Trends of the Year: LPs going direct

It is hard to look past direct investing as the one trend among limited partners that has stirred more interest than any other this year.

From sovereign wealth funds such as Abu Dhabi Investment Authority, to pension funds including Canada Pension Plan Investment Board and Ontario Public Services Employees Union Pension Trust, to family offices such as Man Capital or Chinese fund of funds Gopher Asset Management, making direct investments in private companies has been “very hot”, as the head of private equity at a large pension fund told Private Equity International.

The reasons are varied. ADIA, the world’s second-largest sovereign wealth fund, said in July it had increased its exposure to direct private equity investments amid fears of a potential drop in returns. It cited a combination of high valuations, increasing competition and rising interest rates in the US as potentially dampening future absolute returns for private equity, in its annual report for 2016.

Others, such as Canada’s Caisse de dépôt et placement du Québec, have cited the ability to select the types of assets it feels will be more resilient amid a potential downturn.

Sovereign wealth funds in general have been preparing to ramp up direct investments. Almost half of SWFs surveyed in PwC’s Sovereign Investors 2020 report in 2016 said they would invest in targets directly, up from 21 percent two years earlier.

“They want to do it on their own,” Babak Nikravesh, a partner at Hogan Lovells and one of the organisers of the inaugural Sovereign Investors Conference in New York, told Private Equity International in late November. “Concretely, that means scaling up and putting people on the ground.”

Notable large deals by pension funds this year include CPPIB’s November acquisition of a 30 percent stake in online insurance business BGL Group and fellow pension fund CDPQ’s $400 million investment in Hyperion Insurance Group.

“By investing directly into companies, we choose different type of assets and partners very carefully and we diversify away from standard private equity transactions,” Stephane Etroy, executive vice-president and head of private equity at CDPQ, told PEI. The ability to be selective in assets allows the pension to better stand a potential economic downturn, Etroy added.

LPs are of course bulking up their teams in order to make more direct investments, such as USS Investment Management, the investing arm of the UK’s Universities Superannuation Scheme, which hired three investment professionals in October to help it pursue its continuing shift towards directs.

Interest in the strategy may have reached its peak. According to secondaries firm Coller Capital‘s bi-annual LP barometer, the number of LPs planning to make direct investments has plateaued at 31 percent, after jumping to 30 percent from 17 percent between summer 2006 and summer 2012.

The difficulty of making investments directly, as opposed to through a fund structure or co-investing with a GP, may have contributed to the levelling off of interest in the strategy. Florida’s $196 billion State Board of Administration mulled going direct, according to documents published at the beginning of the year. After robust internal discussion it ultimately passed on the proposal, citing a lack of internal staff resources.

For now, GPs do not appear overly concerned about competition from LP activity in direct investing. While the proportion of LPs who have defined allocations for making such investments remains small – around 14 percent, according to PEI‘s LP Perspectives survey published in December – market participants can expect to see further acquisitions and larger deals by LPs into the new year.

– Marine Cole and Alex Lynn contributed to this report.