This article is sponsored by Portfolio Advisors.
What trends are you currently observing in the mid-market co-investment space?
Ben Hur: Dealflow has been very strong, despite the volatile macro environment we are in. After Portfolio Advisors experienced record co-investment dealflow in 2021, we were conservatively assuming the deal count for our business would decline in 2022; in fact, it increased by 30 to 40 percent, much to our pleasant surprise.
We knew the mid-market buyout space for our extensive set of GP relationships was going to be more resilient in a difficult economic climate, but last year’s result proved how attractive that space is as a place to invest your dollars.
The equity co-investment model has been around for over a decade and has become increasingly popular with both GPs and LPs. That is a function of GPs’ increasing reliance on
co-investment to finance their deals, as well as more sophisticated LP co-investors coming online as a reliable source of capital.
Co-investment allows LPs to be more helpful to their GPs and has therefore become a tool for strengthening those partnerships. It works particularly well in the mid-market, where a lot of GPs are smaller and leaner and want to right-size their equity cheques in a diversified way, leading to more adoption by the GPs.
One other trend we have observed is that the timelines for these deals – from sourcing an opportunity to making a commitment – has shortened considerably over the last two years. Sometimes we are underwriting deals in two weeks from start to finish because the market is so competitive for really good assets.
Adam Clemens: With regards to co-investment and why it has been such a growth market, the important thing that people tend to miss is the relationship angle. There is a lot of focus on what the GPs need money for. However, for those LPs that have made it known they want to be able to support GPs with more capital, the opportunity is extremely valuable. Co-investment gives GPs a lot of optionality to look at deals across a wider range, and it allows LPs to strengthen those relationships, which creates a virtuous cycle.
What is driving activity for these deals in the current market environment?
AC: In 2022, we all continued to be impacted by the knock-on effects of what covid did to financial markets. Last year, that was largely positive: activity was rebounding after a period of relatively steady activity and concerns around portfolios, so we saw increased confidence. This in turn led to a surge of activity, and even some catch-up from delayed or deferred deals.
Today, we hear a lot about the volume of dry powder that sponsors have accumulated, with many of the large funds having raised capital that will create opportunities for co-investment. However, the syndicated debt markets, which are often used to fund large-cap buyout transactions, have recently faced challenges, which resulted in a decline in deal volume at the top end of the market.
Fortunately, there is still a lot of credit available from private lenders in the lower mid-market and growth equity space. In that arena, GPs tend to have steady debt relationships to fund their companies via regular credit providers, and those credit providers tend to stick with them, resulting in more resilient dealflow for mid-market focused co-investors.
Furthermore, where the pricing and availability of debt was impacted last year, dry powder was often there to pick up the slack to meet the purchase price that was required to win deals. Markets that are experiencing a little bit of economic turmoil and uncertainty tend to signal a very interesting vintage for investors, because those conditions dampen purchase prices and allow people to get into deals at lower costs.
“Markets that are experiencing a little bit of economic turmoil and uncertainty tend to signal a very interesting vintage for investors”
BH: There are more opportunities created by volatility, especially in the mid-market. As an example, during the financial crisis, first-quartile mid- market buyout fund returns outperformed year-on-year compared with large-cap first-quartile returns. That is why we think the mid-market will drive activity this year.
To us, there are many more value creation levers that a mid-market buyout manager can utilise to drive growth. For example, small changes – like incrementally expanding the sales force and making small tuck-in acquisitions at attractive valuations – can make a big financial impact.
It’s just more difficult to steer a bigger ship through difficult times. This is the reason many of our mid- market sponsors haven’t been afraid to over-equitise their transaction, given their lack of reliance on financially engineered returns driven by maximising leverage.
Lastly, as we come out of the downturn, those companies will be better positioned with more exit opportunities at stronger valuations after having demonstrated their ability to continue to grow through the downturn.
What is the best way for investors to access the mid-market co-investment opportunity?
BH: We believe that access through a co-investment commingled fund with a multi-manager strategy is the best way. The mid-market is such a fragmented space, with more than 200,000 mid-market companies in the US alone. Further, there are more than 1,000 mid-market GPs willing to underwrite deals in that space. This means that having an extensive and cohesive private equity platform that the co-investment team can source deals from is critical to strategy.
The mid-market returns disparity between first- and third-quartile managers is wide; there are some really good GPs and some not so good ones, so being able to sift through this highly fragmented GP landscape is very important. Being able to leverage our primaries team, who are fully dedicated to underwriting the best managers in the mid-market, helps us minimise the risks associated with co-investing.
Some of the really good mid-market GPs that were best in class a decade ago have now graduated to the upper end of the market. We need to establish new relationships with emerging mid-market GPs to ensure ongoing dealflow without moving upmarket.
AC: The benefits of disciplined portfolio construction are clear when it comes to generating consistent returns over time. A commingled co-investment fund focuses discipline on which deals we are going to do at what price, and creates selectivity and focuses attention on balancing the portfolio to have a mix of GPs, investment strategies and sectors.
The other key element is the diligence we do on these deals to make sure they align properly with the expertise of the sponsor and hold up to scrutiny around pricing, returns, modelling, financials and industry. The co-investment portfolio we select to invest in has to be underpinned by that discipline.
“The most important aspect of our business is the dealflow, and we never take that for granted”
What is your outlook for this part of the market through 2023 and beyond?
AC: We are optimistic. As we talk with others in the market, there is an expectation on behalf of investors that our dealflow and deployment is going to be down as a result of the macro environment. Actually, it is quite the contrary: our dealflow year-to-date in 2023 was greater than it was a year ago, and we are on track to exceed the goals we had for deals in the first half of this year. That speaks to the resilience of this market and the high level of activity in the mid-market and the lower mid-market. We think this will continue, with strong dealflow affording us the ability to remain selective and stay disciplined in constructing an attractive co-investment portfolio.
BH: Relative value will remain highly attractive this year. Things are trading more closely to where they should be, relative to asset quality, so we think we will find really attractive opportunities.
The most important aspect of our business is the dealflow, and we never take that for granted. As such, we want to surround GPs with capabilities, products and services that will help them achieve their goals. By being strategic partners that can support their financing needs, we hope to stay front of mind and continue to generate activity for our co-investment programme.
What does a winning co-investment strategy look like to you? Alternatively, what are the challenges and pitfalls?
Ben Hur: A successful strategy comes down to having dedicated capital and a dedicated team, along with the sourcing engine to tap into GP relationships and refresh those on an ongoing basis. The quality of the GP really is fundamental.
Adam Clemens: You have to be a consistent player too. This is not a market-timing exercise, and the nature of deploying capital in this space does not lend itself to that. A steady, reliable and consistent investor is the one that will do best over time.
In terms of pitfalls, having inefficient processes and inexperienced personnel are really the roadblocks to success. We often hear from GPs that inefficient due diligence by inexperienced LPs becomes a time sink, so those situations need to be avoided.
The process of communicating with the GP has to be done carefully. If you are not going to do a deal, that’s OK, and people understand that – but you have to get to that decision quickly, with minimal burning of time. Sometimes it does take time, but typically the reasons why a deal isn’t going to fit your organisation are obvious in the initial call or the initial materials.
Finally, people can fall in love with a set of relationships established at the outset and build their programme around those sponsors without taking the time to refresh them. Those GPs get bigger and do bigger deals, and the co-investors end up moving up market with them. The only way to stay in the lower mid-market is to keep building new relationships over time and allowing some GPs to climb out of your space.
Ben Hur and Adam Clemens are managing directors and co-heads of co-investments at Portfolio Advisors