Friday Letter: Going it alone

LPs shifting away from fund commitments and towards direct investments could be biting off more than they can chew.  

The Wellcome Trust is a significant UK investor both in terms of its portfolio size – £13 billion (€15 billion; $21 billion) – and the esteem in which it holds private equity as an asset class. Its private equity holdings have been growing steadily and represented 20 percent of its portfolio as of its last annual report.

At PEI’s Africa Forum this month, Ritesh Anand, who heads Wellcome’s investments in Africa and the Middle East, told delegates that given the size of the trust’s portfolio, it faces difficulties committing to smaller funds and, as such, is encouraging GPs to present co-investment and direct investment opportunities. This shift is not new; Wellcome has publicly indicated it is moving away from making LP commitments and wants in on direct deals.

The charity  was reportedly close to gate-crashing Kohlberg Kravis Roberts’ takeover of Alliance Boots back in 2007, having joined forces with buyout firm Terra Firma. While the Terra Firma consortium ultimately withdrew from the race, it signalled Wellcome’s intent to become more directly involved in acquisitions.

Wellcome made good on this intent about six weeks ago, when it participated in the $900 million buyout of failed Florida-based bank BankUnited alongside private equity firms The Blackstone Group, The Carlyle Group, Centerbridge Partners and WL Ross & Co.

While making a few co-investments here and there is not unusual for large limited partners, direct investment programmes that alleviate the need for fund managers altogether would be. Given the amount of work and specialist knowledge required, total GP disintermediation may be beyond the reach of all but the most heavily staffed institutions. If you take sovereign wealth funds and the performance of their direct investments as a comparable, the outlook is not encouraging.

Recent research undertaken by Harvard University and Massachusetts Institute of Technology shows that when sovereign wealth funds pursue direct investments, the performance is patchy and investments are characterised by “trend chasing”: investing when price/earnings ratios are at their highest. “In principle co-investment is a great idea, but in practice it is challenging,” says Harvard University’s Josh Lerner, co-author of the report.

Obviously sovereign funds have their own idiosyncrasies, such as the inherent political agendas often interwoven with investment strategies, but the research raises the point that being ahead of the investment curve requires expertise, flexibility and due diligence capabilities. And as Lerner points out, these organisations could also have difficulty recruiting and retaining the best talent.

Problems may also arise around deal flow. Fund investors will to a certain extent be reliant on GPs to bring them opportunities, and those GPs may think twice about offering up their most promising deals, especially to an institution that has stopped investing in their funds.

To be sure, direct investment programmes for LPs are far from impossible or unrealistic. Take the big Canadian institutions for example. Teachers’ Private Capital, for instance, invests on behalf of the Ontario Teachers’ Pension Plan and developed its blend of private equity fund commitments, co-investments and direct investments way back in 1991. Teachers’ direct investment programme is now widely extolled, but it was loss-making to begin with and developed over time in tandem with the relationships it built with GPs via traditional fund commitments.

All of this should remind LPs thinking of striking out on their own that some may find it harder going than they first thought. And that relationships with fund managers remain crucial puzzle pieces in the private equity landscape. 

PS – Yesterday PEO held its debut webinar on sourcing follow on capital in times of crisis. It was a smashing success. Heavyweight industry experts matched up concepts to case studies, providing the audience excellent take-aways to apply to their daily operations. If you weren't listening in, you can still benefit by ordering a copy of the recording here.