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The direct route

Co-investments look set to increase as firms are finding it hard to raise funds and large buy-outs continue to provide good deal flow. The question is, should institutions consider them?

When the management team at Greycoat, the publicly quoted property company, signed a £540m deal that reverted their company to private status it was one of the biggest private equity transactions of 1999. It was a coup for the team at Mercury Private Equity (now Hg Capital), which led the deal. It was also the type of deal that appealed to institutions, which co-invested in the company alongside Mercury: Greycoat had a proven management team at the helm, and Mercury was able to do the due diligence to ensure that there were no pitfalls in the package.

More opportunities
There are increasing opportunities for institutions such as pension funds and insurance companies to co-invest alongside private equity firms. One of the reasons for this is the fact that deal flow for buy-outs of £100m or over remains good; the other is the current tough climate for raising funds. 'We are moving to an investment climate where the mood is ranging from caution to panic,' says Guy Fraser-Sampson of fund of funds player Horsley-Bridge. 'It's more difficult for private equity funds to raise money. So there is more opportunity to co-invest now.'

Some private equity firms operating in Europe have managed to raise mega-funds in recent months. For example, CVC Capital Partners has just announced that it has raised Europe's largest buy-out fund at E4.65bn. Apax and BC Partners have also raised E4bn-plus funds this year. But these are exceptional. Other firms have had to scale back their ambitions, especially in the US. Whitney, one of the oldest and most experienced private equity operators, closed its latest fund at only just over half its original target of $2bn, and Thomas Weisel was $200m short on its most recent fund of funds. If many firms are unable to raise the funds they need to meet the large buy-out demand, or if they do not wish to be over-exposed to one particularly large deal, they will turn increasingly to institutions and offer them co-investment opportunities. 'If our funds are not big enough to support a deal then we will look to bring in other investors,' says one venture capitalist.
Greycoat was a typical example of this strategy, says one of the executives at Mercury. 'It was a very big deal and we didn't want to take it on by ourselves,' he says. The deal would have eaten into a considerable amount of the fund Mercury was investing at the time and would have weighted it far too much towards Greycoat. Mercury put in £50m, as did Merrill Lynch Investment Managers, and other institutions joined them.

Why co-invest?
In its simplest form, co-investment offers institutions a type of hybrid between investing directly in private companies and investing in private equity funds. One of its main attractions is that, just as with direct investments, institutions don't have to pay a management fee or carried interest on their investment in the private company, allowing them the potential to make greater returns. And, unlike direct investments but similar to investing in private equity funds, institutions don't have to source the deals - the firm they are co-investing with will do that for them. This can save a tremendous amount of time spent on researching new deals. ‘The advantage of being able to co-invest is that all the hard work is left to the venture capitalist,' says the Mercury executive. 'Institutions do have to do some due diligence, but they don't have to source the deal,' he says.

This naturally means that co-investing requires institutions to have a much greater input into individual deals. But if an institution manages to develop (or more likely recruit) the skill set necessary to ensure that it is making good co-investments, it will be in a far better position to select private equity funds in the future. It will also develop a closer relationship with the firm it co-invests with, allowing it to assess far more clearly whether or not to invest in future funds that firm raises.

Some of these upsides depend on how an institution goes about co-investing. If the institution goes for the no fee, no carried interest route, it will have to be an existing investor in the private equity firm it invests alongside and have a good relationship with it and/or be able to offer expertise in a particular field (as was the case with the Mercury/MLIM deal). Knowledge of the business that is being looked at is crucial, according to chairman and chief executive of Parallel Ventures, Paul Whitney. Parallel is a private equity house that specialises in co-investment deals. Institutions are given the chance to do due diligence, but there is often little time to do this properly - three days is the average.

And yet there are few institutions that have carved out a team that is dedicated to screening private equity investment opportunities - and even if they have, the people in that team are unlikely to stick around for too long. 'For co-investments, you need to go to a player that has experience or has an in-house capability,' says Whitney. 'The difficulty with this is that people with direct investment experience are not going stay in-house because they can earn far more money as elsewhere.'

Whitney argues that an advantage of using a company such as Parallel is his experience of approving deals - he's worked for 3i, Cinven, NatWest Private Equity (now Bridgepoint). 'The major problem when institutions co-invest is that often, the people doing the due diligence have never done a deal themselves and are relying on the underlying manager. That's extremely dangerous,' he says. 'The advantage of our approach is that we review the due diligence work and the investment proposition rather than rely on other people's work.'

The fund of funds route
The other route is via a fund of funds, such as Harbourvest or Standard Life. This will remove some of the hard work from co-investing, such as the due diligence, but the fund of funds will take a management fee and carried interest on any co-investment it makes. For instance, Standard Life takes 15 per cent on co-investments (it takes five per cent on fund investments) and Harbourvest takes carried interest on direct investments but not on fund of fund investments. This is a more expensive route than co-investing alongside a private equity firm and it also has the potential for causing a conflict of interest for the fund of funds.
‘People underestimate the conflict issues,' says a director of a major fund of funds investor. His firm is currently considering whether to offer co-investments alongside its existing products. ‘Co-investing is much more lucrative for fund of funds than pure asset management. The temptation must be to sell co-investment over fund investment. However, this is less of an issue if the fund of funds offers a separate co-investment vehicle.'

Guy Fraser-Sampson of Horsley-Bridge agrees. His firm never does co-investments - a decision it took many years ago. 'We don't do co-investments because we recognised there was a conflict of interest,' he says. ‘Every fund of fund that does it takes carried interest.'

Health warning
Fraser-Sampson also points out some of the other dangers associated with co-investing. A lack of diversification is one. Putting money directly into a private equity deal comes with a health warning, he says. ‘If you are making a direct investment in a private equity deal then you should ask if you are getting the level of diversification you should have. Typically, you only invest in five or six deals - but you could end up putting as much into just one transaction. And it's dangerous to try and cherry-pick. If you are an institution you are not equipped to take a view on individual investments. The overall effect on your return could be marginal - all you will save is the management fee.'

Institutions should also beware of private equity firms cherry-picking. Despite the difficult fund-raising climate, funds are getting larger. Firms with large funds are naturally going to want to keep the best deals in their own fund - after all, that's how general partners earn their carried interest. Some might argue that the deals on which many firms will offer co-investment opportunities are not their best deals. In other words, private equity firms are naturally likely to cherry-pick which deals they send out to institutions.

Co-investing is clearly not for the risk-averse or inexperienced private equity investor, especially when taking into account the fact that there is little performance data available on this type of investment. None of the usual private equity research providers, such as the EVCA, conduct analysis of co-investment performance. Therefore, it is potentially less transparent and more risky than investing in a private equity partnership. Institutions that are new to the asset class would do well to steer clear of co-investments - even some of the more established players struggle them, unsure whether to manage them as limited partnership investments or direct investments. However, the returns can be good. ‘The dirfference between investing in one company compared to investing in a fund, where you get a spread of companies, that you take a big hit if it goes wrong,' says one venture capitalist. ‘In comparison, the upside is that it can be a good way to up your returns.'

Clara Young is a freelance business journalist

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