Chapter_9.FoF 16/6/08 1:44 pm Page 65 Chapter 9 Co-investments in funds of funds and separate accounts By Brian Gallagher, Twin Bridge Capital Partners BACKGROUND While co-investing has been an important part of private equity investing for many years, it has recently become much more prevalent and an important area of focus for institutional and fund of funds investors. Undoubtedly, investors have come to realise that there are significant quantitative and qualitative benefits to co-investing. Like much of private equity, co-investing has become much more competitive and allocations to the best deals are coveted. These trends will likely persist into the foreseeable future. Co-investing can be done in all areas of alternative investments including hedge funds, venture capital, mezzanine and buyout investments. Equity coinvestment in buyout deals is the largest and most recognised segment and the focus of this discussion. The concepts and examples illustrated here, however, can be applied to any type of co-investment, regardless of whether the co-investments are done through a fund of funds vehicle or an institutional separate account. HISTORY OF CO-INVESTMENT Co-investment has been around for nearly as long as the buyout industry itself. The practice became mainstream during the mid to late 1990s, as institutional investors sought additional ways to deploy capital and general partners (GPs) began to see limited partners (LPs) as helpful in executing larger transactions. Initially, it was common for equity sponsors to charge a reduced carried interest on coinvestments. As the co-investment industry matured, GPs began to view co-investment investors as true partners. Deals were increasingly done with no management fee and no carried interest. CURRENT STATE OF CO-INVESTMENT Co-investing is now a mainstream and accepted component of today s private equity industry. During fundraising, GPs are routinely asked by interested LPs to address the likelihood of co-investment in their next fund. While some GPs look at co-investment as a requirement to entice certain LPs into a fund commitment, the practice has evolved into an important part of the business model for most equity sponsors, offering a wide range of benefits to both the LP and the sponsor. It is important to note that while many LPs clamour for co-investment opportunities, a significant percentage of these LPs do not have the staffing or infrastructure to respond to and commit to co-investment opportunities in a timely manner. LPs who effectively structure their organisations to execute on a co-investment programme find themselves at a competitive advantage for access to these benefits. THE BENEFITS OF CO-INVESTING TO THE LP Quantitative benefits Substantial quantitative benefits accrue to co-investing LPs. These benefits are attributable to the positive cash flow characteristics associated with today s co-investment deals, including improved net return and accelerated capital deployment. Because coinvesting is done either free of management fee and carried interest, or at substantially reduced rates, the LP will, by definition, improve its net investment returns relative to a programme that invests exclusively in funds. The improvement in net returns for an active co-investor can be as much as 300 basis points or more as compared to a standard fund investing programme. By actively co-investing, an LP can deploy capital with quality sponsors at an accel- While co-investing has been an important part of private equity investing for many years, it has recently become much more prevalent and an important area of focus for institutional and fund of funds investors. 65
In addition to the superior quantitative benefits for an LP, the qualitative characteristics associated with co-investing yield ongoing returns to the relationship between the LP and the equity sponsor. erated rate, which reduces the J-curve effect associated with its private equity investing. A thoughtful and well-constructed co-investment portfolio can also allow the institutional investor to further diversify its portfolio and increase exposure to sectors that the co-investor prefers. For many active co-investing LPs, co-investments typically comprise 25 percent or more of their overall private equity exposure. Clearly, the quantitative benefits experienced by the LP depend on the size of its co-investment portfolio. Exhibit 9.1 highlights the primary quantitative benefits associated with a significant co-investment programme. Qualitative benefits In addition to the superior quantitative benefits for an LP, the qualitative characteristics associated with co-investing yield ongoing returns to the relationship between the LP and the equity sponsor. Coinvestments allow the investor to develop close relationships with senior equity sponsor professionals. This allows the investor to obtain a firsthand understanding in how the sponsor executes the deal process and to obtain better insight into the sponsor s capabilities and operating style. Co-investments normally involve countless hours spent with senior sponsors in the course of underwriting and management of a co-investment. This is invaluable time that helps to develop strong relationships and mutual trust. The co-investment process is also an ideal time for investors to better understand how the sponsor structures and sources its deals, performs due diligence, manages the investment, works with company management, executes on their plan and exits the investment. In addition to an increased level of comfort, this understanding helps the investor to identify the strengths and weaknesses of their sponsor and to make decisions accordingly. A better understanding of the capabilities of the sponsor may lead an investor to significantly increase its commitment to the sponsor s next fund. Conversely, an unsuccessful co-investment experience may lead an investor to reduce its investment or not invest at all in the equity sponsor s next fund. The net result is that coinvestment experiences help LPs make better informed decisions with regard to their GP relationships and fund investments. BENEFITS TO THE EQUITY SPONSOR The benefits of co-investing are not restricted to the LP. In fact, co-investments generate several meaningful benefits for the equity sponsor. Foremost among these benefits is the ability for the sponsor to Exhibit 9.1: Sample net cash flow by year traditional funds of funds vs funds of funds with co-investment $ millions 120 100 80 60 40 20 0-20 -40-60 -80 Year 1 Source: Twin Bridge Capital Partners. Funds of funds Funds of funds with co-investment Co-investment drives improved net cash flow and capital deployment Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12 Year 13 Year 14 66
Exhibit 9.2: The co-investment process Sourcing Due diligence Key terms and governance Post closing do larger deals than its funds may otherwise support, while retaining control over the investment necessary to ensure success. The alternative for the equity sponsor is to pursue a joint investment with another sponsor, which can lead to difficult governance provisions and a decreased ability to effectively control operating decisions. Additional sponsor benefits to co-investment include an expanded LP market, closer LP relationships and the benefit of unique viewpoints brought by the co-investor. Because co-investing has become such a pervasive part of private equity and desired by so many LPs, an equity sponsor that embraces coinvestment can expand its universe of desirable LPs. Like the co-investor, the sponsor also develops a closer relationship with LPs through co-investing. Finally, a knowledgeable and experienced coinvestor brings a unique viewpoint to the transaction and can add insight, relevant advice and a network of resources that can all serve to improve the outcome of the investment. As with the LP, these benefits are realised through careful management by the equity sponsor throughout the coinvestment process. As with any investment, becoming part of the process is crucial to becoming part of the benefits. The next section describes how LPs and GPs work together to manage the co-investment process effectively. THE CO-INVESTMENT PROCESS Every co-investor will have differences in how they source, underwrite and manage co-investments. There are, however, many common features associated with the construction of a successful co-investment portfolio. The simplest approach to describe co-investing and its corresponding benefits, is to step through the process of completing a co-investment transaction (see Exhibit 9.2), including sourcing, due diligence, management of the deal and ultimately investment realisation. Sourcing Because sourcing for co-investments typically comes from existing fund commitments, it is important for the co-investor to express a strong desire for coinvestments both at the time of the fund commitment and through periodic follow up calls and meetings. Just as equity sponsors call on intermediaries to generate deal flow, potential co-investors must be diligent in routinely conferring with their fund relationships regarding their ability to participate in potential co-investment opportunities. The sponsor wants a co-investment partner who can respond quickly to the opportunity and can meet the timeline needed to close the deal. In recent years, the timeline to win and close a deal has become very compressed. This trend is unlikely to abate any time soon. Typically, a sponsor will send to potential coinvestors summary material that describes the transaction and the investment thesis to be carried out by the sponsor. Each co-investment institution will have its own process and procedures for determining interest in an investment. Co-investors differentiate themselves by responding to these opportunities as quickly as possible, even if there is no interest in the transaction. Equity sponsors will often state that a potential co-investor who quickly turns down a deal is much preferred to one that takes weeks to conclude on whether or not it is interested. Due diligence Once a co-investor has decided to move forward with a transaction, the due diligence phase commences. This phase can be lengthy and involve voluminous amounts of material. Fortunately for the The sponsor wants a co-investment partner who can respond quickly to the opportunity and can meet the timeline needed to close the deal. In recent years, the timeline to win and close a deal has become very compressed. 67
While the process of committing to a co-investment may take weeks or months, equity sponsors prefer that the co-investment partner moves through the process in real time alongside the sponsor. co-investor, the core due diligence on the transaction should have been led by a capable equity sponsor and the co-investor should be able to rely on this work. The co-investor often elects to perform supplemental due diligence to improve its evaluation of the investment. Additional resources and relationships that may not be available to the equity sponsor are frequently called upon to provide advice, appraisals, and general information. The result is diligence that is highly reliable and thorough. Every transaction is somewhat different in the due diligence materials needed and produced. Typical items include: market analysis; detailed financial modelling; meetings with company management; third-party diligence review; identification and understanding of the risks and their potential mitigants; and identification of growth opportunities and exit options. By the time a co-investor has been contacted by the sponsor about an opportunity, it is common that some of the information outlined above has been completed, but not all of it. The co-investor will review the initial and ongoing information with the sponsor as the due diligence material is completed. This process can take as little as weeks, but more typically is completed over two to three months. After the completion of all due diligence, each coinvestor needs to formally commit to the co-investment. This commitment is subject to that institution s underwriting and investment committee requirements. While the process of committing to a co-investment may take weeks or months, equity sponsors prefer that the co-investment partner moves through the process in real time alongside the sponsor. Key terms and governance After formal commitment to a co-investment, the final step before funding is the completion of all of the legal documents. These include documents used to acquire the subject company, as well as the documents governing the terms between the equity sponsor and co-investor(s). The legal documents used to acquire the company include the purchase agreement, debt documents and employment agreements. The co-investor will typically review these documents to ensure that they understand the terms of the investment, but will generally have very few comments given that these documents were prepared by a capable equity sponsor and their legal counsel. In effect, legal documentation that raises a number of substantive issues become a due diligence question as opposed to a legal question. The documents governing the agreement between the sponsor and the co-investor should of course be reviewed in detail by the co-investor, with experienced legal representation. Often, these terms will be documented in a limited liability company agreement that includes all of the equity investors as signatories. In this agreement, there are several key terms that the co-investor will want to consider, particularly in an effort to remain aligned with the equity sponsor. These terms include: Pre-emptive rights. If the equity sponsor puts in new equity on any terms, the co-investor will want the right to invest its prorated share in the same deal. Tag-along rights. If the equity sponsor exits any or all of its investment, the co-investor will want to be able to tag along in the sale for its prorated amount. Registration rights. If the exit for the investment is a public offering, the co-investor will want to be able to register and sell its shares alongside the equity sponsor. Information rights. The co-investor will want access to at least quarterly financial information on the performance of the company. Depending on the size of the co-investor s investment, a board seat or board observer seat may be warranted. Typically, if a co-investor has 20 percent or more of the equity in a deal, the co-investor should expect a seat on the company s board; if a coinvestor has 10 to 20 percent of the equity, a board observer seat is more typical; below 10 percent of the equity, the co-investor will typically not attend 68
board meetings and will rely on its financial information rights to remain informed. Proper structuring with regard to each of the rights outlined above is important for the co-investors to feel aligned with the equity sponsor. Post closing The role of a co-investor after closing the transaction is significantly different from the role of the sponsor. The equity sponsor will spend considerable time managing the investment and conferring with management regarding operating issues, acquisition opportunities and other items. The co-investor will monitor the investment s performance closely, either directly through board participation or periodic discussions with the sponsor. Depending on the nature of the investment, there may be a need for additional equity to execute acquisitions. In these cases, the role of the co-investor is more important and the time spent monitoring the deal will be more considerable. MYTHS ABOUT CO-INVESTING While the benefits associated with co-investing are significant and the process fairly straightforward, confusion persists within parts of the institutional investor community with regard to downsides associated with co-investing. These myths include adverse deal selection concerns, rights afforded to co-investors as part of their transactions and underestimation of the effort required to execute a successful co-investment programme. Some institutional investors believe that co-investing leads to adverse deal selection. Their concern is rooted in a belief that equity sponsors will only show their worst deals to co-investors and keep the most promising deals for themselves. This belief runs counter to the experience of most co-investors and does not pass the reasonableness test for a number of reasons. First, equity sponsors do deals they think will perform well and will meet return hurdles. Sponsors, however, do not have prescient knowledge of which deals will work perfectly and which will not. Second, and perhaps more importantly, equity sponsors value and need their LP relationships and therefore strive to ensure that co-investment LPs are satisfied with the sponsor s performance. It is not in the best interests of any party, therefore, to present a substandard deal to a potential co-investor and place an important relationship at risk. Another myth exists with regard to a potential coinvestor s rights in a transaction. Some perceive the co-investor as a marginalised player in deals. The reality is that a fine line exists between a co-investor allowing the sponsor the freedom to execute on its plan and the co-investor ensuring that their interests are protected to the extent possible. Sophisticated co-investors, however, often have the ability to manage this line through active involvement in the deal process and by continuing to participate post close. These investors will determine which minority rights are critical to ensuring a satisfactory outcome. They may also supplement the point of view they bring through board or observer seats, and may be critical in helping finance the future needs of the company. These opportunities allow the co-investor the proper rights to actively manage their investment. Arguably the most common myth seen today is that co-investing is a simple business and an easy extension to fund investing activities. This is incorrect. While the co-investment process is straightforward, it requires careful management to be successful. Like other investment disciplines, there is an art and science to managing a co-investment programme and the skills needed are developed through years of experience. Some of the parties described above see their coinvestment role as passive, including participation in all deals presented by their fund relationship. The history of the buyout industry reflects countless institutions that underestimated the time and effort that goes into building and maintaining a successful co-investment programme. As a result, there are a finite number of institutions today that are well known and well regarded as outstanding co-investment partners. These partners spend significant While the benefits associated with co-investing are significant and the process fairly straightforward, confusion persists within parts of the institutional investor community with regard to downsides associated with co-investing. 69
Many factors determine success in co-investing. First and foremost is experience. A co-investor who has invested in many deals over numerous business cycles develops invaluable experience and insight into what deals will work and which will not. time making independent decisions and participating heavily in the co-investment process. The most successful of these institutions continue to see through the myths today and remain diligent about the selection of their partners and independent about their decisions. SUCCESS FACTORS IN CO-INVESTING Many factors determine success in co-investing. First and foremost is experience. A co-investor who has invested in many deals over numerous business cycles develops invaluable experience and insight into what deals will work and which will not. Quantity and quality of co-investment deal flow is a function of the reputation and experience of the coinvestor. Nothing is more important to an equity sponsor than a co-investor with experience, a stellar reputation, an ability to commit quickly to a potential deal and to stick with the diligence alongside the equity sponsor until the deal closes. It should also be noted that a co-investor builds its reputation by being a supportive partner in good times and bad. There will be circumstances in which a deal does not perform, necessitating corrective action and additional equity. It is in these situations where an experienced and responsive co-investor can distinguish itself. Successful co-investors must also take an objective and dispassionate view of each opportunity presented. Equity sponsors can become enamoured with a company or management team. A good co-investor will try to discern if the investment strategy and the skills of the sponsor warrant an investment. Experienced co-investors will often do only a fraction of the investments offered, so selectivity is an important factor to be considered. Turning down a co-investment that a sponsor believes strongly in is a delicate process that can test the strength of the fund relationship. THE FUTURE OF CO-INVESTING Co-investing will persist as an important and growing segment of the private equity industry into the foreseeable future, with both LPs and equity sponsors continuing to seek the benefits afforded by the coinvesting relationship. While some recent activity shows equity partners partnering on investments to the exclusion of co-investors, the difficulties in governance and increased scrutiny of regulators make these arrangements tenuous. As a result, traditional co-investment LPs will play an increasingly important role in helping sponsors complete future investments. As institutions continue to add co-investing to their list of investment activities, however, the search for topperforming co-investment partners will become increasingly competitive. Just as traditional fund investors relentlessly pursue first quartile fund investments, expectations for co-investments will be similar. The ability to achieve superior co-investment results will continue to be defined by those institutions that align with experienced and proven professionals executing on a proactive and thoughtful programme. Brian Gallagher is a managing partner of Twin Bridge Capital Partners (Twin Bridge). Based in Chicago, Twin Bridge focuses on investing in middle-market buyout funds and co-investments in North America. Twin Bridge currently manages over $500 million in separate accounts. Mr Gallagher has spent most of his career in the middle-market buyout industry, having previously worked at UIB Capital, PPM America and Arthur Andersen. He received his MBA at Northwestern University s Kellogg Graduate School of Management, and a BA in accounting from the University of Notre Dame. He holds the chartered financial analyst designation and is a certified public accountant. Mr Gallagher is a member of the CFA Institute and AICPA. 70