Europe – Monitor


Stretch that fund
Limited partners are increasingly keen to co-invest. What are the issues, and are Europe's general partners making enough of the benefits that direct LP co-investment can deliver?

Why is it that LP co-investment is one of the most talked-about but less often acted upon mechanisms in the private equity investment process?

One answer is that many of today's active funds were raised during the boom times of a few years ago and are of sufficient size that they simply do not see the need for assistance from third parties in providing equity capital. But this overlooks the fact that most funds have a limit on the percentage of the fund that can be invested in any one deal (known as the ‘diversification limit’ and normally set at around 15 per cent). This is a sensible measure designed to ensure diversification of risk and is the main reason why many of Europe's largest private equity deals in recent times have involved syndicates – sometimes including participation from LPs.

In addition, some firms may choose a collaborative approach without necessarily being forced to by the fund's constitution. If the deal is in a sector considered inherently risky for example, the GP may deliberately set a conservative limit on its own equity commitment and encourage other investors to share the risk. In this regard, club deals involving a team of private equity groups provide a useful hedge as well as beneficial cross-fertilisation of knowledge, contacts and relationships. Whether you want an LP to be part of your hedging strategy – and accepting that most LPs' ability to be additive in the transaction process is limited – is a moot point.

Probably the major obstacle to LP co-investment is a simple resource issue. Few such institutions have dedicated staff able to analyse an investment opportunity and make the decision about whether to invest with sufficient speed to meet the timeframe specified by the GP. Says one leading London-based placement agent: “Sometimes the GP offers the LP a deal and the LP says ‘sorry, I'm busy making a few fund investment decisions at the moment, can you come back in a month's time?’ The answer is invariably no.”

Ultimate bonding experience
One of the benefits of LP co-investment is a simple cost issue – here is an opportunity to participate in deals sourced and executed by your GP where there is no management fee or carry, although such agreements are reached on a bespoke basis and may involve monitoring and transaction fees (other investors in the fund, which may not necessarily have co-investment rights, would probably baulk at the idea of a co-investor not sharing the costs incurred by the entire fund).

Another key attraction for both the GP and LP is the soft but not to be underestimated issue of relationship building. For the LP, co-investment provides an unprecedented opportunity to understand the way a GP works as it will have access to such things as investment documents, the due diligence process and meetings with the investee management team. This familiarity with the deal execution process may also help to engender greater trust in the GP and make the investor more inclined to back its future fundraising efforts.

There are potential drawbacks with co-investment. The GP has to bear in mind its primary fiduciary responsibility to all its fund investors and not be drawn into a potential conflict of interest between those who do, and those who do not, have co-investment rights. Such a conflict may arise, for example, where an investment has not breached the diversification limit referred to earlier, but the GP has nonetheless chosen to bring a coinvestor into the deal. If the deal is subsequently a flyaway success, investors without co-investment rights may well question why the fund as a whole only took a piece of the transaction rather than maximise its commitment.

Doughty's call for LP equity
Co-investors also have to consider their status as minority shareholders in a deal. In a transaction where a syndicate participant does not have a strong relationship with the firm leading the deal, it will wish to incorporate into the terms of the transaction a number of terms designed to protect its position as a minority. The LP co-investor is faced here with the dilemma of how much faith to place in its GP. Of course, any action on the part of the GP that compromised its relationship with the LP could be highly counter-productive. Nonetheless, an LP would be brave to enter a deal without any minority protection at all.

Despite these complications, LP co-investment is increasing. For example, €20m to €25m of the €120m of equity invested in Doughty Hanson's recent €390m takeover of French battery maker Saft has been set aside for LPs. When GPs want access to a chunk of additional equity capital, the ability to call on receptive LPs with a dedicated co-investment resource – Hermes is one name frequently mentioned in this context – can be priceless. As the headlines on PEO confirm, there are very large deals to be done at present. Given that debt financing can be stretched only so far, your coinvestors could prove vital – and the duration and reach of your fund will be extended as well.