VIII
Making Co-Investments Work by Brian Schleimann Nordlund, PKA AIP April 2015
Brian Nordlund is a partner at PKA AIP – the alternative investment arm of PKA. Brian is responsible for the Private Funds mandate, which includes monitoring a total exposure of c.$4.5 billion and managing an annual investment budget of c.$700 million covering both fund commitments and coinvestments with private equity, infrastructure and energy funds. Before joining PKA AIP, Brian was engagement partner at the consultancy firm Quartz+Co. In his nine years as management consultant, Brian has provided advisory services to Nordic private equity managers, typically in connection with commercial due diligences. Brian graduated as MSc in Economics and Business Administration in 2004 from Copenhagen Business School, specialising in finance and accounting.
complaining that LPs, who have been screaming out for co-investment opportunities, are unwilling to pick up the opportunities provided. Likewise, some LPs have noted that the co-investment opportunities that have materialized have not met expectations. Since 2013, PKA AIP has actively pursued coinvestment opportunities on behalf of the Danish public pension fund, PKA. As of July 2015, ten coinvestments had been closed, corresponding to 21 per cent of new commitments since 2013. This achievement has been a consequence of dedicated efforts and initiatives to position PKA AIP as an attractive coinvestment partner. While the rationale and approach to co-investment naturally differs between investors, in the following we present our rationale for capitalizing on co-investment opportunities, as well as an overview of how we make the co-investment process work.
MAKING CO-INVESTMENTS WORK
In recent years, we have seen co-investments move ever higher on the agenda for both GPs and LPs as a means of strengthening investor relations, as well as boosting LP returns. In several cases, however, the co-investment process has caused frustration and distress in the relationship despite good intentions from both sides. We have spoken to a surprisingly large number of GPs who feel frustrated with their co-investment experiences,
WHY MAKE CO-INVESTMENTS
Co-investments can be attractive to LPs for several reasons. To us, there are two significant arguments for investing alongside GPs: (1) to reduce cost and
24
expenses, and (2) to extract more value from our current strong relationships. Both are means to achieving the overarching goal of increasing returns for our pension savers.
ADVERSE SELECTION
The concern of adverse selection – that deals offered to LPs as co-investments may be less attractive – is particularly strongly voiced. The implicit logic is that the GP is trying to reduce its exposure to a transaction in which it has less faith. Ensuring that the timing of entry is completely aligned between the fund and coinvestors is the primary way to address this concern.
The first reason is obvious, as investing without fees and carry can be an effective way to increase the return on a private funds portfolio. As with many other pension funds, PKA is measured not only on net returns, but also on total direct and indirect cost base, and must publish its cost ratios every year. A pension fund that has an ambitious private funds program will be significantly disadvantaged in such a benchmark, given the high costs associated with the asset class. Co-investments are an effective way to bring down the weighted indirect cost.
A more challenging concern is whether the transaction offered fits within the GP’s investment parameters and the criteria on which its past success relies. For example, a transaction for which the GP is seeking co-investment may be too large to fit with the GP’s competences. In an attempt to mitigate adverse selection risk, many LPs have established a rigid due diligence process, with some even going so far as to require their own independent review process alongside the GP’s. All investors need to be comfortable about the investment decisions they make, and there is no onesize-fits-all solution in this respect. Nonetheless, LPs ought to ask themselves what they can bring to the due diligence process that is not already sufficiently addressed by the GP.
The second argument has more to do with the internal costs and the most efficient allocation of the investment and monitoring teams’ resources. To the extent that co-investments are made with existing GPs, the efforts involved in the due diligence on the fund commitment, as well as in monitoring and maintaining the relationship, can be leveraged to commit additional capital at relatively low marginal effort relative to making a commitment with a new GP.
Think about how closely GPs are – or should be – scrutinized on capabilities, track record, processes, and team resources during the LPs’ diligence process. Applying the same criteria to the typical LP investment team (including our own here at PKA AIP) would clearly suggest that most LPs are not in a position to credibly second-guess the due diligence of the GP. This should not be read as a motion against diligencing co-investments, but rather as a suggestion that due diligence should focus on the GP’s ability to create value in this particular investment, rather than on an assessment of the target company and the market.
SOME OF THE CHALLENGES TO OVERCOME
In the hunt for improved net returns, there are a number of additional risks and challenges with which any LP must get comfortable. We have seen academic studies that suggest that LPs making co-investments end up with lower net returns than peers who do not make co-investments. There are several possible explanations for this counterintuitive outcome, and we will look at two of them – adverse selection and interest alignment. Avoiding adverse selection and securing real alignment with the GP should be top of mind for any LP. Getting these parameters right is challenging, and any unwillingness to accept the risk of getting them wrong is likely to kill just about any co-investment opportunity screened. In our view, addressing these parameters in a thoughtful way is a key determinant in the success of a co-investment program.
For that reason, PKA AIP believes it is important to spend more time understanding how the investment thesis and transaction characteristics match the GP’s core competences, and how close the deal is to the manager’s defined sweet spot.
25
ALIGNMENT
MAKING IT WORK
Somewhat related to the adverse selection concern is that of alignment. Alignment should be a concern for both LPs interested in co-investments and those that do not participate in such investments. Alignment of interests needs to be established and maintained between the GP, the fund (and its investors), and the co-investors. We would argue that both LPs who co-invest and those who do not can reach their own alignment objectives by the same means – no fees and carry on co-investments.
We have worked on three fronts to both meet our co-investment objectives and address the potential challenges. 1. ESTABLISH THE PROCESS AND THE INVESTMENT CRITERIA
First of all, LPs with a co-investment agenda need to accept that co-investments travel at a different speed than traditional commitments to private funds. This requires LPs to establish an investment committee (IC) approval process that can approve investments within a short period. Even before reaching the IC, the deal must be handled through a process designed with efficiency in mind. This includes careful upfront prioritization and detailing of the criteria on which any opportunity is going to be assessed. Our process supports commercial, legal, and tax due diligence as well as signing within three weeks of being notified of an opportunity already fully diligenced and digested by the GP. Every LP is different; for some it may be right to design a shorter process, for others a longer one. The objective is to achieve a clear and transparent process to all parties involved. This also increases the likelihood of transaction success, and supports the relationship in cases where the transaction is unsuccessful.
An LP without the ability or willingness to coinvest should be concerned about the terms for coinvestments as well. Allowing the GP to profit from co-investments creates a potential misalignment – is the GP pursuing this particular deal because it is the best investment for the fund, or because it allows them to expand assets under management and, with them, their fee base? This should work in exactly the same way for LPs who are co-investing. By removing additional revenue potential for the GP, the particular co-investment is more likely to be offered because it is right for the fund, thereby using the alignment mechanisms of the fund to help minimize adverse selection as well. Hence, a no fee/no carry policy is a key priority from both a cost perspective and to secure proper alignment.
2. COMMUNICATE AND MARKET THE PROCESS AND APPETITE
In our experience, it has proven more effective to keep pushing the message about co-investment appetite as opposed to waiting for opportunities to materialize. Despite the recent focus on objective allocation of coinvestment opportunities (which should be endorsed), it does help to be top of mind with our GPs. We see a clear correlation between how high co-investments have been on the agenda during our communication with a GP and the likelihood of the same GP bringing us a co-investment opportunity. The pivotal point in this communication is not only the appetite itself, but also the specific investment criteria and process, which helps the GP understand what the LP is looking for.
For the same reasons, we find co-investment funds or co-investment rights (as opposed to co-investment opportunities) inappropriate, as they incentivize the GP to make decisions that may not be in the interest of the main fund. To clarify, we are not arguing that adverse selection risk can be completely eliminated, or perfect alignment achieved (you are never fully aligned), but rather that careful upfront thinking can mitigate the associated risks. Furthermore, we believe that investing without fees and carry should – all else being equal – generate a return that is 300-400 basis points higher than investing with a traditional cost structure. In our view, this premium is sufficient to outweigh the additional risks once they have been properly mitigated.
3. DELIVER
Designing the process and conveying the message can only take you so far, but in the end an LP with a desire to
26
make co-investments needs to step up to the plate when the opportunity arises. Too often, the opportunities arrive at inconvenient times. Holiday seasons, periods with extensive time away from the office, or other opportunities taking up time are all legitimate reasons for passing on an opportunity. Nevertheless, to be an attractive co-investment partner, an LP needs to be able to execute when the right opportunity is offered. We expect this from our GPs, and if we want to coinvest with them, we need to be willing to do the same.
27