale 4
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