A CO-INVESTMENTS PRIMER Hedge Funds and Private Equity

Transcription

1 A CO-INVESTMENTS PRIMER Hedge Funds and Private Equity

2 INTRODUCTION The current market environment in which yields remain low and correlations elevated between equity and bond markets has been driving institutional investors to consider a greater role for opportunistic alternative investments in their portfolios. In particular, co-investments are increasingly being sought for return enhancement and diversification across a range of asset classes, including private equity, hedge funds, real estate and infrastructure. JOSEPH PACINI Managing Director, Head of BlackRock Alternative Investors, Asia Pacific A key attraction of co-investments is the ability to participate directly in invitation-only opportunities alongside principal investors, with a single layer of fees costing less than investing through sponsors funds. Few other structures offer investors exposure to investment theses that are dealspecific and diversifiable, alignment with the interests of fund managers and the ability to partner with skilled dealmakers pursuing buyout deals or less liquid hedge fund strategies, such as aviation finance and distressed lending. This paper will look at how co-investment activity may grow this year, current trends driving co-investment opportunities in hedge funds and private equity and explore how challenges to coinvesting can be overcome. Our aim is to help investors interested in expanding their co-investment programmes or co-investing for the first time make informed decisions about this increasingly prominent part of the alternative investment universe. [2] A CO-INVESTMENTS PRIMER

3 PROPORTION OF LP RESPONDENTS GROWING DEMAND FOR CO-INVESTMENTS While co-investing has been around for some time, interest has grown significantly in recent years. Asian investors are particularly interested in adding more co-investments or trying them for the first time. Looking for example at a global survey of 140 private equity investors, 67% of limited partners (LPs) in Asia, where co-investing has been less common, said they expected to increase their co-investment activity in By comparison in North America and Europe, 51% and 46% of LPs respectively said they planned to co-invest more this year. All survey participants indicated they were expecting their co-investments to outperform at some level, and 52% of LPs said they were expecting significantly better returns from co-investments compared with funds. Co-investments historically have taken place between private equity managers and investors. However, within the past decade, as hedge fund strategies have branched out to less liquid strategies that require more upfront capital and longer holding periods, more hedge funds have made co-investments available. A survey of 198 hedge fund managers representing $1 trillion in assets under management in November 2013 showed 60% of managers have offered co-investments or would consider offering them, while only 8% said they would not make co-investments available. 2 FIGURE 1: ASIAN INVESTORS ARE PARTICULARLY KEEN ON CO-INVESTING MORE IN 2014 Private Equity LP Plans for Co-Investments by Location 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 67 % 11% 0% 22% Asia Source: Preqin, February % 36% 1% 12% North America 46% 40% 0% 14% Europe Increase Co-Investment Activity Maintain Co-Investment Activity Decrease Co-Investment Activity Uncertain FIGURE 2: HEDGE FUND MANAGER CO-INVESTMENT PLANS Will continue to offer or would consider offering Not appropriate for my strategy Would not offer to investors Have offered in the past, but don t plan to again Source: Aksia, December Survey respondents were asked to select all that apply. PRIVATE EQUITY AND HEDGE FUND CO-INVESTING TRENDS While all co-investments have a principal investor and one or more partners, there are different co-investment approaches depending on the sponsor. In this section, we will compare the different co-investment approaches of hedge fund managers and private equity general partners (GPs) and discuss current trends giving rise to opportunities. Private equity co-investors typically take controlling equity positions in companies. After taking actions to improve the operational efficiency of the portfolio company which can include restructurings, management changes and asset dispositions, co-investors will ideally exit through an IPO or sale of the target company to a strategic buyer. The holding period for private equity co-investments can vary widely and may last 10 years or longer. Hedge fund co-investors will partner with managers in either debt or equity trades, often involving a high degree of complexity in private markets. Exits from hedge fund co-investments often occur after asset liquidation, contractual maturity or refinancing. The holding periods for hedge fund co-investments usually range between six months to four years. 1% 8% 37% 64% 1. Preqin, LP and GP Co-Investment Survey, February A 2012 Preqin survey found that in terms of location, 44% of LPs with an appetite for co-investments are based in North America, 31% in Europe and the remaining 25% in Asia and Rest of World. 2. Aksia, 2014 Hedge Fund Manager Survey, December [3]

4 Private Equity A strong observable trend in private equity co-investing has been the growth in deal flow. That has a direct bearing on the potential to generate higher returns with co-investments because more opportunities are available. Looking at BlackRock s own private equity platform, co-investment deal flow in 2013 rose nearly 4 times compared with five years ago. This year will likely see GPs offer at least as many co-investment opportunities as they did in % of GPs surveyed in February 2014 said they planned in the year ahead to offer either the same number of co-investment opportunities to LPs or more, while only 2% said they would offer fewer opportunities. 3 GPs have seen co-investments as a source of much-needed capital in the post-financial crisis world and a way to build stronger relationships with LPs. When asked what the benefits of offering co-investment rights are, three-in-four GPs said building stronger relationships with LPs. Fundraising, while improving, remains below pre-crisis levels, partly driven by financial institutions reducing exposure to private equity in the wake of the Volcker Rule and Basel III. In this environment, GPs have been keen on solidifying their LP base for future funds. LPs aiming to co-invest should stay flexible across the private equity spectrum, including growth equity, venture capital, real estate and natural resources. In the US market, for example, smaller deals for minority investments and add-on acquisitions have been on the rise. In 2013, minority investments made up 24% of all private equity deal activity, the largest share in a decade. 4 Case Study 1: Growth Equity Deal Background: The US energy boom has sparked strong demand from small and medium-sized companies for investment capital. An energy infrastructure fund invited Private Equity Partners (PEP), BlackRock s dedicated private equity platform, to co-invest in a midstream natural gas start-up company that provides gathering, processing, compression, transportation and marketing services to producers in the Marcellus region, one of the largest shale areas in the US. Investment Rationale: The start-up s management team has a long tenure in the oil and gas industry and past experience in other shale plays. Marcellus shale is located near the US northeast, which has large natural gas needs. Result: The portfolio company was sold to a strategic buyer, and the deal was fully realised at more than 4 times as of December FIGURE 3: STRENGTHENING CO-INVESTMENT DEAL FLOW Number of Co-Investment Deal Opportunities Seen by BlackRock Source: BlackRock, data as of December Preqin, LP and GP Co-Investment Survey, February PitchBook, 2Q 2014 US PE Breakdown, March [4] A CO-INVESTMENTS PRIMER

5 Hedge Funds Hedge funds have been producing compelling co-investment opportunities for investors by exploiting capital supply imbalances brought about by financial system deleveraging. As traditional lenders and the prop desks of banks reduced their market participation in response to tightened regulations, a vacuum was created. Skilled managers have been able to move into this space and specifically provide urgent capital directly to businesses in need, purchase heavily-discounted, illiquid and impaired assets from companies needing to dispose of them and supply capital to industries where demand has outpaced available funds. Less liquid strategies such as direct lending, leveraged loans, distressed securities, structured credit, asset-backed securities, as well as residential and commercial mortgagerelated activity typically have holding periods of up to four years, positioning them somewhere between a liquid hedge fund strategy (less than a year) and private equity. The complexity of trades involved in these strategies and their liquidity profile often cause less liquid opportunities to be overlooked by many large institutional funds. That contributes to their potential value for co-investors who are willing to tolerate less liquidity in exchange for higher potential alpha. Case Study 2: Opportunistic Credit Deal Background: A manager on BlackRock s hedge funds platform that specialises in bespoke senior secured debt origination had sourced a large wireless communications company in need of funds as it emerged from bankruptcy protection. BlackRock was invited by the manager, which had previously underwritten first lien loans to the company, to co-invest in a senior-term facility. Investment Rationale: The loan was structured as a debtor-in-possession facility (DIP), which is a financing structure for companies in the US bankruptcy process that has priority over existing debt, equity and other claims on the borrower. The DIP was collateralised by underlying wireless spectrum, an asset with limited supply and growing demand based on expanding mobile data traffic. Result: An exit would be predicated upon regulatory approval of an interim operating plan, as well as a confirmed Plan of Reorganization for the company. In this event, the DIP would roll into an approved exit facility. Otherwise, the DIP may be in place through its maturity, or be addressed through an alternate exit plan. FIGURE 4: PRIVATE EQUITY AND HEDGE FUND CO-INVESTMENT APPROACHES Investment Focus Representative Investments Exits Liquidity of Underlying Investments Private Equity Invest alongside GPs who are making investments to take a stake in operating companies. Primarily equity: Buyouts Growth equity Natural resources Private investments in public equities Restructurings Mezzanine financing Private equity co-investment monetisation typically occurs through a public offering or sale to strategic buyer. Multiple exit options at time of investment. Typically ranges from three to five years. Hedge Funds Invest alongside hedge fund managers in direct trades. Both equity and debt: Asset-backed investments Direct lending Private investments in public equities Bank portfolio liquidations Distressed investments Real estate restructuring and repositioning Exits are often defined when the deal terms are drawn. Exit options typically include maturity, asset liquidation or refinancing. Ranges between six months to four years. Source: BlackRock. [5]

6 OVERCOMING THE CHALLENGES OF CO-INVESTING Many investors are interested in direct co-investing, but the reality is that not everyone can do it because of the unique challenges involved. The ability to source, analyse and execute deals in a limited timeframe is crucial and requires significant resources and expertise. For investors aiming to build up their co-investment programme or looking to add co-investments to their portfolio, it is therefore important for them to find wellconnected, highly-experienced partners with access to robust deal pipelines. Sourcing Opportunities While co-investment deal flow is growing, investors still have to be diligent about consistently checking with managers on opportunities, particularly as competition increases. It is now commonplace for investors to actively approach managers raising funds about co-investment opportunities. GPs and managers often share deal flow information with partners whom they have co-invested before. Experience and relationships are therefore key. Professional networks based on strong and longstanding industry relationships with managers, strategic partners, banks and other market participants are important to building relationships. Also, co-investors who have experience with multiple GPs and managers will have a direct advantage in learning about new opportunities. FIGURE 5: PROFESSIONAL NETWORKS IN PRACTICE Private Equity Advantage: BlackRock s private equity team has committed more than $2 billion to more than 100 companies alongside 50 different GPs since Result: Close GP relationships often lead to unique and exclusive co-investment opportunities. For example, BlackRock was the only investor invited by a sponsor to co-invest in a buyout deal for a cellular tower operator. In this case, BlackRock had co-invested with the GP before in a similar deal, and was able to respond quickly to a second invitation to co-invest, resulting in the sponsor not having to reach out to other potential co-investors. Hedge Funds Advantage: BlackRock s hedge fund solutions team has been cultivating manager relationships for nearly two decades. In addition, BlackRock has been a day-one investor in about 60% of the managers on its hedge funds platform. Result: Becoming an early or day-one investor has helped greatly with learning about co-investment opportunities as they arise. In March 2012, as a day-one investor in a hedge fund sponsoring a co-investment to provide urgent capital to a drilling company, BlackRock was positioned to learn about the deal early and commit fully to it, having conducted due diligence on the manager already. Source: BlackRock. [6] A CO-INVESTMENTS PRIMER

7 FIGURE 6: MAIN RISKS AND BENEFITS OF CO-INVESTING Risks: Illiquidity Risk The target of co-investment deals are typically less liquid compared with public market securities and therefore difficult to offload in a hurry. Concentration Risk Co-investments provide focused exposures to individual deals. A diversified approach to building a co-investment portfolio can avoid the risk of a lopsided impact from losses on a deal. Benefits: Strong Return Potential Co-investments offer direct access to high conviction deals from managers. Portfolio Diversification Because they are deal-specific by design, co-investments typically have low correlations to each other and to traditional asset classes, providing strong risk-reducing potential within a portfolio of co-investments, as well as in a broader total fund context. Adverse Selection Risk Choosing co-investments from a limited pool of opportunities can increase the risk of sub-optimal performance. Improved Relationships By partnering closely with sponsors, investors participating in co-investments can improve their chances of learning about future deal flow. Investors who are keen on co-investing but may not have significant networks or extensive co-investment experience to source opportunities may want to consider co-investment multi-manager vehicles, as opposed to co-investment funds created to co-invest in deals from a single vehicle or a single deal. Deal Analysis and Execution Having proven and consistent co-investment deal selection processes in place can greatly help avoid potential adverse outcomes. Each opportunity requires due diligence on the deal itself, the deal sponsor and portfolio implications within a limited timeframe. Due diligence can include preparing comparable sector and valuation analyses, conducting regulatory and legal reviews, and modelling investment returns, risks and exit scenarios. Exit strategies are critical because co-investment targets are often illiquid and direct deals can be challenging to unwind in a hurry. Deal analysis requires time and expertise and investors should be prepared either to dedicate adequate resources to due diligence or to partner with an external manager with the relevant capabilities and experience building properly diversified co-investment portfolios. For example, a fund of direct coinvestments can be an effective tool to reduce concentration risk, the possibility an investor is overexposed to an industry, sector, GP or manager. Delays in fully committing to a deal can mean the difference between participating or not because sponsors typically want co-investment partners who can respond quickly to opportunities and can meet the timeline needed to close a deal. Relatively swift execution when it comes to co-investments is ideal. Indeed, 58% of GPs surveyed in February 2014 said the main downside of offering co-investments was potentially delaying the deal process. 5 Interest in co-investing will continue to expand at a rapid pace, which is why it is also important to keep in mind the obstacles that may prevent some investors from being co-investors. Sourcing opportunities in a competitive marketplace and having the resources needed to conduct due diligence and execute in a relatively short timeframe can be daunting for those new to co-investing and difficult even for seasoned co-investors. Having a partner with access to a significant deal pipeline and the experience and capabilities required to analyse a growing volume of opportunities can help overcome co-investing s challenges. 5 Preqin, LP and GP Co-Investment Survey, February [7]

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