Annual Review 2015: Spotlight on direct and co-investing

Limited partner fervour for co-investment and direct investment opportunities ramped up a notch in 2015. Hardly any interviewee Private Equity International quizzed about forces shaping the industry failed to mention the trend.

A growing number of LPs jostled to stand alongside general partners, and often competed with them, for deals, further blurring the lines between investor and manager. And none more so than Canadian pension funds that stood at the forefront of the evolution of the LP investor base.

Among them, the C$74 billion ($53 billion; €47 billion) Ontario Municipal Employees Retirement System (OMERS) set out its ambitious five-year plan to target 90 percent direct investments by 2020, up from 70 percent currently.

OMERS PE made two investments in June, acquiring, with fellow Canadian investor Alberta Investment Management Corporation as its junior partner, UK-based consultant Environmental Resources Management for an enterprise value of $1.7 billion, and US-based liquid bulk transportation services company Kenan Advantage Group.

When OMERS’ global head of private equity Mark Redman joined the firm 13 years ago, the LP’s investments were split one-third directs and two-thirds funds. Talking to PEI in December, Redman was clear on the firm’s motivation to go it alone.

“First and foremost I’d point to returns. I look at the money we would ‘lose’, in inverted commas, in fees and in carry to a funds programme, and I look at the returns that we generate in our direct programme, and I’m very comfortable with the model that we have.”

The pressure to watch fees was felt by all LPs in 2015, compounded by the threat to future return multiples posed by soaring asset prices. Enduring incentives to co-invest included the chance to obtain more control over asset selection and management and to cultivate manager relationships that could smooth the path to preferred LP allocations in funds.

LPs with different levels of financial resources felt the pull. The Lancashire and London Pensions Partnership (LLPP), with a pool of about £10 billion ($14.6 billion; €12.9 billion) of assets and liabilities created out of the merger of the Lancashire County Pension Fund Committee (LCPF) and the London Pensions Fund Authority (LPFA), told PEI that it was ready to take the leap. The LPFA had already extended its reach into direct investing with a housing project in east London and a £500 million infrastructure partnership with Greater Manchester Pension Fund.

“We will do more co-investment deals, but we are interested in the right deal,” LCPF director George Graham told PEI in July.

The pension was winding down its fund of funds investments. “We will be looking at more direct investment and look at those funds that bring the co-investment opportunities. And we will work with investors in the fund,” Graham added.

Managers have responded by offering increasing volume of co-investment deals, whether to top-up acquisition capital or in recognition that it would help fundraising, and launched managed accounts tailored to specific partners. In mid-2015, the California Public Employees’ Retirement System committed $50 million to Tailwind Capital Partners II Co-Invest B launched specifically for it to invest alongside the US mid-market firm’s Tailwind Capital Partners II fund.

There was also an uptick in the number and size of commingled co-investment vehicles launched. In 2014, 31 co-investment vehicles closed, raising $5.4 billion, according to PEI Research & Analytics. This jumped to 37 funds raising $11.9 billion in 2015.

French manager Ardian was among them, closing its fourth co-investment vehicle on €1.1 billion in November, split between dollar and euro pools of capital. Half of its LPs were new investors, with a high number of family offices.

However, several times over the course of the year PEI heard executives sound a note of caution about LPs stepping beyond their traditional remit, warning that appetite was not always matched by resources, skills, investment agility or even commitment when offered deals.

Hamilton Lane managing director for Asia Juan Delgado-Moreira told PEI that his firm would not be pulled along with the tide toward direct investing, and would always keep the bulk of its private equity investments in funds.

“You have to continue to invest in funds if you want the luxury of that dealflow. Those that shift north of 60 percent [direct investing] will find that the quality of their dealflow goes down dramatically and the risk they take in terms of doing deals will go up.”

Caisse de dépôt et placement du Quebec (CDPQ) executive vice-president of private equity and infrastructure Andreas Beroutsos warned that the trend might come back to haunt the industry. CDPQ’s $23 billion private equity portfolio is 55 percent invested in directs and 45 percent in funds.

“We will only know how well these [other LPs’ co-investments] have fared when the water recedes,” Beroutsos told PEI. “We are already high in the current cycle, and people are taking risks they were not taking three to five years ago. And it’s because they feel more confident. Some people doing co-investments are doing so without the relevant teams. They often see that a big private equity firm has already underwritten the deal, so they say, ‘It must be safe.’”

Whether such investments fail to perform will only be revealed in future investment cycles. For now, it seems LP thirst for co- and direct investment opportunities remains unsated.