Choosy Family offices explore ‘co-investment’ option

The ability to choose the private equity investments in which they participate is becoming increasingly attractive to family offices keen to pursue a more active approach to investment.

Below, Paul Golden looks at how this desire for greater control has boosted interest in private equity ‘co-investment’.

Family offices’ enthusiasm for private equity continues to rise. A Montana Capital Partners study found that nine out of 10 family offices either maintained or increased their private equity allocations in 2016, with 43% expecting to increase their allocation this year.

The 2016 Global Family Office Report, meanwhile, found that holdings in private equity vehicles (including co-investment arrangements) rose by 2.3% from 2015, and that private equity co-investments accounted for 3% of the average family office portfolio.

What’s more, more than half of those interviewed by the researchers said they were looking to commit additional funds to co-investment.

Definition of co-investment

Co-investing is when investors commit capital into an investment entity alongside a private equity fund manager, rather than investing in the entity through that private equity fund manager’s fund.

Such co-investments have become popular recently, in part because investors believe that by avoiding having to pay the high management and performance fees that private equity investments typically involve they will enjoy better returns, even though there are some costs associated with co-investing as well.

In other words, family offices see co-investing as offering a low- to zero-cost way to invest, while at the same time enabling them to put more of their money to work with a select range of favoured managers.

Although hard data is difficult to find, what there is suggests that results are generally positive. More than four in ten of the limited and general partners surveyed by Palico for its Summer 2016 Global Private Equity Compass, for example, stated that co-investments outperformed traditional, “co-mingled” private equity fund investments.

In 2015, the US Securities & Exchange Commission, in announcing an investigation into private equity charging practices, expressed concern that ordinary investors in some private equity funds weren’t being kept sufficiently informed about the co-investments in the same entities by large investors who had been invited to participate, suggesting they might be getting a better deal than those in the fee-heavy fund structure.

Greg Bedrosian, pictured left,  is managing partner and co-chief executive of investment bank Drake Star Partners, which announced last year that it would start investing its own capital alongside single family offices. He cites what he says has been increasing interest from the more sophisticated end of the family office spectrum, particularly from those offices that have been limited partners with some of the successful private equity firms.

“Even five or ten years ago it would have been rare for a family office to get directly involved in a private equity transaction, but there has certainly been year-on-year growth in activity in the sectors we are involved in – technology, media and telecoms – albeit from a low base,” Bedrosian says.

Bedrosian notes that family offices that grew up around a family business often have some sectoral experience that can be deployed when co-investing in these sectors – and that they also, for some reason, seem to have a disproportionate interest in investing in sustainable technology companies.

“Fees and value add are two of the key factors driving private equity co-investment by family offices,” he continues.

“Co-investment offers the opportunity to invest without the typical 2% management fee and 20% carried interest to the fund manager.

“However, it incurs additional costs, such as the requirement to employ in-house investment professionals, who will generally demand incentive-based compensation.”

Element of control over investments

Equally important to the family office investor is the opportunity to participate in deals that a private equity firm has already vetted, but not to be committed to all the deals that it sources, adds Richard Price, chief executive of RB Price & Co, and founder of a private equity co-investment vehicle, Private Equity Co-investments (PECO).

“Performance on any individual co-investment will be a function of how well the particular deal works out – and that may be better or worse than typical private equity fund performance,” he says.

According to Carol Pepper,  pictured left, chief executive of Pepper International LLC, a New York-based family office and consultancy, studies repeatedly demonstrate that those who manage publicly-listed securities, such as exchange-traded funds and investment trusts, struggle to outperform the market. So in order to obtain alpha for their portfolios, family offices are drawn to such alternatives as private equity investments.

As most families made their wealth in either real estate or some type of operating business that they controlled, a pivot to private co-investment puts the family in control of its investment outcome, and allows it to use its skills in managing operating businesses to grow its wealth, she and other experts point out.

Continued growth of co-investing unclear

Bedrosian acknowledges that it is hard to say whether growth in co-investment by family offices will be sustained, particularly because there is limited data on the extent to which such co-investments are actually outperforming conventional investment in private equity funds – that is, when investing directly instead as a passive “limited partner”, or LP, as those who invest in private equity funds are called.

(The private equity houses themselves are called “general partners”, or GPs.)

Pepper explains that many families operate under the premise that they can cut costs and outperform private equity funds by going direct, which is particularly true if they are focused on industries where they have deep expertise.

“However, this theory may prove false if they invest in highly technical areas where they do not have domain expertise” after all, she says.

“It all comes down to the experience and expertise the family can bring to bear on its investments.

“Many company founders prefer to work with family offices than VCs [venture capital investors, another type of private investment entity], who treat them terribly, so there is an interesting stream of deal flow moving to families.”

‘Big ask’

Stephen Culhane, partner and head of the investment management group at international law firm Arnold & Porter Kaye Scholer LLP, warns that outperformance requires institutions to successfully identify future winners and avoid the losers/underperformers – which is a big ask over a long term.

But while co-investments can present some level of adverse selection (for instance, managers may be more inclined to syndicate the deals for which they have less confidence), he says they represent a valuable source of low-cost deals that have been sourced and vetted by trusted managers.

“As a result, co-investments are – and can be expected to remain – an attractive source of low-cost alpha in many portfolios,” concludes Culhane.

“Investors with the knowledge and resources to carefully review co-investment opportunities should seriously consider opportunities to co-invest.”

What co-investing
offers family offices

Private equity co-investment appeals to family offices that want a more active involvement in their private equity investments, but which lack the resources to acquire and properly manage an individual company by themselves, experts say.

Private equity companies offer co-investment rights to certain investors, typically whom they already know, in the hope that it will satisfy this demand, while enabling them, as the general partners of their flagship private equity fund, to continue to attract investment from this and other family offices.

Co-investments are generally determined and structured by sponsors – which are normally private equity houses that are also investing, on behalf of their limited partner investors, in the same investment vehicle – on a deal-by-deal basis, although the opportunity to co-invest will be reflected in the investor’s “side-letter”. A side-letter is a sort of investor agreement that permits some deviations from the core terms of the offering, in exchange for investment.

In some cases, the specifics relating to co-investment opportunities – the percentage to be offered, for example; board representation, veto rights and so on – will be agreed at the time of the fund investment.

Many co-investors will invest directly in the co-investment parent or holding company. However, since the sponsors have a strong desire to retain control, co-investments typically involve participation through an aggregator or syndication vehicle.

These vehicles are routinely formed as limited partnerships that look and feel very much like a fund.

But the benefit of this approach is that it will have predictable governance and tax treatment, as well as terms that will be familiar to investors, and again, lower costs than a true private equity fund investment.




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